We all realize that when your farm expenses exceed your farm income, you have a loss from the operation of your farm. However, were you aware that the amount of the loss that is deductiblemay be limited? One potential limitation is for those losses that become restricted under passive activity rules. Tax laws require farmers to classify income and expenses into two categories: passive and non-passive. Losses from a passive farming activity are limited for tax purposes.
A passive activity is generally any activity involving the conduct of any trade or business in which you do not materially participate. Material participation requires the taxpayer to be involved in the operation of a trade or business activity on a regular, continuous, and substantial basis. So how do you determine whether you materially participate in your farming activities? It can be determined that you have materially participated in the operation if any of the following criteria are met:
- You work 500 hours or more in the activity during the year,
- You do all, or nearly all, of the work in the activity, or
- You work more than 100 hours in the activity during the year, and no one else works more than you do.
There are four other tests, but they are much more complicated and difficult to satisfy.
A spouse’s participation in the activity may also be counted as toward total participation in the activity, whether or not your spouse owns an interest in the activity, and regardless of whether you file a joint income tax return.
It is important to note that the IRS may question whether the material participation threshold is met if you live a significant distance from the business, you were not compensated for your work, or you have a full-time job or many other businesses and investments to manage.Additionally, renting or leasing land to another farmer or rancher does not constitute material participation, and is almost always considered a passive activity.
If it is determined that you have a passive activity loss, the IRS limits the amount you can deduct to the amount of income generated from other passive activities. Passive losses cannot be used to reduce the taxpayer’s non-passive income. However, any additional loss can be carried forward to offset passive income in subsequent years.
In addition to passive activity loss limitations there are several other rules that may have a significant impact on the deductibility of losses sustained from from farming activities. Hobby loss, excess farm loss, and “at risk” rules may limit deductions in other ways. If you are unsure how these or other rules affect your farming activities, please contact your tax preparer to prevent unexpected tax consequences.