Importance of Appreciation in Value of Agricultural Property to the IRS

TerryD — Thu, 24 Jan 2008 01:18:00 GMT

The value of farmland in American’s heartland has been appreciating in value even as the value of many other sectors of the real estate market have been declining in recent months. The fact that one’s farm property -- whether used for agriculture, livestock or horses -- is appreciating in value is of importance from an economic standpoint, and it helps one do battle with the IRS in the event of a hobby loss audit.

Under the hobby loss rule if you have losses in connection with any farming activity, whether horses, livestock or agriculture, the IRS may suspect that the activity is engaged in as a hobby rather than a business. Many farms have a history of losses, on and off.

This Factor is called “Expectation That Assets Will Appreciate in Value.” The term “profit” in IRS Regulations encompasses appreciation in the value of assets such as land and/or livestock used in the activity. The leading case on this point is Engdahl v. IRS. The taxpayer’s land appreciated from $83,l46 to $225,000 over a several-year period. The Tax Court held that this in itself was indicative of a profit motive. There are many similar rulings in Tax Court cases.

One important Tax Court case observed: “If losses, or even repeated losses, were the only criterion by which farming is to be judged a business, then a large proportion of the farms of the country would be outside the pale. It is the expectation of gain, and not gain itself which is one of the factors which enter into the determination of the question.”

The appreciation in value of farm property takes on importance particularly in situations where the taxpayer has been unable to show any profit years. Appreciation in value of your farm or ranch property can help prove that you have an honest expectation of making a profit despite a string of losses. The fact that a portion of your farm is used for a residence or other purposes does not preclude the IRS from considering overall appreciation in value.

This element can be crucial if you are audited by the IRS and cannot show any profit years in recent history. Appreciation in value of your farm or ranch property can help prove that you have an honest expectation of making a profit despite a string of losses.

Improvements such as barns, arenas, pastures, fencing, breeding sheds, stalls, storage facilities, irrigation, ponds, lighting, and landscaping all fall within the type of improvements likely to help increase the value of the land itself.

According to tax regulations, the appreciation in the value of the land used in the activity helps to explain a taxpayer’s willingness to continue the venture despite operating losses sustained during a number of years. It is strong evidence that the taxpayer conducted the activity with an honest and actual objective of making a profit.

However, sometimes (perhaps often) the IRS will argue that the farm property -- particularly in horse and other livestock ventures -- is not economically tied up with the land, so that any appreciation in value is largely irrelevant. This position of the IRS, if and when taken, is contrary to many Tax Court cases on the subject.

It is recommended that taxpayers get a formal appraisal of their property every couple of years to help substantiate the fact that their overall venture is doing well because, if the farm were sold, there would be a significant recoupment of past losses. In a formal appraisal, the appraiser should be able to say that the land is used exclusively for the venture, and that the highest and best usage of the land is that of a farm, whether it be a horse farm, cattle ranch, or agricultural activity.

You should also be able to prove that the land was purchased, maintained and improved with the expectation that it would appreciate in value, and that this increase would enhance the overall profitability of your venture.

To recap: If you are engaged in any type of farming venture, whether it be horses, livestock or agriculture, and if you sustain a significant period of losses that you utilize to offset your principal source of income -- it is important to show that you acquired the farm property with the expectation that it would appreciate in value. You should keep documentation to prove the improvements you made to the property. You should have periodic written appraisals of the property, and the appraisals should indicate that the activity is tied up with the land, that the highest and best use of the property is as a farm, whether horses, livestock or agriculture, as the case might be.

Contributed By: John Alan Cohan, Attorney at Law

John Alan Cohan is a lawyer who has served the horse industry since l98l. He serves clients in all 50 states, and can be reached at: (3l0) 278-0203 or via email at johnalancohan@aol.com

Tax Tips

Importance of Appreciation in Value of Agricultural Property to the IRS

John Alan Cohan is a lawyer who has served the horse industry since l98l. He serves clients in all 50 states, and can be reached at: (3l0) 278-0203 or via email at johnalancohan@aol.com