An important consideration in audits is Factor No. 4 of the IRS Regulations. 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, and was discussed in an early case, Engdahl v. IRS. The taxpayer’s land appreciated from $83,l46 to $225,000 and the livestock appreciated by $l8,000 over their cost basis. The Tax Court held that this in itself was indicative of a profit motive. Later, other decisions looked favorably on evidence that the taxpayer’s assets, particularly farm property, had appreciated in value.
Factor No. 4 takes on significance in situations where the taxpayer has been unable to show any profit years. Evidence that assets used in connection with the livestock activity have appreciated in value can be used to dispel any notion that the enterprise is not in fact operated as a business.
Factor No. 4 can be crucial if you are audited by the IRS and cannot show a profit year. Appreciation in value of your farm or ranch property, or livestock, can help prove that you have an honest expectation of making a profit despite a string of losses.
Evidence that assets used in connection with the activity have appreciated in value can be proven by expert testimony or by an appraisal report. The fact that a portion of your farm realty is used for a residence or other purposes does not preclude the Tax Court from considering the portion used for the livestock or farming activity.
Improvements such as barns, arenas, pastures, fencing, breeding sheds, stalls, storage facilities, irrigation and landscaping all fall within the type of improvements likely to help increase the value of the land itself.
Factor No. 4 takes into account the appreciation in value of the livestock owned by the taxpayer and developed under his stewardship. The fact that certain animals have increased in value because of the efforts of the taxpayer tie into this factor even though the assets were not sold. The Tax Court has recognized the importance of holding onto one’s most valuable bloodstock.
It is recommended that taxpayers get a formal appraisal, particularly if faced with an IRS audit. The appraisal should indicate that the land is used exclusively for the farming activity, and that the highest and best usage of the land is that of a farm. The appraisal of the farm should show that the book value of the realty has increased significantly due to improvements made in connection with the farming activity, and not merely because of population growth or other external factors.
This also justifies a taxpayer’s expenditures on hiring professionals and incurring other costs related to the activity, for in many cases the value of livestock is directly attributable to the amount of money spent in promoting and campaigning.
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. This can be proved by establishing a formal business plan, by obtaining a certified appraisal, by conferring with legal counsel, and obtaining a tax opinion letter from qualified legal counsel.
Factor No. 4, of course, is only one of a number of elements that go into evaluating whether the activity is operated as a business despite a history of losses. But the appreciation in value of the land is important in explaining the taxpayer’s willingness to continue the venture despite operating losses, for if sold the taxpayer may be able to show a profit in the long run.