Hide and Seek Depreciation

[Snaggletooth]

Local drag strip about 40 miles away.

Client, in his 20s, seems to be very good at racing his modified racer. In 2006, he first began racing. I began depreciating his racecar and taking expenses, showing a modicum of prize money as income, but deducted a sizable loss. During that session, I told him that unless he developed a pattern of winnings, I would not continue to treat his racing as a business due to hobby loss rules.

In 2007, more of the same, except there was a 1099. I deducted enough expenses to offset the revenue on the 1099, but refused to report a loss. None of the expenses included depreciation on his modified racecar.

A mutual friend told me he had been winning this summer in 50% of his entries. Haven't seen the final numbers, but if this is true, then he WILL have profit in 2008, and we can begin depreciating his racer once again.

Long and short of this, we depreciated in 2006, did NOT depreciate in 2007, but will depreciate in 2008. Do we:

1)pick up where we left off in 2006 with adjusted basis as of 12/31/06 or
2)pick up where we would have left off as of 12/31/07 as if we depreciated for that year. This means a whole year of depreciation would be wasted.

A good question for the "depreciated or depreciable" theory.

[Black Bart]

Just a theory, but

...we depreciated in 2006, did NOT depreciate in 2007, but will depreciate in 2008. Do we:

1)pick up where we left off in 2006 with adjusted basis as of 12/31/06 or
2)pick up where we would have left off as of 12/31/07 as if we depreciated for that year. This means a whole year of depreciation would be wasted.

A good question for the "depreciated or depreciable" theory.

ordinarily, as you know, when a business is still in existence and operating, assets of that business which are temporarily idle/not being used continue to be depreciated. BUT...in this case...since you didn't take any 2007 depreciation, weren't you saying this was a hobby instead of a business and that the business had temporarily ceased to exist? And wouldn't that mean that depreciation stops just as it does for any discontinued business -- the car then becoming a non-depreciable personal asset with no tax effect? Whaddaya think?

Actually I've never filed a hobby return and am unsure how that's done. For '07 did you put:

1. Income on C -- expenses on A

2. Everything on C (would make it still a business and kill my theory, I guess)

3. Income on 1040 line 21 -- expenses on A

4. Some other way?

[les grans]

Well, how come did you change him from a business in the first year to a hobby in the second year? From your description, nothing changed.... Isn't it how he runs the business, and not whether it's making losses, that's the real test in the hobby loss rules?
Under section 183, isn't the taxpayer entitled to a couple of years of losses, if he uses the "rebuttable presumption" to his advantage, no matter how he runs the business, and then isn't it IRS's job to assess his "business-like manner" in an audit and thus threaten him with hobby status?

I don't have a ready answer to the "allowed or allowable" depreciation question, but I know that I've found a solution several times many years ago. There's a provision somewhere that suspends deductions til the next year when they aren't allowed... Is that in the home office rules? Does it also apply to the hobby loss rules?
No answer, sorry. More later.

[Snaggletooth]

Why did I change?

Well, how come did you change him from a business in the first year to a hobby in the second year? From your description, nothing changed.... Isn't it how he runs the business, and not whether it's making losses, that's the real test in the hobby loss rules?

Good question les grandes, but actually the only thing that changed was the passage of one year to the next.

I have three clients who race at the same track - the other two are hopelessly mired in spending money with no hope of ever winning enough to avoid huge losses. This kind of small-town, dirt-track auto racing is about as likely to produce a profit as raising horses, and the IRS knows it. In fact, even the big name NASCAR racers would operate at a loss were it not for sponsors.

I told the guy in year 1, we would prepare the return using the loss, but unless there was a pattern of improvement, I couldn't continue taking losses. The big problem was in year 2, the race track sent him a 1099 for about $750, so I couldn't just ignore it. I didn't want to show a loss, but I didn't think he should show income either when there was about $4000 in expenses. So I deducted $750 expenses and netted out the 1099 to zero.

If what I'm told is true, he will have $6000-$7000 in revenue for 2008, and will be close to break-even or perhaps a little better.

Why did I change from business to hobby back to business? I don't think there is a statutory application which can supplant subjective judgment on facts-and-circumstances which can change year-to-year. Hindsight is always 20-20, and with this new information, it would be entirely proper to do a 1040X for year 2, taking a $3000 loss. However, I'm not going to invite scrutiny by sending in an amended return asking for a refund on dirt-track racing -- at least not until I have better footing with his 2008 information.

[BHoffman]

Hindsight is always 20-20

Agreed. Would form 5213 be useful for situations like this? I've never used one, but my handy-dandy "The Tax Book" mentions it on page 5-19.

http://www.irs.gov/pub/irs-pdf/f5213.pdf