The maximum federal income tax rate on long-term capital gains is currently 20%. Maximum ordinary income tax rates are up to almost 40%, so the spread between the two is significant. For certain taxpayers, the differential is made even greater by the effect of state taxes. Unlike other assets, the holding period to obtain long-term capital gain treatment on sales of horses is two years.

The two problems most often faced by horse owners when audited by the IRS or comparable state taxing agencies are the "hobby loss" and the "passive loss" rules. To prevail, owners must demonstrate that they have exercised preventive planning, followed good business practices and have documented their business activities.

In general, the tax laws referring the hobby loss rule provide that to deduct expenses that exceed income, the taxpayer must demonstrate that she is engaged in her horse-related activity with the intention of producing a profit. Initially, the burden of proof falls upon the taxpayer. However, if a profit can be shown in two of seven consecutive years beginning with the first loss year, the burden shifts to the IRS to disprove the "general presumption of profit intent."

The IRS cites nine factors in determining whether an activity is a hobby or business. They are very basic business points covering management style, degree of knowledge of the taxpayer, utilization of expert advisors, time and effort the taxpayer spends in the activity, the expectation for asset appreciation and the presence or absence of recreational aspects. From the IRS' perspective, a hobby correlates with fun, while a business means work: In other words, it is okay to enjoy the business, but only if you have a convincing profit motive.

Under the "passive loss" provision, in order to deduct losses suffered as a result of equine business activities from other income, an owner must be able to prove that she is materially participating in the activity. Material participation is satisfied by establishing that the owner spends 500 or more hours actively participating in the business during any taxable year. If the owner does not meet the 500-hour test, she may qualify with 100 or more hours if she participates on a regular, continuous basis throughout the year and meets certain other criteria. However, satisfying the requirements of this test is more difficult.

Hours spent by a husband and wife can be combined to accommodate these requirements. If an owner cannot prove material participation, losses can only be taken against other passive income. The sale of the investment, however, triggers the deductibility of all past losses disallowed.

Treat your horse-related activities as you would any other business venture. Carefully plan your time and the timing of your horse-related income and expenses. Simple documentation will aid in proving your intent to make a profit and active participation.

Horses may generally be depreciated over three to seven years. Longer periods of depreciation may be elected, and always apply in the case of foreign-based horses. Racehorses over two years old and breeding horses over 12 are depreciated over three years; all others are depreciated over seven years.

At first glance it seems more advantageous from a depreciation standpoint to purchase a horse over two years old. In the case of IRS rules, note that age is determined by the actual date of birth, not the industry-accepted January 1 of each year. Furthermore, to prevent taxpayers from purchasing at the end of the year and obtaining a large depreciation deduction, more than 40% of the purchases during one year are made during the last quarter, reduced depreciation results.