Pay particular attention to tax-related issues in operating your stable. Although some consider the applicable tax code provisions onerous, they are, in reality, manageable. However, it is most advantageous to be familiar with the provisions most commonly applicable to this business. They are the difference between long-term capital gains rates and ordinary income tax rates and the hobby loss and passive loss issues.
The following pages are written to merely acquaint you with equine tax issues. The American Horse Council publishes two very good reference books dealing with taxes. They are Tax Tips for Horse Owners and The Horse Owners Tax Manual. These publications are the tax references for the equine industry. If you are seriously considering becoming an owner or are already an owner, we encourage you to acquire these publications for your library. For more information, please visit the American Horse Council's web site at www.horsecouncil.org.
The Capital Gains Spread
The maximum federal income tax rate on long-term capital gains is 15%. Maximum ordinary income tax rates are 35%, so the spread between the two is significant. For certain taxpayers, the differential is made even greater by the effect of state taxes. Unlike other assets, the holding period to obtain long-term capital gain treatment on sales of horses is two years. Legislation is now pending to change the holding period to one year.
The Hobby Loss and Passive Loss Issues
The two problems most often faced by horse owners when audited by the IRS or comparable state taxing agencies are the "hobby loss" and the "passive loss" rules. To prevail, owners must demonstrate that they have exercised prudent business planning, followed good business practices and have documented their business activities.
Hobby Loss Provisions
In general, the tax laws referring the hobby loss rule provide that to deduct expenses that exceed income, the taxpayer must demonstrate that she is engaged in her horse-related activity with the intention of producing a profit. Initially, the burden of proof falls upon the taxpayer. However, if a profit can be shown in two of seven consecutive years beginning with the first loss year, the burden shifts to the IRS to disprove the "general presumption of profit intent."
The IRS cites nine factors in determining whether an activity is a hobby or business. They are very basic business points covering management style, degree of knowledge of the taxpayer, utilization of expert advisors, time and effort the taxpayer spends in the activity, the expectation for asset appreciation and the presence or absence of recreational aspects. From the IRS' perspective, a hobby correlates with fun, while a business means work: In other words, it is okay to enjoy the business, but only if you have a convincing profit motive.
Material Participation "Passive Loss"
Under the "passive loss" provision, in order to deduct losses incurred as a result of equine business activities from other income, an owner must be able to prove that she is materially participating in the activity. Material participation is satisfied by establishing that the owner spends 500 or more hours actively participating in the business during any taxable year. If the owner does not meet the 500-hour test, she may qualify with 100 or more hours if she participates on a regular, continuous basis throughout the year and meets certain other criteria. However, satisfying the requirements of this test is more difficult.
Hours spent by a husband and wife can be combined to accommodate these requirements. If an owner cannot prove material participation, losses can only be taken against other passive income. The sale of the investment, however, triggers the deductibility of all past losses disallowed.
Treat your horse-related activities as you would any other business venture. Carefully plan your time and the timing of your horse-related income and expenses. Simple documentation will aid in proving your intent to make a profit and active participation.
Horses may generally be depreciated as three or seven year property. Longer periods of depreciation may be elected, and always apply in the case of foreign-based horses. Yearlings, racehorses and breeding horses over 12 are depreciated as three-year property; all others are depreciated as seven-year property.
In the case of IRS rules, note that age is determined by the actual date of birth, not the industry-accepted January 1 of each year. Furthermore, to prevent taxpayers from purchasing at the end of the year and obtaining a large depreciation deduction, more than 40% of the purchases during one year are made during the last quarter, reduced depreciation results.
The 2009 Economic Stimulus Bill provides an expensing allowance and bonus depreciation for horses purchased. Please visit the American Horse Council's website or contact your equine tax professional for more information.