Post-JGTRRA Racehorse Ownership

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) in-creased the Sec. 179 deduction to $100,000 for 20032005 (adjusted for inflation starting in 2004) and allowed 50% additional depreciation under Sec. 168(k)(4) in the year of acquisition on most business property other than real estate. These provisions make it more tax advantageous to own a racehorse.

Overview

Under Sec. 168(b)(2)(B) and Regs. Sec. 1.263A-4(a)(4)(i), horse owners are deemed to be in the trade or business of farming; thus, their horses are depreciated over either a three-year or seven-year life, using the 150% declining-balance (DB) method. The normal recovery period and the applicable recovery percentages are presented in Exhibit 1 (see Rev. Proc. 87-57, Sections 3 and 4 and Table A-14).

According to Sec. 168(b)(4), salvage value is ignored. Generally, unless the Sec. 168(d)(3) mid-quarter convention applies, the Sec. 168(d)(4)(A) half-year convention applies to reduce first- and last-year depreciation by 50%.

A taxpayer may elect to expense some or all of the cost of a horse under Sec. 179. For 2003, the maximum cost that could be expensed was $100,000, provided the overall acquisition cost of eligible property for the year did not exceed $400,000; see Sec. 179(b)(2). If expenditures exceeded $400,000 for 2003, the $100,000 amount had to reduced, dollar-for-dollar, for the excess; the expense deduction fully phased out at $500,000 of costs.

Example 1: T purchased a three-year-old horse, not yet raced, for $200,000 in December 2003 and elected Sec. 179; thus, the maximum depreciation deduction is as follows, using the 150% DB method and assuming the half-year convention applies. For 50% bonus depreciation, T must be the original user of the property and the horse must have been acquired after May 5, 2003, under Sec. 168(k)(4)(B)(i). If the horse were ac-quired after Sept. 10, 2001 and before May 6, 2003, bonus depreciation would be only 30%.

For subsequent years, the depreciation calculation is as follows:

If T had already used the maximum Sec. 179 deduction for 2003 or was ineligible to do so, the total 2003 depreciation would be $125,000 (($200,000 x 50%) + ($100,000 x 25%)) and subsequent depreciation would be as follows:

The JGTRRA provides additional tax advantages, as it substantially increases the depreciation taken in the year of purchase. The early write-off will allow a horse owner to recoup his or her investment more rapidly, by reducing the cash outflow for the payment of taxes. In Example 1 above, the JGTRRA provided for an incredible 81.25% deduction in the year of investment in a horse costing $200,000, using Sec. 179. Without the Sec. 179 election, an enticing 62.5% write-off is permitted when investing after May 5, 2003 in a more-than-two-year-old racehorse.

Sec. 179 Complications

To depreciate or elect Sec. 179 for an acquired horse for 2003, an owner had to place the horse in service in 2003. According to Sec. 179(c)(1), the Sec. 179 election is made annually; the owner must select the horse(s) to which it applies. As Example 1 above illustrates, the depreciation rules (including 50% bonus depreciation) apply to a horses residual cost after reduction by Sec. 179. If the total cost of horses placed into service during the year exceeds $400,000, the $100,000 deduction is reduced, dollar-for-dollar by the excess, under Sec. 179(b)(2).

In addition, the amount expensed cannot exceed the taxpayers taxable income derived from any trade or business, according to Sec. 179(b)(3). Under Regs. Sec. 1.179-2(c)(7), for married individuals filing jointly, the income (losses) are aggregated when applying the trade-or-business taxable-income limit. Some horse owners thus believe that if they are in a loss position for the year, they cannot elect Sec. 179. Under Regs. Sec. 1.179-2(c)(6)(iv), however, employees are deemed to be engaged in the conduct of a trade or business.

Example 2: Y, a horse owner, is a salaried employee with $125,000 of 2003 wages. She has a 2003 $15,000 loss in her horse operation, ignoring the cost of a three-year-old racehorse she acquired during 2003 for $20,000. Y may expense the cost of the horse under Sec. 179 and show an overall $35,000 loss from the horse operation ($15,000 + $20,000). If Y is not subject to the Sec. 469 passive activity loss (PAL) rules or the Sec. 183 hobby-loss rules, Y could offset the $35,000 loss against her $125,000 salary.

Example 3: Z bought an unraced yearling under age two (i.e., seven-year re-covery property) for $150,000 in June 2003 and broke him and placed him into training.

Thus, more than 85% of the yearlings cost could be written off for 2003.

Example 4: The facts are the same as in Example 3, except that the total purchases of Sec. 179 properties during 2003 exceeded $500,000, so there is no Sec. 179 deduction. The 2003 depreciation would be as follows:

In this example, approximately 55% of the yearlings cost could be written off in the first year. Examples 3 and 4 above assume that Z did not place more than 40% of depreciable assets in service during the fourth quarter of 2003. Had Z placed more than 40% into service during that fourth quarter, he would be required to use the Sec. 168(d)(4)(c) mid-quarter convention and regular depreciation would differ. The taxpayer could still take advantage of Sec. 179 and the bonus depreciation rules.

Conclusion

Individuals in the 35% bracket are possible racehorse investors. Assuming the potential problems with the hobby-loss and PAL rules are overcome, higher-bracket individuals would end up having the government subsidize over one-third of their losses. If, on the other hand, an investor was fortunate enough to invest in a future Kentucky Derby winner, taxable income associated with the sale of a  racehorse would be taxed at 15%, after Sec. 1245 depreciation recapture (and assuming no Sec. 1231 issues). The opportunity to make large sums of money with limited investment does exist; the JGTRRA just enhanced the possibilities.

From Russell H. Hereth, MBA, CPA, Associate Professor of Accountancy, Hans Sprohge, CPA, ABV, Ph.D., Professor of Accountancy, and John Talbott, CMA, Ph.D., Professor of Accountancy, Wright State University, Dayton, OH (None affiliated with Grant Thornton LLP)