Always dreaming of owning a Kentucky Derby horse

Derby Day is just around the corner. One of the big things happening at horse racing tracks is the opportunity to own a “share” of a thoroughbred horse. Last year’s Kentucky Derby winner, Always Dreaming, had five owners that split the Derby purse of $1.24 million. Always Dreaming was a horse-racing partnership horse. A partnership-owned racehorse gives people an opportunity to fulfill their dreams to own a racehorse and compete at the highest levels of the sport.

Horse ownership and the IRS

There are some big tax deductions for horse owners. It depends on the “style” of ownership, with the key word being “passive.” Passive income is investment in a business activity with no material participation. Passive owners can’t use losses from their thoroughbred “investment” to offset wage or other business income, but must pay tax on income.

To avoid passive loss limits, an owner must meet certain material participation requirements, such as spending 500 or more hours at this business activity during the year. A small piece of good news: if a spouse accompanies the owner to the horse track or other duties, their participating hours count towards the 500-hour requirement as well.

Horse partnerships and syndicate owners

Horse owners who are part of a partnership or syndicate are typically considered “passive,” i.e. individuals can’t deduct net losses against other business income, but will pay tax on net income. They will also be responsible for reporting their share of income and expenses on a tax return. In this instance, the partnership will need to file a Form 1065 and send a Form K-1 to each partner, which all partners must use to report details of income and loss in their personal tax returns. Each partner’s tax liability is based on an allocation agreed to in the partnership agreement.

Horse racing and IRS hobby loss rules

To qualify as a business and not a hobby, for IRS purposes, a horse racing partnership should make a profit in two years out of any seven. If year after year, the partnership declares losses, the IRS could decide that it is a hobby and disallow all net losses.

Horse betting and the IRS

Taxpayers who win $600 or more may receive a tax form reporting the prize, a W-2G or in some cases a 1099-MISC. The IRS will compare the information on the taxpayer’s return with the tax form reporting gambling winnings. For this reason, failing to report the prize as income is the surest way to get audited.

Just because a taxpayer doesn’t receive a tax form does not make the winnings tax-free. Taxpayers still have a responsibility to report their prize on their tax return as “other income.”

Derby winners can deduct losses

Gamblers may deduct their losses, but only as much as they report in winnings. So, if a taxpayer entered two pools at $10 each and won $100 from one pool, they could net the entry fee from the winning pool against the income, reporting $90 in winnings. For taxpayers who itemize, the entry fee from the losing pool and any other gambling losses would be taken as an itemized deduction, up to a maximum of $90.

Winners this weekend need to keep more than their ticket to claim their prize. They should keep a record of their expenses and income for next April’s tax deadline – or if they’re professional gamblers, their June 15 estimated payment deadline is approaching.

Taxation in the horse industry can be complicated. Taxpayers should consult a tax professional about their participation in horse partnerships and whether they are eligible for tax advantages.