Are you an American taxpayer? We will share several recommendations with you
If you are an American tax-payer, you’ve probably stumbled upon the words “active yacht ownership” or "boat as a business". This post was written to help you better understand what this concept is and how it may apply to your situation. Additionally, there are other considerations you may want to discuss with your financial advisors outside of an “active business”.
What does Yacht ownership have to do with tax deductions?
- We point out and discuss the possible merits and challenges associated with the tax implications of owning a yacht.
- The phrase “active yacht ownership” refers to the business strategy of purchasing a yacht and placing it into a charter program to generate income
- Section 183 of the IRS code, also known as the “hobby loss rule”, limits the losses that can be deducted from income that are attributable to hobbies and other not-for-profit activities.
See the entire webinar
In this edition of our yacht sales webinar, the Navigare team discusses tax planning for yacht buyers looking to place their yacht in charter with Giselle Alexander. Giselle Alexander is a Certified Tax Law Specialist, a CPA, and holds a Masters in Law in Taxation. After transferring from a Big-4 accounting firm, she transitioned into tax controversy. As a member of the prevailing legal team for the landmark case, Kline vs Commissioner, Giselle Alexander is at the cutting edge of the IRS rules for the business of placing yachts in a charter fleet and running an active business. Listen in to hear her recommendations and hear her answer to your most common questions!
While we point out and discuss the possible merits and challenges associated with the tax implications of owning a yacht, this is not intended to provide tax advice, as only a professional accountant or financial advisor acting in a fiduciary capacity should advise you. If you are looking for a reputable CPA to assist you with your decisions surrounding a yacht purchase or making your boat available for charter, please contact Navigare Yachting and we will share several recommendations with you.
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How you choose to run your business, whether in your name or through a dedicated corporation, will have an impact on the depreciation you can take if any. The choice is yours, however holding title to the yacht in a corporate entity, either an LLC (limited liability company), partnership, or corporation, for example, reduces your legal exposure and financial risk. Holding title through a legal entity may also trigger tax consequences and advantages not available to individuals. However, notwithstanding the potential tax benefits, most yacht owners will choose an LLC or another Corporate entity to reduce their liability associated with the yacht.
What is active yacht ownership?
The phrase “active yacht ownership” refers to the business strategy of purchasing a yacht and placing it into a charter program to generate income, thus reducing the cost of yacht ownership. Generally, the program allows for some personal use of the yacht at the discretion of the owner. In some circumstances, additional tax credits are available beyond the “traditional” deduction of day-to-day business expenses. These tax benefits may vary and may or may not apply to your particular situation. To verify your active participation in the business, the IRS has defined several criteria that one must meet before the additional deductions may be legally taken. These criteria include, but are not limited to:
- The ability and intent to make a profit (this is called the “hobby loss rule”, explained below)
- The owner must perform at least 100 hours of work on the business each year, and more than any other person related to the yacht’s activity (for purposes of the 100-hour test, a taxpayer’s spouse’s participating in the activity is also treated as participation by the taxpayer).
Such hours of work constitute “material participation” in your business and may include:
- attending a boat show, and
- maintaining the business’s website and promoting the business online, and
- travel for physical inspection of your yacht as well as testing of the vessel and its systems, and
- getting to know the intended sailing grounds where your yacht will be placed to promote your charter business.
Active Participation is very different from passive activity (such as long-term real estate rentals). Generally, any rental activity is deemed a passive activity, without regard to what extent the taxpayer participates in the activity. However, your yacht business is not considered a rental activity if:
- The average period of customer use for the yacht is seven days or less;
- The average period of customer use for the yacht is 30 days or less AND significant personal services are provided on behalf of the yacht owner for making it available for use by customers.
- Extraordinary personal services are provided by or on behalf of the owner of the yacht in connection with making the yacht available for use by customers.
Expensing through Section 179
One of the most well-known incentives available when actively participating in a business is a section of the IRS code called “Section 179”. It was designed to help small businesses as they set out to buy or lease new or used equipment. It allows a taxpayer to deduct the cost of certain types of property (such as a yacht) on their income taxes as an expense, rather than requiring the cost of said property to be capitalized and depreciated. As of January 1, 2018, under section 179(b)(1), the maximum deduction is capped at $1,000,000 per year. This means that a taxpayer may elect to deduct up to $1,000,000 of the value of the yacht per year. If you adhere to the IRS guidelines and get the competent advice of a knowledgeable CPA, your charter yacht operations may qualify as an active business eligible to take advantage of this and other sections of the IRS code.
