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Wildlife Activities and the Hobby Loss Rule

Tree Farmer Magazine: March/April 1999 - Volume 18, No. 2

Wildlife management is an integral part of most Tree Farmers' operations. No particular tax implications arise from including wildlife. But, as I''ve noted in the past there is the issue of whether or not expenses related directly to wildlife enhancements are deductible as an ordinary and necessary business expense related to the income potential of your Tree Farm. There is very little guidance on this issue except for a few unpublished IRS rulings and some Tax Court cases.

Many Tree Farmers lease their land to a group of hunters and the Tree Farmer focuses on the management of the timber. As such, it's possible the IRS will consider the timber activity and the hunting lease to be two separate activities, a timber business and a hunting rental activity. Of course the tax treatments are different.

The costs for the two activities have to be accounted for separately. The best way to treat your wildlife and hunting lease activities is an issue worth discussing with your tax advisor. It's particularly important if you have been planning to use special use valuation as part of your estate plan. This is because rental activities are valued for estate tax purposes at highest and best use, instead of current use.

Running Gunning Club

Consider a case that focused on the application of the hobby loss rule to a farm which included a "gunning club." The absentee landowner was the operator of the club so the activity constituted a business. Sparre vs. Commissioner [CCH Dec. 36,782(M)] Tax Court case illustrates the factors the IRS evaluates to determine if the amount of deductions allowed for an activity are fully deductible as business expenses under Section 162 of the Internal Revenue Code, or should be limited to the income from the activity for the year under the hobby loss rule, Section 183.

In 1961, Mr. and Mrs. Sparre bought a 191 acre farm in Kent County Maryland, for $24,000. The farm included a dilapidated colonial house, a barn, implement shed, broken down outbuildings, and fences. The land was previously farmed except for a 40- acre woodlot, seven- acre pond, and gravel pits. The land was hilly and bordered on a small creek running into Chesapeake Bay.

The Sparre's purposes for buying the farm were (1) to have a retirement home in 1978, (2) provide a supplemental source of income, and (3) realize the expected increase in the value of the land. At the time of purchase Mr. Sparre was a salaried manufacturing manager. He and his wife lived in Worton, Maryland, and he worked in Wilmington, Delaware. Prior to the purchase he consulted numerous experts in the vicinity of the farm to determine potential uses of the farm and if $24,000 was a reasonable price.

The farm activities produced continuous losses from 1962 until the time of the trial in 1979. The tax years in issue were 1971 and 1972. The losses average about $15,000 per year. The Sparres' income averaged about $40,000 per year. Mr. Sparre made extensive efforts to seek the best available advice on how to maximize income from the farm. The tillable ground was limed and crop-shared or cash rented for corn production by local farmers. Over time food plots were established to attract waterfowl and upland game, and waterfowl was raised for release on the property. Revenue from hunting gradually rose. The house was improved so that hunting revenue could be increased by providing room and board to hunters. Neither of the Sparre's were hunters.

Tax Court Supports Sparres

The IRS contended that the Sparres' farm and gun club business deductions should be limited to income from the activity under the provisions of the hobby loss rule. The Tax Court, however, ruled that the Sparres' were engaged in the activity with the intent to make a profit. The farming and hunting activities were ruled to be a single activity because of their integrated operation. It noted that when land is purchased or held primarily with an intent to profit from its increase in value and the taxpayer also farms, the farming and holding of the land ordinarily are considered separate activities unless the farming reduces the net cost of holding the land. This means offsetting tax, insurance interest, depreciation on improvements and other costs directly associated with holding the land.

The losses were also not unexpected. The initial analysis of the activity based on input from experts was that it would take 10 to 12 years for the operation to produce a profit. Thus, the Sparres' entered the activity knowing that they would have to bear the cost of building up the property and the business before making a profit.

The Tax Court went into great detail about the Sparre's farm finances. This was possible because the Sparres' kept detailed financial records which they provided to the IRS. The court gave great weight to the fact that the Sparres' operated in a business like manner. They sought the best available advice about alternative ways to earn income from the farm and ways to reduce the cost of activities they were already engaged in. Even though they did move to the farm prior to retirement, the court noted that very little of the depreciation or operating expense deductions were associated with the house rented to hunters and which the Sparre's eventually occupied.

At the time of trial the farm was worth $500,000. The court noted that as of 1972, one of the tax years at issue, the Sparre's losses totaled $135,000 while the property was worth $260,000 more than they paid for it. Thus, the appreciation more than covered the accumulated the losses.

The court also emphasized that the farm losses were a large percentage of the couple's relatively modest income. The losses compared to other income made it clear that the farm was a financial burden, providing an incentive for them to manage it to produce a profit.

This case again illustrates that the hobby loss rule need not restrict a Tree Farmer's sincere attempts to engage in activities related to timber and wildlife production when motivated by profit. But you must conduct the activities in a business- like manner, not like something you're doing simply to have fun or help the environment. Maybe tax benefits for altruism, other than charitable deductions, will become part of the law someday. But, we're not there yet.

The following article has been reproduced here from the "Tree Farmer" magazine with the permission of the American Forest Foundation, 1111 19th Street, N.W., Suite 780, Washington, D.C. 20036. (Telephone 202.463.2462)