Alpaca Tax Planning

Alpaca Taxes:
Why Not Have Uncle Sam Help You Buy Your Alpacas

By Jacquie Joner

Did you know that Rome’s Caesar once said “all the world should be taxed?” It seems our politicians have also acquired this opinion, at least when you look at your tax bill each year. The great and wonderful thing about our Alpacas (and your future Alpacas) has meant a huge tax savings for us each year that we have owned these sweet creatures. It’s serious money too. Our tax bills each year have been in the five figures due to our custom home building business earnings and profits. This past year we even received a refund! That’s the first time for that in “ages.” No one we know wants or likes to pay taxes, and this is a legitimate tax shelter. Alpacas have been classified with livestock of all types (beef, dairy, sheep, goats, etc.). These deductions are real. Nearly everything is tax deductible. The fences, feed, veterinarian, their buildings for shelter, showing fees, advertising, pasture grass seed, fertilizer, equipment used to perform related tasks are depreciated, and so on are all deductibles for your taxes. No complaints there.

The "Jobs and Growth Reconciliation Tax Act." was enacted into law on May 28, 2003, and amended for the 2008 tax year. The new rules added several powerful incentives for people who buy alpacas. The 179 deduction has been raised to $250,000, and it is available thru 2010. In addition, for 2008, special bonus depreciation is available for farms making large capital investments in 2008 and 2009. If the Alpacas are raised for profit, as in any business, the expenses from your venture can be written off against income.

Here is how the unique advantages for the Alpaca farmer/owner work. (The Alpaca owner does not need to keep the Pacas at his/her farm. They can be agisted – boarded – at the seller’s farm or wherever you choose. You still have the tax writeoffs.) Uncle Sam will pay for a portion of the cost of acquiring your herd if you are presently paying income tax and will likely continue to pay income tax over the next six years.

To begin with you write off 100% of your original purchase price, up to a maximum of $250,000, in the year of purchase. A person in the 45% tax bracket can mean deductions for depreciation for which the animals are eligible may save you up to 45% of your original cash outlay for purchase of your Alpacas.

Hypothetically a person buying 10 or so females for approximately $250,000, pays $75,000 down, and takes advantage of IRS code section 179. The really amazing thing is that you can insure your Alpacas, finance the balance over 3-4 years, and Uncle Sam gives you a tax refund of $121,408 and you would have cash out of pocket of only $8,711 in the first year. Again, this applies to the 45% tax bracket (state & federal). The total after tax cost of your $250,000 investment is $180,850 over the 6-year asset life the IRS allows.

Our Uncle Sam really does help buy your alpacas. In this case, he provides you tax breaks to the tune of $69,150. What is really nice is the lion's share of the tax savings occurs in the first year. New alpaca farmers usually have the greatest need in the first year when building barns and fences, etc. The tax savings due to accelerated depreciation are very helpful during farm start-up. If you are investing more than $250,000, the special bonus depreciation provides even greater benefits as calculated by your tax professional.

North American Alpaca Co. can provide the after-tax cost of your prospective alpaca purchase according to the tax law update as prepared by our tax professionals. Simply e-mail us at jwjacqueline@msn.com and we will be glad to provide a six-year projection that calculates the after-tax cost of your alpacas. Of course, you need to engage your own tax professional for advice in setting up your business tracking and proper handling of these tax breaks.

This information is given to you only as a suggestion for your benefit. It is not professional advice. It is best to be aware of your benefits to know that there really are benefits to be gained. We can snail mail you some printed information as well, if you would like. Here are some scenarios to consider toward the decision of your purchase of Alpacas.

TAX DEFERRED WEALTH BUILDING

Wealth building with your Alpacas, while deferring tax on your investment's increased value, a small farmer can purchase several Alpacas and then, as your herd to grows over time, you won’t be paying tax on its increased size and value. If the same amount of money was invested in a Certificate of Deposit, any interest earned would presently be taxable. Also, the CD could not be depreciated to offset the amount of tax due.

