Where I live, in Middle Tennessee, more and more people are seeking out large tracts of land and either building or rehabbing a farmhouse on the land. Being close to Nashville or Franklin or Brentwood, but having some space to enjoy the beauty of Middle Tennessee has become a dream of more and more property buyers. Real estate brokers are marketing large tracts of land as mini-farms and in some cases, if the tract is big enough, as full-blown farms.
Horse breeding and cattle breeding and ranches are all possibilities if the tract of land is big enough, and as more and more families of wealth gravitate towards the mini (or maxi) farm or ranch in Middle Tennessee, more and more issues are going to come up about whether their farming/ranching activities have a profit motive or are instead hobbies.
Here’s the issue: if you have losses in an activity such as farming or ranching you cannot deduct those losses under Section 183 of the Internal Revenue Code if your activity does not have a profit objective. In other words, no deductions for hobby losses.
A case decided and published yesterday by the U.S. Tax Court offers a highly illuminating (and for tax law fans, highly entertaining) review of the issues that come up when someone claims losses on an activity such as farming or ranching and it is arguably not their primary source of income.
In the case of Robison v. Commissioner (here’s a link to the case, so you can read it yourself), the taxpayers had a ranch in the western part of the U.S. of about 500 acres where they raised horses (at first) and cattle. Over the course of about 15 or 16 years, they had never had a profit from the ranch. Their losses each year ranged from just under $200,000 to almost $750,000. They deducted their losses on their tax returns and the IRS disallowed the deductions, resulting in significant tax liabilities.
After going through the whole story of how much effort and work the taxpayers went through to improve and operate the ranch, the Court said that the IRS was wrong–the taxpayers did have a profit objective and it was not just a hobby.
Hooray for the taxpayers! But wait a minute.
Although the taxpayers were entitled to take deductions for their losses on the ranch, their losses had to held in suspended animation and not taken as deductions in the years they suffered the losses. Instead, the taxpayers would only be able to utilize the losses as tax deductions when they made a profit on the ranch (and only in an amount equal to the profit on the ranch) or until they sold the ranch. The problem?
The passive activity limitation in Section 469 of the Internal Revenue Code.
The Court looked at the records and could not find that the taxpayers had satisfied the requirement of working 500 hours per year on the ranch (and the hours worked as “investors” did not count). Without proof that the taxpayers had worked 500 hours in a given year on day-to-day operations of the ranch, the loss for that year was in effect “suspended.”
Here’s the moral for all the prospective farmers and ranchers in Middle Tennessee (and elsewhere)—if you expect to have losses on your mini-farn or mini-ranch, you must be able to prove that you have a profit motive and that the operation of the mini-farm or mini-ranch is not just a hobby.
And you must be able to prove that the mini-farm or mini-ranch is not a passive activity for you. You should contemporaneously document through keeping careful and thorough records that all the time and effort (and what you’re actually doing) to operate the mini-farm or mini-ranch on a day-to-day basis. If you don’t have a manager for your farm or ranch, it will be easier to show that your own time and efforts are focused on the day-to-day operations, but if you have a manager you will need to take special care to document your actual activities and work in operating the farm, rather than just acting as a passive investor.