Most performance horse owners begin their horse ownership and performance horse activities for purposes other than pecuniary (monetary) gain. Nevertheless, many hope eventually to turn a profit as their horse progresses in skill or as their equine business develops. If you treat your equine activities as a business, you might be able to use any losses incurred in those activities to offset other income. Early tax planning strategies can lead to an unexpected reward, an indirect subsidy by the federal government of your equine activities.

Assume the following situation: Mr. Smith, a performance horse owner, earns $500,000 from wages and non-equine related business activities in 1996. Due to the purchase of two new horses and other related expenses, Mr. Smith’s equine-related business activities incur total losses in 1996 of $100,000. Assuming Mr. Smith has no other deductions and if the equine activity qualifies, he will be able to reduce his taxable income to $400,000 by deducting the $100,000 equine loss. At a combined federal and state marginal tax rate of 45%, the horse owner would save $45,000 in taxes from this deduction. Put another way, it will have cost Mr. Smith only $55,000 to invest $100,000 in his equine activities in 1996. The other $45,000 is effectively provided by the federal and state governments.

For equine activity losses to be deductible against other income, early tax planning is crucial. Two provisions of the Internal Revenue Code (the “Code”) operate to deny this deduction if the taxpayer either engages in his equine activities as a hobby or fails to materially participate in the activity (a “passive activity”). Section 183 of the Code provides that expenses from a “hobby activity” can only offset income generated by that hobby activity. If hobby expenses exceed hobby income, those expenses must be carried over and can only be used to offset future hobby income in later years.

Section 469 of the Code provides that if a taxpayer does not materially participate in an activity that generates a loss, that loss can only be used to offset income from other activities in which the taxpayer does not materially participate. If a taxpayer’s equine activity is not considered a hobby and the taxpayer materially participates in the activity, all net losses from the activity can be used to reduce the taxpayer’s overall tax liability. This article considers the hobby loss restrictions