The hobby loss rule (Section 183)
Section 183 of the IRS code, also known as the “hobby loss rule”, limits the losses that can be deducted from income that are attributable to hobbies and other not-for-profit activities. In general, losses which occur in for-profit activities are not limited and can be used to offset other income from other activities. But the Section 183 limitation curtails those deductions when the activity has been deemed a hobby. It is generally accepted that if one generates a profit 3 out of 5 years, the activity is not considered a hobby. However, the code does not state that a profit MUST be made for 3 out of 5 years to clear the hobby loss rule. Therefore, your business must demonstrate “the ability and the intent” to make a profit. Expert accountants make recommendations on how to justify the “ability and intent” to generate a profit while running a business of yacht charters. Demonstration of “ability and intent” can be shown through careful research before starting a charter activity, and demonstrated by drafting a thorough business plan, documenting charter and non-charter activities rigorously, keeping accurate books of account, and also actively promoting the yacht available for charter. Since each tax situation is unique and varies from year to year, we advise all of our clients to seek proper professional assistance on this matter before engaging in the charter activity.
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Claiming depreciation within your for-profit boat activity
As explained above, expensing under Section 179 of the IRS is the most accelerated form of depreciation. Section 179 allows a taxpayer to expense (or deduct as a current rather than a capital expense) up to their basis in the vessel, currently capped at $1 million per year, of the total purchase price of new and used qualified depreciable assets it purchases and places in service in 2018, with certain limits. Those unable to claim this allowance may recover the cost of qualified assets over longer periods, using the depreciation schedule from Sections 167 or 168. The special allowance under Section 168 has become known as “bonus depreciation”. Note that it is only applicable if the yacht owner and taxpayer did not use the property before its acquisition and did not acquire the property from a related party. Additionally, a yacht is considered qualified property since it has a recovery period of 20 years or less, however, Section 168 will only apply to a new yacht.
Section 465 of the IRS code limits losses that may be deducted by certain taxpayers engaged in covered activities under section 465. The at-risk rules apply to the leasing of depreciable personal property, including boats and yachts. Any loss from the covered activity for the year is allowed only to the extent the taxpayer is at-risk concerning the activity at the close of that year.
Alternative strategy: boat as a second home
Should the active business route not suit your sailing program or your circumstances, the second home qualification may be of interest to you. A watercraft that has at least one berth, a galley, and a toilet can qualify for a mortgage interest deduction as a second home. However, deductions are limited for rentals of a second home used for personal purposes:
- If renting out the second home (yacht), the taxpayer must use it himself/herself for the longer of 15 days or 10% of the number of days the yacht is rented out.
- If a boat is not a personal residence because there are too many rentals or two few personal-use days, it is treated as a rental property and all expenses, including interest, are allocated between rental use and personal use. The personal use portion of the interest expense is not deductible because the property fails to qualify as a residence.
Expenses attributable to rental use are deductible but are subject to the passive, activity, hobby loss, and at-risk limitations described above.
Prospects looking to purchase a yacht and place it into a charter program should also prepare their exit strategy. It’s critical to understand ahead of time the consequences of terminating the program you've engaged in; one of the most significant events being the recapture, or repayment of certain deductions, at the time you resell your yacht.
Another factor looked at by the IRS in their analysis of how to treat your business, is whether the yacht owner sought independent tax advice outside of the charter operators that promoted the yacht sale in the first place. Therefore, we urge our clients to obtain the expert guidance of a CPA who can walk them through their options and prepare them for a potential tax audit. Many brokers and yacht management companies do not disclose all of the risks and uncertainties of owning a yacht as a business. Very few charter arrangements will satisfy the IRS requirements, and tax audits can be detailed and onerous! Should you need further assistance, please contact us, we would be delighted to speak with you and your CPA about creating a charter program well suited to your unique needs.
For more information, please review the following. We do not undertake to provide any advice on your tax situation, but these links could help you ask the right questions of your CPA or other tax professional. Please note that the tax code regulations and tests are updated and amended by the IRS regularly, and therefore we recommend that you speak to a tax and legal professional for more information on any of these topics.
Boatinglaw.com, Checklist for Significant Vessel Purchase http://www.boatinglaw.com/maritimearticles/purchaseofavessel.html
IRS Publication 925 – Active vs. Passive Activity https://www.irs.gov/pub/irs-pdf/p925.pdf
Section 179 (26 U.S.C.A. §179) https://www.law.cornell.edu/uscode/text/26/179
Section 168 (26 U.S.C.A. §168) https://www.law.cornell.edu/uscode/text/26/168
IRS Publication 936 - Boat as a Second Home https://www.irs.gov/pub/irs-pdf/p936.pdf