US tax laws and the ‘Who’s On First’ routine

One of the great comedy routines of all time is Abbott and Costello’s “Who’s On First.” It’s great because it makes sense and doesn’t make sense at the same time.

Costello asks if he is a catcher, and fields a bunt, he would throw the ball to who at first base? Abbott answers, “Naturally.” So Costello replies, “I throw it to Naturally?” No, Abbott replies, you throw it to Who.

Naturally replies Costello. No, says Abbott, you throw it to Who. This is followed by, in sequence, Naturally, well OK, say it that way, I didn’t say it that way, I said throw it to Naturally, no you throw it to Who, Naturally.

When it’s time to pay the players, Costello says who picks up the check for the first baseman. Of course he does Abbott replies. The man’s earned it hasn’t he? Who has earned it? Yes.

This is ridiculous use of language and precise use of language, all at the same time. So it is sometimes with the tax law. And thus we often feel that we’re in a comedy routine. And our clients are ready to hit us with a bat.

Net capital gains are tax favored, subject to a lower rate of tax. Many people think I mean a long-term capital gain. I do not.

A net capital gain may include a long-term capital gain (LTCG). Or maybe not. The LTCG must first pass a hurdle that involves netting other types of capital gains and losses, including longterm and short-term. It may then become a net capital gain.

Section 1231 gains may also become net capital gains. These are gains from the sale of either land or depreciable property if these assets are used in a business. Oh, and held for more than one year.

But these Section 1231 gains must pass their own gauntlet. They must be netted with any current year Section 1231 losses. And they must then be netted against any net Section 1231 losses from the past 5 tax years. Then, they too, may be net capital gains.

So the (kind of) best way to say it is that capital gains are from investment property and Section 1231 gains from business property.

Unless the business is selling that particular type of property. Then the property is inventory and is neither a capital nor a Section 1231 asset. It then cannot become part of a net capital gain.

My sister, who is perhaps the worst joke teller in the world, ends all jokes with “get it?” This is not how you end a joke. I won’t ask you if you “get” my explanation above.

The tax world, I have learned, has some Abbotts, who do get it, and some Costellos, who think they get it until a particular question leaves them flummoxed. And I think we all know we want to avoid a flummoxed tax adviser.

Although both LTCG income and Section 1231 gains can end up as taxfavored net capital gains, they travel their own road to get there. Section 1231 gains in particular have some bumps in their road.

The new tax law tells us that capital gains may be invested in an opportunity zone (OZ) to permit the capital gain to be deferred until 2026. The gains must be reinvested within 180 days of realization.

Section 1231 gains must wait until December 31 of the year they are realized to determine if they qualify as the type of capital gain that may be deferred into an OZ. The gain has to be a net capital gain to qualify and we must wait to discover its status.

Taxpayers with investment interest expense can only deduct that interest if they have investment income. LTCG income may be treated as investment income. Section 1231 gains may not – they are not from an investment.

So both LTCG and Section 1231 gains may be part of a net capital gain, but only the LTCG is a capital gain that may be offset by investment interest.

Section 1231 and LTCG income can both be net capital gains. But net capital gains are not capital gains; sometimes they are more than that, other times not. If you can follow whether it is Who or Naturally fielding that throw, maybe tax law also makes sense to you.