IRS CODE SECTION 179 DEDUCTION

This deduction is available every year when you purchase IRS code 1245(a) (3) assets that are acquired for use in an active business [(Code Section 179 (d) (1)], assuming that you have not used the deduction on a computer or some other qualifying asset. Many people do not understand that you can use this deduction to write off your purchase of up to $250,000 worth of alpacas this year and that they can take another $250,000 deduction next year for additional qualifying assets. The following example takes into consideration IRS code section 179. For a copy of the code section, please give us a call at 360 687-2977 or email us at jwjacqueline@msn.com.

Example purchase price (one or more alpacas): $250,000
Consider Section 179 tax deduction ($250,000)
Anticipated tax savings 45% (tax bracket 45%) ($112,500)
Your actual after-tax cost out of pocket $137,500

That’s pretty impressive. If you are in the 45% tax bracket (state & federal) the government will reduce your taxes by 45% of the cost of $250,000 worth of alpacas. The deduction is available for all taxpayers with an active business. To see how much this will benefit you, simple calculate your state and federal tax bracket and multiply it by the amount of your purchase up to $250,000.

Here are requirements:

Sufficient income to use the deduction. Income must be earned income to utilize the deduction. Earned income includes wages & self employment income, but Social Security and pension income do not qualify.
Unused part of your deduction can be carried forward for future years.
It is possible to pass up on electing to take the deduction and just depreciate the cost of the Alpacas. That would allow creation of a net operating loss, carried back two years and possibly obtain a refund of previously paid taxes.
To gain the benefit from the 179 deduction you (the tax payer) is limited to placing no more than $800,000 of qualifying assets in service for the same year as the deduction being taken.

AN ADDITIONAL 50% FIRST YEAR DEPRECIATION

Congress, to stimulate the economy, gave taxpayers an additional 50% first-year depreciation write-off for most new capital assets in 2008. This includes single-purpose agricultural buildings placed in use before December 31, 2008. Agricultural buildings, as defined below, also qualify for the Section 179 deduction.

"Single purpose agricultural (livestock) or horticultural structures. A single-purpose agricultural (livestock) or horticultural structure is qualifying property for purposes of the section 179 deduction. For purposes of determining whether a structure is a single-purpose agricultural structure, poultry is considered livestock.

Agricultural Structure. A single-purpose agricultural (livestock) structure is any building or enclosure designed, constructed, and used for both the following purposes: 1) To house, raise, and feed a particular type of livestock and its produce. 2) To house the equipment, including any replacements, needed to house, raise or feed livestock."

Section 179 Deduction
IRS Publication for farmers, Chapter 8, Depreciation, Depletion, and Amortization.
This additional write-off means that you can recover more of the cost of a business asset, such as an alpaca or a barn, in the year you put it in service.

HOBBY FARM RULES

The first step in qualifying for favorable tax treatment as a farmer is establishing that you are in business to make a profit. You can not raise alpacas as a hobby farmer and receive the same tax preferences as a for-profit farmer. A farming operation is presumed to be for profit if it has reported a profit in two of the last seven tax years, including the current year.

If your farm fails the two years of profit test, you may still qualify as a "for profit" enterprise if your intention is to be profitable. Some of the factors considered when assessing your intent are:

You operate your farm in a business-like manner.
The time and effort you spend on farming indicates you intend to make it profitable.
You depend on income from farming for your livelihood.
Your losses are due to circumstances beyond your control or are normal in the start-up phase of farming.
You change your methods of operation in an attempt to improve profitability.
That you make a profit from farming in some years and how much profit you make.
You or your advisors have the knowledge needed to carry on the farming activity as a successful business.
You made a profit in similar activities in the past.
You are not carrying on the farming for personal pleasure or recreation.
You don’t have to qualify on each of these factors - the cumulative picture drawn by your answers will provide the basis for the determination.

FARMERS TAX GUIDE

One of the frustrating factors in dealing with the IRS rules is getting to a definitive answer. The code is often more grey than black or white; consider the following statement which is found in IRS publication 225, Farmers Tax Guide:

"This publication covers some subjects on which a court may have made a decision more favorable to taxpayers than the interpretation of the Service. Until these differing interpretations are resolved by higher court decisions or in some other way, this publication will continue to present the interpretation of the Service."

It is recommended that those who farms Alpacas obtain a copy of this handy guide at your local IRS office or at the IRS website at http://www.irs.gov/pub/irs-pdf/p225.pdf. for more information.

