The 2003 tax cut offered great perks for investors -- and also created a few snags that should be avoided.

THE FEDERAL INCOME-TAX rate cuts included in the 2003 law were nothing but good news for investors. But that doesn't mean there weren't some nasty little potholes left behind by our pals in Washington. Here are five tax-wise investing tips on how to make the most of the new laws -- while avoiding some potentially painful blow-outs.

1. Get Long-Term Tax Breaks on Short-Term Investments
Our current federal income-tax rate structure gives you plenty of incentive to make every effort to satisfy the more-than-one-year holding period rule before selling appreciated investments held in your taxable accounts. That way, you'll qualify for the new 15% maximum rate on long-term capital gains rather than get stuck paying short-term capital-gains rates, which are the same as rates on your as ordinary income (and can run as high as 35%). Sometimes, though, a long-term holding period just isn't possible -- especially if you speculate on stock-market movements by making short-term trades in ETFs (exchange-traded funds). Well-known ETFs include QQQs (QQQ) (which track the Nasdaq 100 index) and Spiders (SPY) (which track the S&P 500).

The good news: You can beat the system. Here's how. Instead of ETFs, consider trading in broad-based equity index options. These investments are treated as so-called Section 1256 contracts. This is very beneficial because all gains and losses from going long or short in Section 1256 contracts are automatically considered to be 60% long term and 40% short term. Your actual holding period doesn't matter (weird but true). This means short-term profits from trading in broad-based equity index options are taxed at a maximum federal rate of only 23%. That sure beats the 35% maximum rate on short-term ETF profits.

You can buy broad-based options that track moves in major sectors like pharmaceuticals, transportation and defense. For info about exactly which equity index options qualify as broad-based options eligible for the tax-favored 60/40 treatment (and which count as "narrow" options that don't receive tax-favored treatment), check out the brokerage firm Twenty-First Securities' Web site.

2. Be Sure to Lock in the 15% Rate on Qualified Dividends
You probably already know that qualified dividends are now taxed at a mere 15%. But do you know about the holding-period rule? Specifically, you must hold the stock on which the dividend is paid for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the first day the stock begins trading without the right to receive the upcoming dividend payment). If you don't pass this test, the dividend is taxed at your regular rate, which can be as high as 35%. Ouch.

3. Think Twice Before Borrowing to Buy Dividend-Paying Shares
Here's a tactic I've seen recommended as a savvy new investment strategy: Borrow to buy dividend-paying stocks to hold in your taxable brokerage-firm account. The idea is that you can then deduct the resulting interest expense against an equal amount of ordinary income that would otherwise be taxed at up to 35%. But you only pay 15% on all the qualified dividends and long-term capital gains generated by your leveraged stock investments. Unfortunately, this seemingly smart strategy is a loser for many folks. Here's why.

Reason No. 1: You may be unable to claim a current deduction for all the interest expense on borrowings to buy those dividend-paying stocks. This is because loans used to buy stocks (or any other taxable investment securities) generate so-called investment-interest expense. It can be deducted only to the extent of net investment income. Any excess investment-interest expense gets carried over to the next tax year and subjected to the very same net investment-income limitation rule all over again. For this purpose, net investment income is defined as taxable interest income, short-term capital gains, certain royalty income and the like, minus any allocable expenses. Investment income doesn't include long-term capital gains or qualified dividends. Since you can't count long-term gains or qualified dividends as part of your net investment income, you probably won't have nearly enough to currently deduct all the interest expense you rack up to buy those dividend-paying stocks. If this is your situation, there's no tax advantage to borrowing to buy dividend-paying shares. Sorry. The exception is when you have enough net investment income (typically because you have lots of interest and short-term capital gains) to currently deduct all your investment interest expense. However, relatively few fall into this category.

Reason No. 2: Another little-known fact is that your brokerage firm is generally allowed to lend dividend-paying shares held in your margin account to short sellers. You then receive payments in lieu of dividends as compensation for the dividends you would have received on those lent shares. However, payments in lieu of dividends are ineligible for the 15% maximum rate. Instead, they get taxed at your regular rate, which can be as high as 35%. The tax-planning solution here is to keep your dividend-paying shares in a separate brokerage firm account that has no margin loans against it (assuming your brokerage firm is nice enough to permit this).

 Also See
· How to Exploit the New Tax Law
· The SmartMoney.com Capital Gains Guide

Notwithstanding the preceding warnings, there's one common scenario in which borrowing to buy dividend-paying stocks can actually make sense -- purely from a tax perspective, that is. If you use home-equity-loan proceeds to buy the shares and can deduct all the interest under the qualified residence interest rules, it would be a tax-smart arrangement, because your interest expense is fully deductible for "regular" tax purposes. However, you'd be unable to deduct any of the interest under the dreaded alternative minimum tax (AMT) rules, which, unfortunately, affect more and more folks every year. In any case, borrowing against your home to invest in stocks strikes me as a pretty risky maneuver and a not-very-good idea.

4. Watch Out for Tax Rate on Foreign Dividends
Dividends from qualified foreign corporations are theoretically eligible for the 15% maximum tax rate. But watch out when dividends are subject to tax withholding by a foreign country. Under the complicated foreign-tax-credit rules, you may not receive credit for the full amount of withheld foreign taxes. So you could wind up paying more than the advertised 15% rate to the foreign country even after collecting your U.S. tax credit. For this reason, try to avoid investing in corporations subject to foreign-tax withholding rates of more than 15% on dividends. Or you can simply buy American and eliminate this concern entirely.