Owning a race horse can be a thrilling and potentially lucrative investment. However, the initial purchase of a horse and subsequent expenses such as boarding, transportation and veterinary care are substantial. Therefore, many equine enthusiasts choose to pool resources and purchase the animals through a partnership or a limited liability company (LLC). Hence, the cost to each individual is reduced while still enabling the experience of owning a race horse.
Ownership as a partner or LLC member may allow an investment in a higher quality animal than you could otherwise afford or perhaps allow the purchae of multiple horses and hence spread the risk therefore minimizing the impact of potential financial and emotional disappointments. If a management company is involved, you will gain access to effective professional management of the venture.
However you choose to own your race horse: there are also potential tax advantages to your investment.
Returns on your investment will be derived from race earnings, potential breeding fees or syndication of stud fees and perhaps upon the ultimate sale of your horse. Race horses are generally depreciated over a three year period. Therefore, significant depreciation, losses and expenses are available to offset income of the LLC and perhaps other income of LLC members.
As such, significant tax deductions may inure as a result of the investment. However, there are several issues to consider; specifically the "hobby loss" and "passive loss" rules.
Hobby Loss Provisions: To deduct expenses that exceed income, the taxpayer must demonstrate that they are engaged in 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 these factors in determining whether an activity is a hobby or business as follows:
1. THE MANNER IN WHICH THE TAXPAYER CARRIES ON THE ACTIVITY: Sound business practices, a business plan and modifying methods of carrying on the operation when it has been unsuccesful support the existance of a business.
2. THE EXPERTISE OF THE TAXPAYER OR HIS ADVISORS: The taxpayer's industry expertise or an effort to learn how to successfully manage in the equine industry will support a business objective.
3. THE TIME AND EFFORT EXPENDED BY THE TAXPAYER IN CARRYING ON THE ACTIVITY: This factor considers the time devoted to the horse activity, either in planning, supervising or in performing labor. If substantial time is not devoted by the taxpayer but he employs qualified people, the lack of time he spends will not necessarily indicate a hobby.
4. EXPECTATION THAT THE ASSETS WILL INCREASE IN VALUE
6. THE TAXPAYER'S HISTORY OF INCOME OR LOSSES IN THIS ACTIVITY
7. THE AMOUNT OF OCCASIONAL PROFITS, IF ANY, WHICH ARE EARNED: The costs of maintaining horses in training are generally greater than the amount of purse monies available. This is tolerable to owners because most have a desire to be a part of the sport and because of the potential for profit.
8. THE FINANCIAL STATUS OF THE TAXPAYER: A lack of substantial income from other sources is favorable in determining that your horse operation is a business. Conversely, a large income from other sources may work against you.
9. ELEMENTS OF PERSONAL PLEASURE OR RECREATION: Personal motives for recreation or pleasure are contrary to assertion of the activity as a business. This does not mean the taxpayer can't enjoy the activity, but motives must include an objective of making profit.
The IRS does not add up the number of positive and negative factors and base its decision on a mathematical result. To the contrary, the courts appear to have placed greater emphasis on some of the factors than they have on others.
"Passive Loss": Under the "passive loss" provision, to offset losses incurred as a result of equine business against other ordinary income, an owner must be able to prove that they materially participate in the activity. A taxpayer materially participates in an activity if he or she works on a regular, continuous and substantial basis in equine operations.
A taxpayer is required to identify the amount of his or her participation in a trade or business activity for each year. The type and quantity of time documented determines whether an activity should be treated by the taxpayer as passive or non-passive. A taxpayer can have a significant financial interest in a business, and yet not materially participate.
Material participation is a year by year determination. Consequently, it is conceivable that a taxpayer could be passive in one year and materially participating in the subsequent year. If an activity is considered passive, its losses can only be deducted to the extent of passive income.
Note that the ultimate sale of the investment will trigger the deductibility of all past losses disallowed.
Therefore, even if you own your race horse as part of a group and the venture is intended to be profitable, operated in a business-like manner and has sufficient expertise and resources: each taxpayer must consider their own unique position when determining the tax treatment of their investment.
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