Once you're established as farming Alpacas with the intent to make a profit, it is possible to deduct all qualifying expenses from your gross income. The discussion from here forward presumes you are a cash basis taxpayer and you keep good records. Accrual basis tax payers would also be allowed the same tax treatment, but their timing might be different.

First, the following items must be included in your gross income calculations:

Income from the sale of livestock
Income from sale of crops, i.e., fiber
Rents
Agriculture program payments
Income from cooperatives
Cancellation of debts
Income from other sources, such as services
Breeding fees

Then the following expenses may be deducted from this income:

Vehicle mileage at .505 cents a mile for all farm business miles
Fees for the preparation of your income tax return farm schedule
Livestock feed
Labor hired to run and maintain your farm (remember, you must not deduct the expense of maintaining your personal residence)
Repairs and maintenance
Interest
Breeding fees
Fertilizer
Taxes and insurance
Rent and lease costs
Depreciation on animals used for breeding, real property improvements, barns and equipment
Farm-related travel expenses
Educational expenses, which improve your farming expertise
Advertising
Attorney fees
Farm fuel and oil
Farm publications
Professional fees for organizations such as AOBA (Alpaca Owners and Breeders Assn.) dues and registry
Miscellaneous chemicals i.e. weed killer
Vet care
Small tools having a useful life of less then one year

Please note: Personal and business expenses must be allocated between farm use and personal use, for instance, with such expenses as utilities, property taxes, accounting, etc. Only the farm use portion can be expensed.

AT RISK RULES

Once you've determined your net income or loss, it is included on your tax return as an addition to or a deduction from your ordinary income. Losses can be carried back for two years and forward for twenty years. To deduct any loss, you must be at risk for an amount equal to or exceeding the losses claimed. The "at risk" rules mean that the deductible loss from an activity is limited to the amount you have at risk in the activity. You are generally at risk for:

The amount of money you contribute to an activity
The amount you borrow for use in the activity

You must establish the cost basis of your assets for tax purposes. This basis is used to determine the gain or loss on sale of an asset and to figure depreciation. In determining basis, you must follow the uniform capitalization rules found in the IRS code. Animals raised for sale are generally exempt from the uniform capitalization rules, and there are other exceptions for certain farm property. You need to become familiar with these rules.

Once the cost basis of your various assets has been established, you take a charge for depreciation against your annual income. This process allows you to expense the historic cost of an asset to offset present income. The effect is to create non-taxable cash flow on a current basis. This benefit is especially attractive in an environment of higher taxes.

ALPACAS SIX YEAR WRITE-OFF

There are several methods of writing Alpacas off, beginning with the straight line method which allows you to deduct one-fifth of their cost each year, except the first year, in which the code allows for a prorated write off based on the month of your purchase. The net result of this method is that it takes six years to write off your Alpacas. The straight line system can only be used by making an election. There is also the modified accelerated cost recovery system using 150% declining balance and the half-year or mid-quarter convention (MACRS) which allows animals to be written off as follows: 15% year 1, 25.5% year 2, 17.85% year 3, 16.66% years 4 and 5, and 8.33% year 6. This is an accelerated schedule allowing for a larger percentage of the asset to be written off early. The MACRS system is the system preferred by the IRS since it does not require an election. Alpacas born at your ranch have no cost basis and cannot be written off, although they may qualify for capital gain treatment on sale. The costs related to financing or interest on your purchase is also deductible. Many people pay cash for their animals so writing off the interest is not an issue. The following example articulates the benefits of tax deductions, both Section 179 and 2008 Special Bonus Depreciation, derived from an investment in Alpacas. The examples do not include expenses for feed, veterinarian care, supplies, and transportation.

FINANCING

Consider this scenario: what would happen if you purchased a herd of Alpacas and built a barn for $350,250.00. Assuming you are in the 45% overall tax bracket (state and federal), use both the section 179 deduction and 50% bonus depreciation in year one, use the MACRS depreciation method, provide a $100,000 down payment, finance the balance at 8% interest for four years, and insure the investment for full value. If you would like to receive a customized projection, similar to the following, for your purchase, please email us at jwjacqueline@msn.com. All alpaca breeding stock and capital equipment acquisitions of up to $250,000 can be 100% expensed in the year of purchase. Fifty percent bonus depreciation is applied to qualifying assets in excess of $250,000 (Please consult your accountant to determine how these benefits pertain to your actual taxable circumstances.)

