This article was first published in Blood-Horse Magazine
Federal depreciation incentives included with the Tax Cuts and Jobs Act continue to benefit Thoroughbred horse and farm owners. This article provides an in-depth look at the rules surrounding the 100% bonus depreciation, generally the most useful of these incentives to industry participants.
This discussion is intended for those active owners operating their horse and farm activities as businesses that use the cash method of accounting.
The new law significantly expanded bonus depreciation. The percentage that may be currently deducted for tax purposes increased to 100% of the purchase price for qualifying property placed in service through 2022. After 2022, the percentage drops by 20% each year until it becomes 20% in 2026. In addition, the definition of qualifying property was expanded to include assets that have been previously owned but not those being reacquired by the purchaser. Previously, assets used by a prior owner did not qualify.
Common equine assets that may qualify for this 100% write-off include racing prospects (yearlings, 2-year-olds in training), racehorses, broodmares, stallions, equipment, fencing, land improvements, and barns. To qualify, these items must be predominantly used in the United States (which makes sense given the desire to stimulate economic growth in the United States).
A person claiming bonus depreciation is not limited by taxable income. The deduction may be used to create or increase a net loss and there is not a specific dollar amount limitation on an annual basis.
For these reasons it is much more valuable than the Section 179 depreciation, which is limited to net income and also to a fixed annual dollar amount. Bonus depreciation also is not prorated based on the timing of the purchase. So a qualifying purchase made on Dec. 31, if placed in service then, is eligible for the same amount of bonus depreciation as property purchased for the same price earlier in the year.
In order to claim the bonus depreciation, the asset must be “placed in service” during the tax year. For tax purposes, racing prospects may be placed in service either in the fall of the yearling year when training begins or when they begin racing.
Breeding stock may be placed in service when available to be bred, even if the purchaser does not plan to breed the horse until the following year, or when bred. Quite commonly, mares are purchased in the breeding stock sales in the fall and placed in service upon purchase, even though they typically would not be bred in the Northern Hemisphere until the following winter to spring. The same is true for stallions or stallion shares. Once a methodology for placing horses in service is chosen, it should be followed consistently for tax reporting purposes.
However, just because the cash has been paid does not necessarily mean the horse has been placed in service. For example, if shares in a stallion prospect are purchased while the horse is still racing to secure ownership in the stallion, these would not be placed in service until the horse is retired from racing and available to be bred or begins breeding. On the other hand, a horse that has been purchased and placed in service but not yet paid for would be eligible for bonus depreciation.
In addition, some leases might be “disguised purchases” and may enable the lessee/purchaser to currently claim bonus depreciation. So, it is important to look beyond the label on the contract or the time at which cash is expended to determine whether bonus depreciation is currently available.
Those purchasing farms also may currently use bonus depreciation to deduct the purchase price allocable to qualifying items such as barns, land improvements, fencing, and equipment.
This could result in a substantial portion of the purchase price being eligible for immediate deduction. Addressing this allocation prior to purchase via agreement with the seller in the closing documents or by an appraisal that allocates a portion of the purchase price to these depreciable assets is important to maximize potential deductions.
While bonus depreciation is a timing difference, it can be financially meaningful. To illustrate what this is worth to a horse owner, let’s use the following example. If a yearling is purchased for $500,000, this $500,000 may be fully deducted in year 1 (subject to some limitations briefly mentioned later in this article), rather than over an eight-year period. (Yearlings use seven-year lives for tax depreciation, but this is actually claimed over an eight-year period.) This is a federal tax savings of $185,000 if the purchaser is in the highest federal individual tax bracket. By accelerating this deduction versus claiming it over time, the cash savings in this specific example are roughly $30,000 if a 5% rate of return is used.
This cash savings increases if a higher rate of return is used, if the asset is depreciated over a longer life, or as the purchase price of qualifying assets increases.
Opt-out option
Owners may opt out of this immediate write-off by filing an election to do so with their tax return. So why would someone choose to elect out of this bonus depreciation?
If the horse venture is otherwise profitable, an owner might wish to report a net profit for hobby loss rules that shifts the burden of proof to the IRS if profits are reported in two out of seven years. Additionally, horse owners might prefer to align the related depreciation expense better during the period of time that horses or the farm would produce income in future years.
Also, passive investors in the horse business participating via multi-member entities may receive little-to-no-tax benefit by accelerating this deduction and instead create a state withholding tax issue in future years when purse winnings are generated or the horse is sold with no remaining tax basis.
Alternatively, the 100% bonus depreciation may be claimed on certain classes of assets while electing out of others. So, if it makes sense to deduct the depreciation on barns over the standard 20-year life while claiming the 100% write-off on horse purchases, an election could be filed to opt out of the 20-year asset class only.
This is made on a class-by-class basis and not an asset-by-asset basis. Horses should be categorized appropriately when evaluating on a class-by-class basis, given that different types of Thoroughbred horses have either a three-year or a seven-year life.
Property acquired from a related party or via inheritance or gift does not qualify for bonus depreciation. Inventory not yet placed in service, such as typical weanling-to-yearling pinhooks, or weanlings not yet placed in service also are not eligible.
Limitations
As with most other tax incentives, a few limitations that might currently reduce or eliminate this 100% deduction may apply. The tax law created a provision that limits net 2018 losses from all business ventures for individuals, trusts and estates to $250,000 ($500,000 for individuals filing jointly). This limit is indexed for inflation after 2018. Any net business loss that exceeds the limit is converted to a net operating loss.
Bonus depreciation might significantly increase the net business loss generated and cause this business loss to be currently limited. For many industry participants who are affected, this creates a one-year deferral of this excess loss that then might be used to offset all sources of income in the subsequent year, subject to the normal net operating loss carryover rules. So owners faced with excess business losses might still want to currently claim bonus depreciation.
Another item of caution: Many states have decoupled from this favorable bonus depreciation so this may be a Federal tax benefit only, depending in which states a horse or farm owner operates.
As sales season kicks into high gear, this 100% write-off option presents some planning opportunities for those looking to reduce taxable income. It is important to speak with your tax advisors regarding your specific situation prior to making any purchases, but the potential tax benefit of utilizing bonus depreciation could be substantial.