Farm Bill Passes; Significant Changes Benefit Horse Business
In late May 2008 a portion of the Equine Equity Act was passed by Congress overriding the President’s earlier veto of the larger legislation known as the Food, Conservation and Energy Act of 2008. In the November 18, 2005 issue, MarketWatch reported that the US House and Senate had both introduced slightly different versions of the Equine Equity Act with three main benefits to horseman:
- Make horses eligible for federal emergency assistance as are other species of livestock;
- Establish a three year recovery period (depreciation) category for all race horses, regardless of age when placed in service; and
- Reduce the holding period to one (1) year to qualify for capital gains on the sale of a horse or horse related assets held for use in a trade or business.
Unfortunately, neither the House or Senate bills introduced in late 2005 became law, but the first two provisions outlined above have now passed all the hurdles in the 2008 “Farm Bill” (of which the Equine Equity Act is but a small part) and will take effect for four years (unless extended by Congress) starting on January 1, 2009. The third proposed major change to be introduced, the reduction of the capital gains holding period to one year to bring this period in line with the holding period for most other assets used in a trade or business, was left out of the final version without adequate explanation. The two positive changes for those in the horse business made in the legislation, although temporary, afford an opportunity to make business/tax planning decisions with greater certainty, at least during the next four years.
Eligibility for Federal Emergency Loans:
For those horsemen and horsewomen victimized by devastating natural disasters prior to the effective date of this legislation, there was no ability to access federal emergency loans. This was not the case for other livestock farmers. Now the definition of eligible farmers has been changed to specifically include “equine farmers or ranchers” and the definition of “livestock” expanded to include horses. Those in the horse business suffering the effects of natural disasters now will be eligible for the same federal assistance available to other farmers. This change, for example, should make “horse farmers or ranchers” subject to any reoccurrence of MRLS, severe drought, flooding or other qualifying natural disaster, eligible for federal emergency assistance heretofore not available.
Shorter, Uniform Depreciation Period for Racehorses:
Perhaps the most significant benefit of the recently passed legislation for those in the horse business is the reduction of the depreciation period for all racehorses to three years, regardless of when the horse is placed in service. Under prior law (“Pre- Farm Bill Tax Law” on the chart below) a racehorse purchased for business use could only be depreciated over the shorter three (3) year depreciation period if it was placed in service after it turned two (2) years old. If the taxpayer started the process of breaking and training the horse for racing in the fall of its yearling year, there was a risk that such a horse, if depreciated as an eligible three (3) year property, upon audit could be re-characterized as a seven (7) year property. The likely consequence of unsuccessfully asserting the right to three year recovery would be the recapture by the IRS of the tax benefit taken, together with a penalty and interest payment.
With the change in the law in the Farm Bill, the IRS can no longer take the position that the horse was placed “in service” as a yearling when the breaking and training began, instead of when the horse first raced (usually, but not always, after the second calendar birthday of the horse), and therefore must be depreciated over the longer seven year recovery period applied to all horses other than those two years of age or older when placed in service. This technical position was antithetical to the underlying purpose of the depreciation rules, i.e. to give the taxpayer an opportunity to “depreciate” the assets used in its trade or business over a period of time reasonably related to the actual functional life of the asset.
Fortunately, the Farm Bill’s Equine Equity Act provisions directly address this inconsistency and eliminate any confusion by treating all race horses as three (3) year property eligible for full depreciation within three and a half years after placed in service. The half year convention will usually still apply (unless the taxpayer acquires and places in service a disproportionate amount of depreciable assets in the last quarter of the tax year, then the mid quarter convention may apply) to all horses in the first year depreciation is taken, regardless of when acquired or placed in service during the tax year. This change brings into line the actual useful life of the asset being depreciated (i.e. a racehorse) many of which have finished their respective racing careers within three years after first placed in training. This change will only be in effect for the tax years 2009-2013 unless extended by Congress. Otherwise, Internal Revenue Code Section 168(e)(3)(A) (the section setting the depreciation rules) will revert to its prior, confusing and somewhat treacherous form.
Potential Market Impact/Planning Opportunity:
Yearling buyers considering deferring some purchases until after the effective date of the Farm Bill (January 1, 2009) to take advantage of the favorable change in the depreciation rules should first compare the net after tax effect of purchasing yearlings in 2008, and taking advantage of the generous bonus depreciation and expensing provision of the Economic Stimulus Act (passed in February 2008). This temporary “stimulus” package (applicable to purchases in the tax year 2008) affords the taxpayer bonus depreciation of fifty percent (50%) of the purchase price of the new asset in addition to an increased expensing limit.
Certain rules apply to bonus depreciation to make its grant by Congress consistent with the underlying purpose of the Act. The bonus depreciation option cannot be used if the property acquired had been previously used in a trade or business. It must be new (unused) property satisfy the underlying purpose of the stimulus bill, i.e. to stimulate production of new goods and crank up the economy. For example, if the taxpayer purchases an older racehorse with multiple starts on its past performance, or an older mare with several foals on her produce record, purchasing these assets would not entitle a buyer to take advantage of the generous bonus depreciation offered by Congress in the 2008 economic stimulus bill.
The bonus depreciation, however, is available for qualified (i.e. new) assets regardless of when purchased during 2008. The regular depreciation is also still available for the remaining fifty percent of the purchase price (basis) of the asset. The combination of the two forms of depreciation can lead to immediate depreciation deductions of up to sixty two and a half percent (62.5%) of the cost of the acquired asset in the first tax year of ownership, which compares vbery favorably to the roughly thirty percent (30%) deduction available under the old seven year depreciation schedule.
A further benefit offered by the Economic Stimulus Act is the immediate increase of the dollar amount of the expensing allowance to $250,000. In other words, a taxpayer can immediately write off, as if it were an ordinary expense, up to $250,000 of the cost of any eligible asset (horses and farm equipment included) acquired in 2008. Some special rules apply to certain classes of farm equipment (vehicles). This expensing option is reduced dollar for dollar by the purchase of eligible property in excess of $800,000 during the 2008 tax year. The taxpayer must affirmatively make the election to treat depreciable property in this manner. Taking full advantage of this provision alone could result in a tax saving of up to $100,000 for a taxpayer in the 40% marginal tax bracket, including federal, state and local taxes ($250,000 expense deduction x .40 = $100,000).
Congress has combined the benefits of the Economic Stimulus Act with the benefits of the Farm Bill to provide different, but compatible tax benefits to purchasers of horses and equipment during 2008 and beyond. The Farm Bill changes will sunset at the end of tax year 2013 so there is a narrow window to take advantage of some unique tax planning opportunities. Overall these benefits are designed to encourage investment and keep the markets active during a time when the perception is that the economy, and the horse market, needs a little push.
- Those in the horse business should anticipate increased interest in the investment in racing and breeding stock as a result of the increased tax advantages of ownership afforded by the amended Internal Revenue Code. Horse owners should consider selling to meet anticipated demand.
- Evaluate all horse assets held in the trade or business and consider the merits of taking built in gains and adjusting horse portfolios (culling and upgrading) to enhance likelihood of profitability.
- Consider long term business plan. Many of the current code provisions on cost recovery, expensing and capital gains will sunset in 2013 or sooner.
As each taxpayer’s circumstances will vary significantly based upon all facts and circumstances, readers should consult with a tax attorney or accountant before taking any action in reliance upon any information provided in the charts or in the text of this article.