FIVE YEAR AFTER TAX PURCHASE PROJECTION

(See PDF document to view entire Tax Planning table)
The total after-tax cost of purchasing a $350,000 herd for taxpayers in the 45% bracket (state and federal) is $253,663, spread over six years, including principal, interest, and insurance.

CAPITAL IMPROVEMENTS

Capital improvements to your ranch can also be written off against income. Barns, fences, pond construction, driveways, parking lots all can be expensed over their useful lives. Equipment such as tractors, pickups, trailers and scales each have an appropriate schedule for write off. The depreciation schedule for each asset class varies from three years to forty years. A barn or special purpose agricultural building can be written off pursuant to Section 179 in the year it is put in service. If you do not chose to write the barn off as a Section 179 asset then you can depreciate it. To qualify for a 179 deduction it must be put in service after May 5, 2003 and before 2010.

The original cost basis of an asset is reduced by the annual amount of depreciation taken against the asset. Other costs add to basis, such as certain improvements or fees on sale. The changes to basis result in the adjusted cost basis of the asset. Upon sale excess depreciation previously expensed, must be recaptured at ordinary income rates. The recapture rules are a bit complex, as are most IRS rules, but the IRS Farmers Publication mentioned explains them well.

CAPITAL GAINS VS. ORDINARY INCOME

When an asset is sold, for instance a female Alpaca, which was purchased for breeding purposes and held for several years, the gain or loss must be determined for tax purposes. If this Alpaca was purchased for $20,000 depreciated for two and a half years or, say, 50% of its value, and then resold for $20,000, there would be a gain for tax purposes of $10,000. In other words, your adjusted cost basis is deducted from your sale price to determine gain or loss.

Once you've determined the amount of a gain, you must classify it as either ordinary income or capital gain. In 2008 ordinary income was taxed at a maximum rate of up to 35% and capital gains were taxed at rates of up to15%. Previously these rates were 39% and 20% respectively. The sale of breeding stock qualifies for capital gains treatment (except that portion of the gain which is subject to depreciation-recapture rules). Any Alpacas held for resale, such as newborn cria which you do not intend to use in your breeding program, would be inventory and produce ordinary income on sale. Animals born on your ranch and held for breeding purposes, which usually involves holding them for more than two years, can be taxed at capital gain rates on sale. The capital gains treatment of sale proceeds are an attractive benefit of raising Alpaca breeding stock

CHARITABLE DEDUCTIONS AND EXCHANGES

There are other tax-saving strategies that can be utilized with operating your farm. For instance, you are entitled to claim a charitable deduction for the fair market value of a capital asset, which you contribute to a qualifying charity or institution. You can also exchange like for like (Section 1031) assets and avoid the tax of a sale. An example of this strategy would be a breeder who wanted to diversify his bloodstock. If he sold his Alpacas and simply bought more, he would be required to pay tax on his gains. If he exchanged his Alpacas for others, there would be no tax due. Employing the exchange concept can be very beneficial. For it to work efficiently, a third-party buyer is usually introduced into the transaction. The model for this type of transaction would be a real estate exchange. Your CPA would be familiar with the use of like/kind exchanges and how it might benefit you.

INSTALLMENT SALES

Installment sale rules allow you to defer income to future years. If you sell an Alpaca with credit terms, you can defer your gain until you receive payment (except that portion of the gain which is subject to depreciation recapture rules). If an animal dies of disease and is insured, you can use the involuntary conversion rules in the code. These rules allow tax-free replacement of your animal.

CONCLUSION

We are not accountants. This information of tax issues omits a number of rules which will impact your taxes. We did not talk about tax preference items, alternate minimum taxes, employment taxes and other concepts of importance. These things are complicated. Usually they require assistance from a CPA and/or an attorney.

To summarize, the major tax advantages of conducting an Alpaca business include the use of expensing capital assets depreciation, capital gains treatment, and the benefit of offsetting your ordinary income from other sources with losses from your farming business. Wealth-building by deferring taxes on the increased value of your herd is a big plus. You or your professionals need to keep your eye on the tax law changes instituted by Congress.

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