Farmers are sometimes surprised to find that the full amount of a year's loss from farming isn't the same loss amount that they can claim as a deduction on their tax return for the year. There are several sets of tax rules that must be met in order for a farm loss to be deductible. Farmers without crop insurance to cover losses should be aware of these rules that may limit the amount of deductible losses that can be claimed. The rules to be aware of include:
- "At-risk" rules1
- The excess farm loss rules
- The passive income rules.
The at-risk rules generally apply to all trade or business activities, including farming. These rules apply to farms that are taxed as S corporations and all farms that are not incorporated.2The farmer is considered to be at risk for the following amounts which are adjusted and determined at the end of each tax year:
- The amount of money and the basis in property contributed by the farmer to the farm business, and
- The amount of farm debt for which the farmer is personally liable. Debt for which the farmer pledged property as collateral qualifies as long as the pledged property is not already being used in the farming business as security for the amount borrowed.
The following debts generally do not qualify as debt included in the farmer's at-risk amount:
- Debt borrowed from a relative or another person that has an interest in the farm (other than as a creditor)3
- Nonrecourse debt
- Debts with a guarantee or stop-loss arrangement
Nonrecourse debt is generally debt that the farmer is not personally obligated to pay.
The amount of a loss that a farmer can deduct for the year may be limited to the amount the farmer has at risk in the farming business.
Fred's full-time job is working on the family farm. He purchased the farm, including buildings and all equipment in 2005 for $1 million. Fred purchased the farm with a down payment of $50,000 and a $950,000 mortgage. Fred lives in Illinois, where state law indicates that the mortgage constitutes recourse debt for which Fred will be personally liable in the event of default. After making monthly mortgage payments, Fred paid down $50,000 of the principal amount of the mortgage. Accordingly, at the end of 2012, the principal amount of Fred's mortgage is reduced to $900,000 and Fred's equity in the farm is $100,000 ($50,000 down payment plus $50,000 reduction of mortgage principal from making mortgage payments). At the end of 2012, Fred has a farming loss in the amount of $360,000. In addition, Fred had the following additional contributions to the farm business:
- An additional $10,000 to provide working capital if needed (which was still in the farm business bank account at the end of the year).
- A tractor with a cost basis of $5,000.
Fred's wife, Carol, works for a medical technology company. Carol received wages in the amount of $200,000 for the year.
A simplified balance sheet at the end of 2012 is as follows.
Fred would like to claim at least $200,000 of the $360,000 farm loss in 2012 to use against Carol's income on their joint return. However, the amount of deductible loss that Fred can claim for the year might be limited by the at-risk amount he has in the farm business. Fred's at-risk amount for 2012 is calculated at the end of the 2012 tax year4as follows.
In this case, Fred has an adequate at-risk amount ($1,015,000) to allow his full deduction of the $360,000 loss (as long as no other limits reduce the amount of deductible loss for the 2012 tax year).
Use the same facts as the previous example, but Fred during 2012, Fred had to renew his mortgage and the bank required Fred's mother to guarantee the mortgage. Guaranteed debt does not count toward Fred's at-risk amount. Fred's at-risk amount for 2012 is as follows.
While Fred has a 2012 farm loss of $360,000, he has only $115,000 at risk in the farm operation after his mother becomes guarantor of the mortgage. Therefore, of the $360,000 farm loss, the at-risk rules limit Fred's deduction to $115,000. This leaves a remaining suspended loss of $245,000 ($360,000 total loss - $115,000 deductible loss) that Fred must carry forward to future tax years until it can be used.