Losses From Operating a Farm

If your deductible farm expenses are more than your farm income, you have a loss from the operation of your farm. The amount of the loss you can deduct when figuring your taxable income may be limited. To figure your deductible loss, you must apply the following limits.

• The at-risk limits.
• The passive activity limits.

The following discussions explain these limits.

If your deductible loss after applying these limits is more than your other income for the year, you may have a net operating loss. See Net Operating Losses, later.

If you do not carry on your farming activity to make a profit, your loss deduction may be limited by the not-for-profit rules. See Not-for-Profit Farming, later.

At-Risk Limits

The at-risk rules limit your deduction for losses from most business or income-producing activities, including farming. The at-risk rules limit the losses you can deduct when figuring your taxable income. The deductible loss from an activity is limited to the amount you have at risk in the activity.

You are at risk in any activity for:

1. The money and adjusted basis of property you contribute to the activity, and
2. Amounts you borrow for use in the activity if:
   1. You are personally liable for repayment, or
   2. You pledge property (other than property used in the activity) as security for the loan.

You are not at risk, however, for amounts you borrow for use in a farming activity from a person who has an interest in the activity (other than as a creditor) or a person related to someone (other than you) having such an interest.

For more information, see Publication 925.

Passive Activity Limits

A passive activity is generally any activity involving the conduct of any trade or business in which you do not materially participate. Generally, a rental activity is a passive activity.

If you have a passive activity, special rules limit the loss you can deduct in the tax year. You generally can deduct losses from passive activities only up to income from passive activities. Credits are similarly limited.

For more information, see Publication 925.

Net Operating Losses

If your deductible loss from operating your farm (after applying the at-risk and passive activity limits explained in the preceding discussion) is more than your other income for the year, you may have a net operating loss (NOL). You also may have an NOL if you had a personal or business-related casualty or theft loss that was more than your income.

If you have an NOL this year, you can use it to lower your taxable income in another year or years. You may be able to get a refund of all or part of the income tax you paid for past years, or reduce your tax in future years.

To determine if you have an NOL, complete your tax return for the year. You may have an NOL if a negative figure appears on the line shown below.

1. Individuals - line 39 of Form 1040.
2. Estates and trusts - line 22 of Form 1041.
3. Corporations - line 30 of Form 1120 or line 26 of Form 1120-A.

If the amount on that line is zero or more, you do not have an NOL.

There are rules that limit what you can deduct from gross income when figuring an NOL. These rules are discussed in detail under How To Figure an NOL in Publication 536.

In general, these rules do not allow the following items.

• Personal exemptions.
• Capital losses in excess of capital gains. (Nonbusiness capital losses may only offset nonbusiness capital gains.)
• The section 1202 exclusion of 50% of the gain from the sale or exchange of qualified small business stock.
• Nonbusiness deductions in excess of nonbusiness income.
• Net operating loss deduction.

Example.   Glenn Johnson is a dairy farmer. He is single and has the following income and deductions on his Form 1040 for 2002.

INCOME
Wages from part-time job	$1,225
Interest on savings	425
Net long-term capital gain on sale of farm acreage	2,000
Glenn's total income	$3,650
DEDUCTIONS
Net loss from farming business (income of $67,000 minus expenses of $72,000)	$5,000
Net short-term capital loss on sale of stock	1,000
Standard deduction	4,700
Personal exemption	3,000
Glenn's total deductions	$13,700

Glenn's deductions exceed his income by $10,050 ($13,700 - $3,650). However, to figure whether he has an NOL, he must modify certain deductions. He can use Schedule A (Form 1045) to figure his NOL.

Glenn cannot deduct the following items.

Nonbusiness net short-term capital loss	$1,000
Nonbusiness deductions (standard deduction, $4,700) minus nonbusiness income (interest, $425)	4,275
Personal exemption	3,000
Total adjustments to net loss	$8,275

When these items are eliminated, Glenn's net loss is reduced to $1,775 ($10,050- $8,275). This is his NOL for 2002.

Carrybacks.   If you have an NOL for a tax year ending during 2002, you must generally carry back the entire amount of the NOL to the 5 tax years before the NOL year (the carryback period). However, you can still choose to carry back an NOL to the 2 (or 3, if applicable) years before the NOL year. Any remaining NOL can be carried forward for up to 20 years. You can also choose not to carry back an NOL and only carry it forward. See Waiving the carryback period, later. There are rules for figuring how much of the NOL is used in each tax year and how much is carried to the next tax year. These rules are explained in Publication 536.

Unless you choose to waive the carryback period, as discussed later, you must first carry the entire NOL to the earliest carryback year. If your NOL is not used up, you can carry the rest to the next earliest carryback year, and so on.

Refigure your deductions, credits, and tax for each of the years to which you carried back an NOL. If your refigured tax is less than the tax you originally paid, you can apply for a refund by filing Form 1040X, Amended U.S. Individual Income Tax Return, for each year affected, or by filing Form 1045, Application for Tentative Refund. You usually will get a refund faster by filing Form 1045, and generally you can use one Form 1045 to apply an NOL to all carryback years.

Exceptions to 5-year carryback rule.   Eligible losses can qualify for shorter carryback periods.

Eligible loss.   You can choose a 3-year carryback period for an eligible loss. An eligible loss is any part of an NOL that is:

• From a casualty or theft, or
• Attributable to a Presidentially declared disaster for a qualified small business.

Generally, an eligible loss does not include a farming loss (explained next).

Only farming losses attributable to Presidentially declared disasters in tax years that begin after August 5, 1997, and before January 1, 1998, are considered eligible losses subject to a 3-year carryback period.

