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In the year that the mutual funds were sold, you would report the sale on schedule D. You would also include your cost basis of $25,000. The net result would be a loss of $17,000 on schedule D. However, since the sale of mutual funds result in a capital loss, you will only be able to deduct $3,000 of the loss against ordinary income. The unused loss would then carry forward to the 2010 return and you could deduct up to $3,000 against ordinary income and the remainder continues to carry forward to subsequent years.
If you have any capital gains, you can offset capital gains with the capital losses to any extent, but you can only deduct $3,000 per year against ordinary income. Worst case scenario is that it would take 6 years to fully deduct the loss.