Old MacDonald Had a Farm… and Income… and Loss

Most people have become pretty familiar with the concept of long-term capital gains (and for the past few years, qualified dividend income) and how they are subject to favorable federal income tax treatment compared to other types of income.

But many people have a hard time grasping how different types of activities can impact the outcome on their income tax returns. More specifically, classifications such as “trade or business,” “passive,” “rental,” “portfolio” and “investment.”

Farmers are particularly susceptible to these differences because they often receive income from several different sources. They also tend to, sometimes incorrectly, see all sources of income as “farm income,” causing them to believe that “a dollar spent is a dollar of deduction.” Issues surrounding income classification have become magnified with the impact of shale drilling and related payments being received by landowners.

For example, a farmer with several hundred acres may receive income from many different sources:

  • Sales of grain, raised or purchased livestock, federal program payments, custom hire work.
  • Royalties from existing oil and gas wells on owned property.
  • Rental of land, homes or buildings on the land, or lease bonuses on gas drilling agreements.
  • Sales of land used in farming, land held for investment, or equipment used in farming operations.
  • Interest and dividend income on savings and investments.

Of this list, only the first item is trade or business income (although timber sales can be treated as either trade or business or capital gains, depending on the election made). The reason this is important to understand is that if certain activities create losses (like rental activities), those losses may be limited due to passive activity rules.

Also, small businesses, farmers in particular, tend to heavily utilize the election to expense purchases of equipment under Section 179. The hidden trap is that this election can only be used to offset trade or business income, but not below zero. For example, the taxpayer may have $20,000 of rental and royalty income, and $20,000 of farm business income, before any consideration of depreciation on new equipment purchases. Common thinking is that a $40,000 equipment purchase can be written off immediately under Section 179, eliminating the total income of $40,000. However, the elected expensing of that equipment can only be used to reduce the farm business income to zero, leaving the $20,000 of rental and royalty income subject to tax.

Of course, this is a simplified example, and highly summarized explanation of the issues. Be sure to consider income classification when planning and making decisions on things like equipment purchases.

This article was originally published in Illuminations: Facts & Figures from people with a brighter way, a Rea & Associates enewsletter, 2/13/2013.

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.