preserve and grow the value of an estate on behalf of his or her heirs. Roughly speaking, the government wants about one-third of what you earn and half of what you have when you die. Individuals often view the IRS as an enemy who relentlessly confiscates a significant portion of their income. This is a reasonable assessment for ordinary income items such as salary and interest. However, investors interested in capital appreciation have a more complex relationship with the IRS. In this situation the IRS can be viewed as a partner whose influence can be at times costly and at other times beneficial. We have no choice but to live with this partner, so it is important to understand how the IRS operates. In a world without taxes, an investor who owns an asset sees a direct relationship between the future price of the asset and his gain or loss (e.g., the investor's return is 10 percent if the asset appreciates by 10 percent). The situation changes when the IRS becomes our partner. With the introduction of long-term capital gains taxes, the tax man says: "If you earn a positive return, give me 20 percent of it; if you earn a negative return, I will refund 20 percent of the loss." This is the essence of our relationship with the IRS with respect to appreciation. However, our uninvited partner adds four important caveats-and three of these actually favor the taxpayer: II The timing option. Capital gains taxes are due only when an investment is sold. You decide when to cash in your chips and settle up with the IRS. II The short-term option. The IRS will bear 40 percent of the loss if you earn a negative return during the first year. If you earn a positive return, you can let the gain ride, holding the position for at least one year. When you eventually sell, the IRS takes only 20 percent of the gain. II The disposal option. The IRS waives its claim to capital gains tax on your appreciation on assets you give to charity or hold until death (the step-up in basis). The fourth caveat limits the tax man's generosity: II No absolute subsidy. The IRS will not subsidize overall net losses. Realized losses can only be netted against gains or carried forward to offset future gains.3 The IRS will bear part of a realized loss only if the investor has other realized gains against which to net the loss. Taxes lower the expected return on investments. Capital gains taxes make the government a de facto partner in all investment activities. The terms of this partnership are complicated, and a number of its terms can be worked to the investor's benefit. The option of a tax-free step-up in basis, the ability to defer recognition of gains and accelerate recognition of losses, asset allocation and asset location 3Taxpayers are allowed to deduct up to $3,000 in realized losses from ordinary income. Excess losses can be carried forward.