Tax Planning Opportunity
Tax Benefits to Horse Owners Increase Dramatically
The 2003 Tax Act, recently passed by Congress to stimulate the economy, has several very favorable provisions for the equine industry.
The Act reduces the capital gain rate from 20% to 15% for sales and exchanges of capital assets after May 5, 2003, including installment payments received from transactions that closed prior to May 5. The lower rates apply generally to assets held for more than one year, and to horses held for breeding or sporting purposes for at least 24 months. This would include all racing and breeding stock, but not horses held for resale or as inventory. This reduced rate expires Jan. 1, 2009. Satisfying the capital gains holding period is more important today as the spread between ordinary income and capital gains rates increases (i.e., the difference between 35% ordinary marginal rate and 15% capital gains rate).
To demonstrate the impact, assume you purchased a 5-year-old maiden mare in January 2001 for $200,000. If you sell the mare, now in foal to a top commercial sire, after May 5, 2003 for a gain of $500,000, you would owe $75,000 (15% of $500,000) in taxes. If you had sold the mare for the same price a day earlier, you would owe $100,000 (20% of $500,000) in taxes. Your tax savings is $25,000.
Prior to the 2003 Tax Act, a buyer of depreciable property was able to expense up to $25,000 of the cost of qualifying property (including horses and farm equipment) purchased, so long as the total of all depreciable property acquired during the year did not exceed $200,000. Subsequently, the amount of the allowance has been quadrupled to $100,000, so long as the total purchases of all depreciable property by the buyer during the year does not exceed $400,000. Above that cap, the amount allowed to be expensed is reduced dollar for dollar for each ollar invested above $400,000. The allowance applies to all depreciable property placed in service between Jan. 1, 2003 and Dec. 31, 2005 (retroactive) and applies to all depreciable property whether or not the property has been used before. This is not the case with the new, more restrictive, provisions.
The 2003 Tax Act increases first-year bonus depreciation to 50% of the cost of horses and other eligible property acquired after May 5, 2003. This provision sunsets on Dec. 31, 2004, limiting this benefit to the two tax years (2003 and 2004). Prior to the Tax Act, first year bonus depreciation was 30%. The most significant limitation on bonus depreciation restricts eligibility to property the "original use" of which commences with the purchaser/taxpayer. In the equipment context, the term "original use" has been defined to exclude any used equipment, regardless of whether the prior use corresponds to the use of such property by the purchaser/taxpayer acquiring the depreciable asset.
This definition may cause some confusion when applied to horses. Horses are not single-use assets like equipment. A horse that has been raced, but never bred, should qualify for bonus depreciation claimed by the taxpayer acquiring the horse for first use as a breeding animal; i.e., the "original use" of the horse for breeding purposes commences with the purchaser. A maiden mare or first-year stallion (or a fractional interest therein) should qualify as depreciable property eligible for bonus depreciation.
Caveat: Anticipate that the IRS will question this interpretation of the law and could disallow bonus depreciation for horses other than here the original and only use commenced with the 2003 purchaser/taxpayer. There is no issue with respect to unraced calendar yearlings and 2-year-olds acquired and placed in service during 2003, as neither category would have a "use" prior to its first use as a racehorse.
You may elect out of the bonus depreciation on a class by class basis, claiming 30% instead of 50% of the bonus first year depreciation for qualified property, or electing not to claim bonus first year depreciation at all. You should consider making this election to claim the 30% first year bonus depreciation, or electing out of it entirely, if you have net operating losses about to expire or anticipate being in a higher tax bracket in future years. Expensing, bonus depreciation, nd regular depreciation in combination should result in an effective deferral of taxes. When earned income is taxed, it will be at more favorable rates. The 2003 Tax Act reduces individual marginal income tax rates from 38.6, 35, 30, 27, 15, and 10% to 35, 33, 28, 25, 15, and 10%, retroactive to Jan. 1, 2003.
The reduction of the capital gains and marginal income tax rates, quadrupling of the expensing allowance, and increase in first-year bonus depreciation should allow participants in the horse industry to realize significant tax savings.
The changes implemented by the 2003 Tax Act do not operate in a vacuum. Old friends like the passive loss and hobby loss provisions remain in the Internal Revenue Code. Nevertheless, taxpayers actively participating in the equine industry should be rewarded with significant reductions and deferrals of federal income taxes. Every taxpayer's planning opportunities will differ, and the impact of state and local taxes will vary, but all taxpayers should review what they own and how they structure transactions in light of the tax law changes. For example, it would make sense for some owners to sell their horses, particularly homebreds, at favorable capital gains rates and reinvest those dollars in other horses eligible for the expanded expensing and depreciation allowances.
Thoroughbred breeder Joel B. Turner is a member of Frost Brown Todd in Louisville, Ky.