Donald Tobin (Ohio State), Ann Romney’s Tax Deductible Horse Activity — The Tax Code Got This Right!:

Ann Romney’s love of horses and Steven Colbert’s infatuation with Rafalca, one of her dressage horses, have created a buzz about horses, money, and taxes. Romney owns a one-third interest in Rafalca, and Rafalca will be competing, with her rider, Jan Ebeling, in the Olympic dressage event.  In the most recent uproar, the Romneys are criticized for deducting $77,731 for the Romney’s share of Rafalca’s expenses. But here is the catch: Because of anti-abuse provisions contained in the Tax Code the Romney’s only actually deducted $49 on their return. Assuming the Romney’s are in the 35% tax bracket, the benefit to the Romneys was about $17. Not much worth working yourself into a lather about.

Although it is not clear what expenses make up the $77,731 figure on the Romney’s return, assuming the figure is correct, the Romney’s effectively received no tax benefit from the activity. They will only recoup these expenses if the Rafalca activity returns a profit. Here is how it works.

Under Section 469 of the Code, losses from passive activities, generally activities where you are a passive investor and do not materially participate in the activity, are only deductible against passive gains. The passive loss provisions were added as part of the Tax Reform Act of 1986 as part of a series of changes to clamp down on abusive tax shelters. The idea was to prohibit taxpayers from deducting losses when the taxpayer was not primarily involved in the activity.

If a person actively runs a business, the activity is not a passive activity and the profit and loss from the business can be deducted on a tax return. So for example, pretend your spouse is a teacher making $50,000 a year and you run a hot dog stand. If the hot dog stand loses money (say $10,000), you can deduct the $10,000 loss from the $50,000 your spouse earned. That is what some news reports were implying when they said the Romney’s deducted $77,731 from the horse activity.

There is a catch however. If there were a passive investor in the hot dog stand who did not participate in its management or operation, and she incurred the $10,000 loss, she could not deduct the loss unless she had other passive gains. The idea is that the Code allows the loss once someone can show that he has some gain in some passive activity. The Romneys are arguably in that situation. Since the $77,731 is a passive loss it can be deducted only against passive gains. Since the Romneys had a lot of passive losses, they had to allocate the passive gains among the various losses. The Romneys generated $2,170 in passive gains, and had over $2 million in losses. The passive gains were thus spread across the losses. Once this allocation was done, $49 of the horse activity was deductible against the $2,170 in income. In effect, the Romneys were not able to deduct over $2 million in passive losses.

Now some have noted that the Romneys may still get the deduction because they can carry over the loss to future years. The Code provides that if an asset is fully sold, the loss generated from the activity, if it is an activity engaged in for profit, would not be a passive loss. Thus the Romneys will only get a large tax deduction from Rafalca, if Rafalca is sold at a loss and they actually suffer a loss. This raises the specter that taxpayers may ultimately be subsidizing Romney’s horse activity.

The Romney story caught my eye because I am constantly telling my wife that we cannot deduct expenses for Patrick, the wonderful, but not Olympic caliber, dressage horse she rides. Why can Ann Romney deduct expenses for Rafalca while we cannot deduct expenses for Patrick? That raises one more question. Is the Romney activity actually an activity for profit, or is it a hobby? Does she actually intend for Rafalca to turn a profit? Would she actually sell Rafalca? I don’t doubt that Rafalca could be sold for a huge amount of money, but could she be sold for a profit? If the activity is a hobby, the Code limits the deduction by only allowing expenses to the extent of gains. Thus, if Romney’s activity is a hobby and not an ordinary and necessary business expense or an investment activity, she could not deduct losses in excess of gain.

The moral of this story, however, is that the Tax Code is working here to properly disallow the deductions. If Ann Romney is engaged in this activity as a hobby and not as a business, her deductions should be limited to her income from the activity. Ann Romney’s love of horses is admirable and her care of Rafalca commendable. Taxpayers should not foot the bill when wealthy individuals, or not so wealthy individuals, engage in these types of activities for love, and not profit. Ann Romney clearly loves horses, and she is sharing that love with others. From my perspective, it is her money, and her love, so go for it. I and glad that at the moment the Tax Code is working and that I, and other taxpayers, are not subsidizing Ann Romney’s horse activity. I already do enough of that at home.