Passive Loss Rules
Tax rules require the farmer to classify income and losses into two categories: earned or passive. If the farmer's loss is from a passive farming activity, the use of any resulting farming loss is limited for tax purposes. A passive farming loss can generally only be claimed against other passive income. It cannot be claimed against the farmer's earned (or "active") income from other sources.
The degree of the farmer's participation in the farming activity determines whether the farming activity is active or passive. If the degree of a farmer's activity in the farming operation meets one of the several "material participation" tests under the applicable tax rules, the income or losses from the farming operation will not be categorized as passive.6The losses will therefore not be subject to the limitation of being used only against passive income but rather, can be used against active, or earned income.
A farmer having self-employment income from the farm operation, typically reported using Schedule F, will generally be considered to materially participate in that farming activity.7While leasing real estate is generally considered a passive activity, special rules exist for farmers that lease land that make it easier for the farmer to meet the material participation requirement. A landlord farmer is considered to be a material participant if that farmer performs any three of the following four activities:
- Pay at least half of the direct costs of producing the crop or livestock using cash or credit.
- Providing at least half of the tools, equipment and any livestock used in the production activities.
- Advise or consult with tenants.
- Periodically inspect the production activities.
Alternatively, if the landlord farmer does not perform three of the above tests, material participation still exists if the farmer does one of the following:
- Regularly and frequently makes (or takes an important part in making) management decisions that substantially contribute to the success of the arrangement
- Works at least 100 hours over a period of five weeks or more in activities connected with agricultural production, or
- Performs other activities that show material and significant involvement in the production of the farm commodities.8