There is a Silver Lining to Drought and Adverse Weather Conditions for the Horseman

By: Stephen A. Drake, Ph.D., CPA, CFP, PFS

There are a number of States affected by drought, flooding and other adverse weather conditions in 2002. Normally, the horseman may view these events as an adverse event. However, these conditions can have a silver lining from a tax point of view. The IRS allows the horseman to wait to report any applicable gains on affected horse sales to the next year. In other cases, the horseman can reinvest the proceeds from affected sales into other, similar horses but take up to 2 years or more to do it. Accordingly, there is some very interesting tax planning that can be done.

As a result of limited water and pasture in much of the US, the horseman may be reducing the number of head in his inventory. Or, with some advance planning, the horseman may find that a restructuring of his inventory of horses is best accomplished this year. Any sales must be primarily done for weather related reasons but often, these reasons can be coordinated with the horsemanís business plan to accomplish multiple tax and financial goals. This planning can provide for the sale of horses without a current income tax.  2002 may be just the year for the horseman to diversify his horses and defer the gain(s) the IRS allows. As always, planning is the key.

Letís review some of the rules.  The IRS allows a one-year deferral on sales of horses when sold for weather related reasons. In other words, if the horseman lives in a federally designated affected area then any sales (even to areas outside the weather-affected area) can be reported in the next taxable year. The main purpose of the horsemanís business must be ěprincipallyî related to farming/ranching. A separate entity such as an LLC (limited liability company) that operates the horse business would qualify. For the horseman with no separate business entity he may have a harder time under the ěprincipally-relatedî rules but the IRS has been relatively generous with its definition so it is still possible.

A tax deferral means the tax has been moved to the next year not completely forgiven by the IRS.  The horseman will still have to report the gains from the affected horse sales in the following year. But, if the horseman expects more expenses next year then he can plan around this additional income. Further, the horseman may be able to do what few other taxpayers can do. He can ěincome averageî. Income averaging left the IRS rules for most taxpayers many years ago. For the horseman it can still be used. This concept is discussed later in this article.

Another planning option available is the two-year reinvestment period where the horseman sells weather-affected horses. In this situation, the horseman can reinvest the horse sale proceeds into similar horses but take up to two years after the end of the year in which the sale occurred to do it.

• Example:

Joe Jones sells $100,000 of horses from a weather affected area on June 30, 2002 (sales can happen outside the weather affected area). These horses are all raised so all of the $100,000 is gain. This $100,000 must be reinvested into other, similar horses but Joe can take until December 31, 2004 to do it. Thus, Joe had approximately 2.5 years to make the reinvestment. As long as Joe reinvests the $100,000 into other similar horses by December 31, 2004 he will have no income tax to pay. There will be no tax until Joe sells some of the new horses he just bought. This may be many years later.

The reason this IRS rule is helpful is that it will allow Joe to diversify his horses in either more horses or fewer horses then he had before. Further, he can take 2 years or longer to do it. It is much more flexible then a normal exchange of horses.

In either the one year deferral or the two year reinvestment rule discussed above, the horseman has to show that he is making the sale(s) because of weather related reasons and the sales are in excess of what he would normally have sold. There are some elections that have to be attached to the horsemanís tax return showing some of these calculations. If the horseman is living is a weather-affected area then taking advantage of these rules should not be too difficult. Coordinating this planning with the horsemanís business plan is imperative.

In the case of the one-year deferral, any type of horse would qualify. In the case of the two-year reinvestment, all horses except sporting horses would qualify. Thus, horses held for breeding would qualify.

These deferral (reinvestment) provisions by the IRS can assist the horseman in restructuring the make-up of the horses he has and can accumulate income in a specified year to show a ěprofitî or an ěas-if profitî for purposes of the 2 out of 7 year test. (For those who want to understand these rules then please see my website).

• Example:

Sue Smith decides that she is going to sell 5 extra horses in 2002 and justifies the extra sales because of drought or other weather related situations in her area. She can likely qualify to defer the gain on the 5 horses into the next taxable year and report her gain then. Or, she can reinvest the proceeds of the 5 horses into either fewer or more horses to diversify her horse inventory. She must accomplish this by the end of the second taxable year after selling the 5 horses. This period of time may allow Sue to see how market values of horses are going or selected breeds are doing in the market. In other words, Sue has a free wait-and-see period of 2 years or more to know how and when she will reinvest the proceeds. Sue will have to reinvest in similar horse(s) as she sold. In other words, she will have to reinvest in other breeding horses if she sold breeding horses.

• Example:

Sue, in the same circumstances as above, decides she wants to sell the 5 horses in 2002 and is trying to show a profit in 2 out of 7 years. Even if Sue reinvests in new horse(s) these sales and reinvestments should count in the showing of a profit for IRS purposes. After all, Sue had a profit but she simply reinvested that profit on a tax deferred arrangement. This is a very important negotiation point with the IRS. Sue had a profit on the sale of horse(s) but this profit did not show on her tax return. This would still count in the showing of a profit to the IRS for purposes of the 2 out of 7-year test.

The IRS allows the horseman to ěincome averageî where his income has increased from prior years. Income averaging generally averages the horsemanís taxable income over the last 3 years. If the horseman had losses in prior years and now has a large taxable income then income averaging could apply to reduce any tax liability. Thus, where the horseman did not reinvest all or any of his weather related horse sales, he should check if income averaging would reduce his tax. This technique may be very important if the horseman wants to accumulate income into a single year but pay the lowest amount of tax possible. As stated above, this could be the case where the horseman is looking to plan for his profit year.

The horseman could also use income averaging to reduce income taxes on the sale of farm buildings and structures (but not land). This planning could be significant for the horseman looking to sell his farm and/or horses. In some cases, income averaging tax rates are better then capital gain rates.

Stephen Drake has been advising the equine industry for over 25 years. His articles appear in many State and National equine publications. For more information please contact him at 877-218-7800, sdrake@optimafr.com or visit his website for many equine-related articles of interest at www.optimafr.com