Farming loss.   The carryback period for a farming loss is 5 years. A farming loss is the smaller of:

• The amount that would be the NOL for the tax year if only income and deductions attributable to farming businesses were taken into account, or
• The NOL for the tax year.

You can choose to treat a farming loss as if it were not a farming loss. If you make this choice, you can choose a 2-year carryback period. For more information, see When To Use an NOL in Publication 536.

Different carryback periods.   If you have a farming loss and a loss that is not from farming, you can choose different carryback periods for these losses.

Carryovers.   If you do not use up the NOL in the carryback years, carry forward what remains of it to the 20 tax years following the NOL year. Start by carrying it to the first tax year after the NOL year. If you do not use it up, carry over the unused part to the next year. Continue to carry over any unused part of the NOL until you use it up or complete the 20-year carryforward period.

For an NOL occurring in a tax year beginning before August 6, 1997, the carryforward period is 15 years.

Waiving the carryback period.   You can choose not to carry back your NOL. If you make this choice, you use your NOL only in the 20 year carryforward period. Once made, the choice is irrevocable.

To make this choice, attach a statement to your tax return for the NOL year filed on or before the due date of the return (including extensions). This statement must show you are choosing to waive the carryback period under section 172(b)(3) of the Internal Revenue Code. Also, if you filed your return timely without making that choice, you may still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). Attach the statement to the amended return and write Filed pursuant to section 301.9100-2 on the statement. File the amended return at the same address you filed the original return.

Partnerships and S corporations.   Partnerships and S corporations generally cannot use an NOL. But partners or shareholders can use their separate shares of the partnership's or S corporation's business income and business deductions to figure their individual NOLs.

Not-for-Profit Farming

If you operate a farm for profit, you can deduct all the ordinary and necessary expenses of carrying on the business of farming on Schedule F. However, if you do not carry on your farming activity, or other activity you engage or invest in, to make a profit, you report the income from the activity on line 21 of Form 1040 and you can deduct expenses of carrying on the activity only if you itemize your deductions on Schedule A (Form 1040). Also, there is a limit on the deductions you can take. You cannot use a loss from that activity to offset income from other activities.

Activities you do as a hobby, or mainly for sport or recreation, come under this limit. So does an investment activity intended only to produce tax losses for the investors.

The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

In determining whether you are carrying on your farming activity for profit, all the facts are taken into account. No one factor alone is decisive. Among the factors to consider are whether:

• You operate your farm in a businesslike manner,
• The time and effort you spend on farming indicate you intend to make it profitable,
• You depend on income from farming for your livelihood,
• Your losses are due to circumstances beyond your control or are normal in the start-up phase of farming,
• You change your methods of operation in an attempt to improve profitability,
• You, or your advisors, have the knowledge needed to carry on the farming activity as a successful business,
• You were successful in making a profit in similar activities in the past,
• You make a profit from farming in some years and how much profit you make, and
• You can expect to make a future profit from the appreciation of the assets used in the farming activity.

Presumption of profit.   Your farming or other activity is presumed to be carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed to be carried on for profit if they produced a profit in at least 2 out of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity is more than the deductions for it.

If a taxpayer dies before the end of the 5-year (or 7-year) period, the period ends on the date of the taxpayer's death.

If your business or investment activity passes this 3- (or 2-) years-of-profit test, it is presumed to be carried on for profit. This means the limits discussed here do not apply. You can take all your business deductions from the activity on Schedule F, even for the years that you have a loss. You can rely on this presumption unless the IRS shows it is not valid.

If you fail the 3- (or 2-) years-of-profit test, you still may be considered to operate your farm for profit by considering the factors listed earlier.

Using the presumption later.   If you are starting out in farming and do not have 3 (or 2) years showing a profit, you may want to take advantage of this presumption later, after you have had the 5 (or 7) years of experience allowed by the test.

You can choose to do this by filing Form 5213. Filing this form postpones any determination that your farming activity is not carried on for profit until 5 (or 7) years have passed since you first started farming. Form 5213 must be filed within 3 years after the due date of your return for the year you first started farming. However, if you receive a notice from the IRS proposing to disallow your farm loss, file this form within 60 days after receiving the notice.

The benefit gained by making this choice is that the IRS will not immediately question whether your farming activity is engaged in for profit. Accordingly, it will not limit your deductions. Rather, you will gain time to earn a profit in 3 (or 2) out of the first 5 (or 7) years you carry on the farming activity. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit (and cannot otherwise show that you operated your farm for profit), the limit applies retroactively to any year in the 5- (or 7-) year period with a loss.

Filing Form 5213 automatically extends the period of limitations on any year in the 5- (or 7-) year period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.

Limit on deductions and losses.   If your activity is not carried on for profit, take deductions only in the following order, only to the extent stated in the three categories, and, if you are an individual, only if you itemize them on Schedule A (Form 1040).

Category 1.   Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses (see chapter 13), belong in this category. For the limits that apply to mortgage interest, see Publication 936, Home Mortgage Interest Deduction.

Category 2.   Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than the deductions you take (or could take) under the first category. Most business deductions, such as those for fertilizer, feed, insurance premiums, utilities, wages, etc., belong in this category.

Category 3.   Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity is more than deductions you take (or could take) under the first two categories. The deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, divide depreciation and these other deductions proportionally among those assets.

Individuals must claim the amounts in categories (2) and (3) above as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2%-of-adjusted-gross-income limit. See Publication 529, Miscellaneous Deductions, for information on this limit.

Partnerships and S corporations.   If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares.

For more information on not-for-profit activities, see Not-for-Profit Activities in chapter 1 of Publication 535.

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