Unrealized Appreciation Farmland Value and the Hobby Loss Rule
Appreciation in value of a taxpayer’s farm or ranch property is often a significant issue in the context of the hobby loss rule. Although a “reasonable” expectation of profit is not required, the profit objective must be bona fide. It is the expectation of gain, and not the gain itself, which matters.
While the maintenance of complete and accurate books and records is important, it is equally important to consider the effect that repairs to and development of farmland has on the growth and success of an operation.
In Fields v. Commissioner, 42 T.C.M. 1220, involving a cow-calf activity, the Tax Court said that the taxpayers’ losses were explainable in part because of costs incurred in developing the property. This case is important for both horse and cattle activities.
The taxpayer had a 74-acre farm with residence. Various improvements were made to the land, including pastures, ponds, fences and land clearing.
The Tax Court held that the future resale of the developed farmland for a profit must be considered in evaluating the taxpayer’s overall profit motive.
The Tax Court also noted the poor market conditions for the sale of livestock, and said that the taxpayer’s losses were “unsurprising” given the poor economic climate. Moreover, the taxpayer’s pastureland was burdened by a drought that curtailed the planned expansion of the cattle herd, and reduced the availability of cattle for sale.
This principle applies to any horse or livestock venture under the hobby-loss rule: If the taxpayer’s primary intent is to breed, sell and/or race horses, or to operate a cattle ranch, then unrealized appreciation of the land may be considered as part of an overall intent to profit from activity, irrespective of the actual profits.
This principle is set forth in IRS Regulations section 1.183-1(d(1):
“The term ‘profit’ encompasses appreciation in the value of assets, such as land, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profits from current operations is derived, an overall profit will result when appreciation in the value of the land used in the activity is realized since income from the activity together with appreciation of land will exceed expenses of operation.”
In most instances, where the land is integral to overall operations, the holding of the land and the horse or livestock-related activities are considered a single activity. In such cases the argument is that the taxpayers hope to reap an eventual profit from the resale of the farmland, even though there might be a history of losses on the horse or livestock activity itself.
The IRS will attempt to refute this by contesting the taxpayer’s valuation of the property. It is therefore important to have an expert appraisal to support the valuation. Also, the IRS will argue that the holding of the land and the horse or livestock operations are two separate activities--in other words, the land was purchased primarily for the purpose of deriving a profit from its appreciation, and that the farming activity was collateral to that purpose. This argument will usually fail, because in most instances the land is integral to the horse or livestock venture.