Slots, Racing Fund, and Tax Law
New York Thoroughbreds as an Attractive Investment

By Russell Hereth and John Talbott

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IRC Section 1231

IRC section 1231 provides taxpayers with the opportunity to treat transactions under a best-of-both-worlds scenario. Gains and losses from the disposition of Section 1231 assets are netted, and when gains exceed losses, the net gain is treated as long-term capital gain for that year. For individuals, this gain would be subject to the more favorable long-term capital gains rates. This is true even though depreciable property used in a trade or business is not a capital asset under the definition of capital assets found in IRC section 1221. In a year when section 1231 losses exceed gains, the net section 1231 loss is treated as ordinary and offsets other types of income.

IRC section 1231(c) does require a look back to determine if net section 1231 losses had been recognized (deducted as an ordinary loss) during the previous five years. Those prior losses must be recaptured as ordinary income before the long-term capital gain treatment will apply to the remainder of the net section 1231 gain. Once it has been recaptured, the net section 1231 loss is not recaptured again.

To qualify for IRC section 1231 treatment, a property must meet the standards outlined in Treasury Regulations section 1.1231-2:

• Depreciable real or personal property (including rental real estate), and
• Livestock held for draft, breeding, dairy, or sporting purposes.

The property normally must have been held for more than 12 months. However, livestock such as horses held for draft, breeding, or sporting purposes must be held for 24 months or more to qualify [Treasury Regulations section 1.1231-2(i)].

Exhibit 1 provides a flowchart of the tax rules applicable to the sale and exchange of thoroughbreds. Note that if an individual has the intent to breed or race a raised horse but then succumbs to a sale offer within 24 months of purchase, the proceeds are taxed as ordinary income, because a raised horse generally has a zero basis. If the 24-month holding period has been met, however, the sale may qualify for long-term capital gain treatment.

Racehorses are not capital assets, but they do qualify as items used in a trade or business. If purchased horses are sold at a gain and the 24-month holding period has been met, any depreciation expense that has previously been deducted must be recaptured as ordinary income.

The remainder of the gain will be section 1231 gain and in many cases subject to long-term capital gains treatment. For example, assume that a three-year-old racehorse, Born to Boogie, was purchased in January 2005 for $100,000 and was sold in APRIL 2007 for $125,000. Depreciation taken on the animal under depreciation rules totaled $100,000. This $100,000 must be recaptured as ordinary income under IRC section 1245. The remainder of the gain will be section 1231 gain and taxed at long-term capital gains rates (Exhibit 2).

If one further assumes the purchase of an unraced three-year-old for $200,000 in August 2006 and the sale of that horse for $250,000 in December 2007, the entire gain will be taxed as ordinary income. If the holding period had been greater than two years, the depreciation would have to be recaptured as ordinary income, but any remaining gain would have been subject to IRC section 1231 treatment.

Break-Even May Result in a Positive Cash Flow

Assume, for example, that a taxpayer with an effective federal marginal tax rate of 35% spent $25,000 on a stud fee in 2004 and another $45,000 from years 2004–2007 to raise and train the resulting foal. If we disregard the tax implications of the mare and assume that the foal is sold for $70,000 in 2007 after the two-year holding period has been met, a venture-accounting scenario would show a net income of zero:

Sale price of colt $70,000
Stud fee $25,000
Raising/training 45,000 70,000
Net income $ 0
Even though no economic gain results from the sale, the taxpayer obtains a positive cash flow of $14,000 by converting ordinary income into a long-term capital gain via section 1231. The cash flow calculation is as follows:
Tax savings associated with
raising/training ($70,000 x 35%)
$24,500
Sale price of colt $70,000
Basis of raised colt 0
Gain on sale $70,000
Taxes paid (70,000 x 15%) 10,500
Net cash savings $14,000

The positive cash flow stems from the 20% differential (35% to 15%) on long-term capital gains and ordinary income (20% x $70,000 = $14,000).

While losses are not desirable, they are sometimes unavoidable. The losses that result in a net IRC section 1231 loss are generally preferable to capital losses. As anyone who has ever been unfortunate enough to sell securities at a loss can attest, the tax treatment for net capital losses is not palatable. Net capital losses are deductible up to only $3,000 per year against ordinary income. The full amount of any net IRC section 1231 losses is deductible, however, if IRC section 183 hobby loss and section 469 passive activity problems are avoided. IRC section 1231 presents a major tax advantage of owning depreciable business assets such as horses. If losses are encountered on the sale of depreciable purchased horses, those losses can be used to offset ordinary income. No investor wants to lose money, but it is much easier to swallow if federal tax savings cover one-third of the loss.

To illustrate a net IRC section 1231 loss, assume that a taxpayer sells a horse with an adjusted basis of $100,000 for only $70,000, resulting in an IRC section 1231 loss of $30,000. Assume that this is the only section 1231 transaction during the year and the taxpayer’s marginal tax rate is 35%.

