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Racehorse owner finishes out of the money in Tax Court passive loss case

March 10, 2009

Trailer salesman Douglas A. Schmuecker likes the ponies so much that he got into the business. The Tax Court sets the stage:

In 1993 petitioner got involved in horse racing. During the years at issue, he owned or co-owned five or six racehorses. They were not always the same horses. Sometimes he would acquire a horse by winning a "claiming race"; sometimes one of his horses would be claimed by someone else and he would reinvest in another horse. Because of the expense involved, petitioner generally owned no more than three horses outright at any time. The other horses he co-owned, typically 50-50, usually with his primary horse trainer, Marv Johnson.
Marv Johnson kept all or most of these horses, along with 40 or 50 others, at his ranch, which was distant from petitioner's residence. Marv Johnson and his staff provided all necessary services for taking care of the horses, such as feeding, grooming, and training them. They decided when the horses were ready to race, decided on the races to enter (either on their own or in consultation with petitioner), and hauled the horses from meet to meet. Petitioner paid a fee for these services.

Mr. Schmeuker claimed net losses from his horses totalling about $64,000 from 2001-2003. Often the IRS goes after such losses on a "hobby-loss" basis, but instead they attacked them on a "passive loss" theory. The passive loss rules generally defer losses from businesses in which the taxpayer doesn't "materially participate" until the business either generates income or is sold.

The Tax Court's fact summary wasn't good for Mr. Schmeuker:

According to petitioner's statement, he was "not required to do anything as far as services" in his horse-racing business. In fact, he had no firsthand experience in training horses and did not even ride horses. Before acquiring racehorses his only previous experience in horse racing consisted of going to races with his father. Petitioner did not contemporaneously maintain logs of time spent on his horse-racing business.

That made it easy for the court. They reviewed the tax law "material participation" rules (summarized below) and concluded that the taxpayer failed to support his claim that he "materially participated."

On the good side for the taxpayer, a passive loss a far better result than a hobby loss. Passive losses are just deferred; when he gets out of the businesses, he should be able to take the losses.

Cite: Schmuecker, T.C. Summ. Op. 2009-32

MATERIAL PARTICIPATION BASICS

The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

Tags: hobby loss.material participation.passive losses.tax court.