Many horse owners don’t realize the importance of Factor No. 4 of the IRS Regulations. This Factor is called “Expectation That Assets Will Appreciate in Value,” and has taken on greater significance than formerly, particularly in situations where the taxpayer has been unable to show any profit years. Evidence that assets used in connection with the horse activity have appreciated in value can be used to dispel any notion that the enterprise is not in fact operated as a business.
Factor No. 4 can be crucial if you are audited by the IRS and cannot show a profit year. Appreciation in value of your farm or ranch property can help prove that you have an honest expectation of making a profit despite a string of losses. The term “profit” encompasses appreciation in the value of assets such as land and/or livestock used in the activity.
Evidence that assets used in connection with the horse activity have appreciated in value can be proven by expert testimony or by an appraisal report. The fact that a portion of the realty is used for a residence or other purposes does not preclude the Tax Court from considering the portion used for the horse activity.
Improvements such as barns, arenas, pastures, fencing, breeding sheds, stalls, storage facilities and landscaping all fall within the type of improvements likely to help increase the value of the land itself.
In addition, Factor No. 4 takes into account the appreciation in value of the bloodstock owned by the taxpayer and developed or trained under his stewardship. The fact that certain animals have increased in value because of the efforts of the taxpayer tie into this factor even though the assets were not sold. The Tax Court has recognized the importance of holding onto one’s most valuable bloodstock because it enhances the reputation of your farm and helps produce the line of foals you are focusing on.
A certified appraisal of the farm should show that the book value of the realty has increased significantly due to improvements made in connection with the horse activity, and not merely because of population growth or other external factors. The appraisal should also indicate that the land is used exclusively for the horse activity, and that the highest and best usage of the land is that of a horse farm.
In the case of Engdahl the taxpayer’s land appreciated from $83,146 to $225,000 and the horses appreciated by $18,000 over their cost basis. The Tax Court held that this in itself was indicative of a profit motive. The l986 Meagher decision, likewise, looked favorably on evidence that two of the petitioner’s horses had appreciated in value. There are many similar discussions in Tax Court cases.
This Factor is also important in justifying a taxpayer’s expenditures on hiring professional trainers and incurring other costs related to the horse activity.
You should also be able to prove that the land was purchased, maintained and improved with the expectation that it would appreciate in value, and that this increase would enhance the overall profitability of your horse venture. This can be proved by establishing a formal business plan, by obtaining a certified appraisal, by conferring with legal counsel, and other procedures.
The Scheidt case involved a taxpayer who was “in anticipation that his stallion would prove himself capable of siring winning foals.” This feeling of “anticipation,” however vague and subjective, was a fact that the Tax Court said proved the owner had the requisite expectation under Factor No. 4, even though the particular asset used in his activity, i.e. a stallion, was never bred.
It is better to show that this expectation pertains not to just one, but to the entire group of horses that you own. The actual or “potential” increase in value should be documented by a bloodstock agent or other bloodstock appraiser.
John Alan Cohan is a lawyer who has served the horse industry since l98l.