Thus, the net IRC section 1231 loss, deductible as an ordinary loss, will reduce the taxpayer’s taxable income by $30,000 and at the 35% rate save the taxpayer $10,500 in taxes. Had this been a capital loss, and assuming the taxpayer had no other capital gains or losses, the deduction for the current year would have been limited to $3,000, yielding a tax savings of only $1,050.

IRC Section 183: Hobby Loss Provision

The impending introduction of slot machines at New York racetracks has prompted some horse investors to believe that racing purses will be increased substantially in the years ahead as wagering becomes more convenient for the public.

Nevertheless, it is entirely possible that a thoroughbred owner may lose money. Therefore, a need exists to examine IRC section 183, commonly referred to as the “hobby loss” provisions. IRC section 183 provides that a taxpayer cannot generally deduct expenses that are greater than the gross income from an activity, if the taxpayer does not engage in that activity for profit. The burden of proof with regard to profit intent is normally borne by the taxpayer. IRC section 183 does permit the taxpayer, however, to shift the burden of proof to the IRS in cases where the taxpayer shows profit in any two of seven years for activities related to horses. This is referred to as the general presumption of profit intent.

Proving a profit motive hinges upon the facts and circumstances of each activity. Treasury Regulations section 1.183-2(b) specifies nine relevant factors to be considered in determining whether an activity is a hobby or a business. No single factor, or even a majority of the factors, can assure that the courts will determine the activity to be profit-motivated.

Recent Tax Court decisions indicate that conducting the activity in a businesslike manner is of primary importance. The taxpayer, or the taxpayer’s advisors, should also possess the necessary expertise for the activity. The well-informed horse owner who adopts a flexible business plan will be more sucessful if challenged by the IRS in the courts.

Material Participation

If taxpayers with economic losses pass the hobby loss challenge, they will be confronted with the passive activity loss rules of IRC section 469 and the material participation requirement. Material participation determines whether the taxpayer’s losses are currently deductible. If not currently deductible, these losses must be deferred and written off in subsequent years when the taxpayer generates passive income or disposes of the entire interest in the passive activity.

According to Treasury Regulations section 1.469, a taxpayer materially participates in a horse activity if he meets one of the tests listed in Exhibit 3. A sole proprietor racing horses may meet tests 1 or 4. A proprietor would probably be precluded from using tests 2 and 3, however, because the trainer would substantially participate for more than 100 hours. General partners, S corporation shareholders, and limited partners may have even more trouble meeting the tests while racing horses.

The failure to meet the material participation requirements may not be that disadvantageous, however, from a tax standpoint. Because the sale of an entire interest in a passive activity triggers the deduction of all related suspended losses, it may be possible to put together short-term partnerships, LLCs, or temporary S corporations such that losses will not be held in suspense for long periods. For example, a racing partnership could buy yearlings or two-year-olds and terminate the partnership when the horses reached three or four years old. Any losses from these partnerships should be deductible at that time. There could also be provisions for not terminating the partnership if it were profitable.

Tax Law Creates Potential Opportunities

Individuals in the 35% marginal tax bracket are potential racehorse investors, strictly from a tax standpoint. Assuming that potential problems with the hobby loss and passive activity provisions are not an obstacle, individuals in this bracket would have the government subsidizing over one-third of their losses. If, on the other hand, the investor was fortunate enough to invest in a winner like Funny Cide, the 2003 Kentucky Derby and Preakness champion, taxable income associated with the sale of the horse would be taxed at 15%, once the depreciation had been recaptured under IRC section 1245 and assuming no recapture under the IRC section 1231 look-back rule. The opportunity exists to earn large sums of money with limited investment.

Moreover, events such as the lucrative Breeders Cup (an entire program of elite races), corporate sponsorships, and Arab involvement in Dubai have provided additional upside possibilities above and beyond the New York Thoroughbred Breeding and Racing Fund. In addition, the introduction of slots at racetracks promises to be popular. Saratoga Gaming and Raceway opened video lottery terminals in 2004, and gambling activity doubled in 2006. This growth indicates there is no lack of gamblers willing to patronize these new video lottery terminals (V. Zast, “The Enema, the Band Aid and Preventive Medicine,” New York Racing, Volume 9, February 2006). Considering there are future plans to install between 4,500 and 5,000 terminals at both Aqueduct Racetrack and Belmont Park, there is the potential for racing purses to increase significantly, since a portion of the terminals’ take will go toward purses. The challenge, of course, is to purchase a winning horse. Potentially favorable tax treatment substantially mitigates the downside of this challenge.

Russell Hereth, CPA, MBA, has a tax practice in Cincinnati, and John Talbott, CMA, is a professor of accountancy at Wright State University in Dayton, Ohio. They are the authors of A Practical Tax Guide for the Horse Owner, Tenth Edition.

©2008 The New York State Society of CPAs. Legal Notices