Publication 225: Farmer's Tax Guide; Gains & Losses

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Table of Contents

Important Changes

Reduced capital gains tax rates. The maximum tax rate on net capital gain has been reduced for individual taxpayers for sales, exchanges, or conversions of assets after May 5, 2003. The lower rates (from 20% to 15% and from 10% to 5%) apply to assets held more than one year. See Capital Gains Tax Rates, later.

Qualified 5-year gain eliminated. The 8% maximum tax rate for qualified 5-year gain has been eliminated for sales and other dispositions after May 5, 2003.

Introduction

During the year, you may have sold or exchanged property. This chapter explains how to figure your gain or loss on the sale or exchange and determine the effect it has on your taxes.

Topics - This chapter discusses:

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If you sell, exchange, or otherwise dispose of your property, you usually have a gain or a loss. This section explains certain rules for determining whether any gain you have is taxable, and whether any loss you have is deductible.

A sale is a transfer of property for money or a mortgage, note, or other promise to pay money. An exchange is a transfer of property for other property or services.

You usually realize a gain or loss when you sell or exchange property. A gain is the amount you realize from a sale or exchange of property that is more than its adjusted basis. A loss is the adjusted basis of the property that is more than the amount you realize.

See chapter 7 for the definition of basis, adjusted basis, and fair market value.

Amount realized.

The amount you realize from a sale or exchange is the total of all money you receive plus the fair market value of all property or services you receive. The amount you realize also includes any of your liabilities assumed by the buyer and any liabilities to which the property you transferred is subject, such as real estate taxes or a mortgage.

If the liabilities relate to an exchange of multiple properties, see Treatment of liabilities under Multiple Property Exchanges in chapter 1 of Publication 544.

Amount recognized.

Your gain or loss realized from a sale or exchange of property is usually a recognized gain or loss for tax purposes. A recognized gain is a gain you must include in gross income and report on your income tax return. A recognized loss is a loss you deduct from gross income. For example, if your recognized gain from the sale of your tractor is $5,300, you include that amount in gross income on Form 1040. However, your gain or loss realized from the exchange of property may not be recognized for tax purposes. See Like-Kind Exchanges, next. Also, a loss from the disposition of property held for personal use is not deductible.

Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized, and any loss cannot be deducted. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.

The rules for like-kind property exchanges must be followed carefully to ensure the validity of these exchanges.

The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following.

Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. See Deferred exchange, later.

If the like-kind exchange involves the receipt of money or unlike property or the assumption of your liabilities, you may have a recognized gain. See Partially nontaxable exchange, later.

Multiple-party transactions.

The like-kind exchange rules also apply to property exchanges that involve three- and four-party transactions. Any part of these multiple-party transactions can qualify as a like-kind exchange if it meets all the requirements described in this section.

Receipt of title from third party.

If you receive property in a like-kind exchange and the other party who transfers the property to you does not give you the title, but a third party does, you can still treat this transaction as a like-kind exchange if it meets all the requirements.

Basis of property received.

If you receive property in a like-kind exchange, the basis of the property will be the same as the basis of the property you gave up. See chapter 7 for more information about basis.

Money paid.

If, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid.

Example.

Bill Smith trades an old tractor with an adjusted basis of $1,500 for a new one. The new tractor costs $30,000. He is allowed $8,000 for the old tractor and pays $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old tractor. If Bill sold the old tractor to a third party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old tractor equal to the difference between the amount realized and the adjusted basis of the old tractor.

Reporting the exchange.

Report the exchange of like-kind property, even though no gain or loss is recognized, on Form 8824, Like-Kind Exchanges. The instructions for the form explain how to report the details of the exchange.

If you have any recognized gain because you received money or unlike property, report it on Schedule D (Form 1040) or Form 4797, whichever applies. You may also have to report the recognized gain as ordinary income because of depreciation recapture on Form 4797. See chapter 11 for more information.

Qualifying property.

In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify.

The rules for like-kind exchanges do not apply to exchanges of the following property.

Property you use for personal purposes, such as your home and your family car.
Stock in trade or other property held primarily for sale, such as crops and produce.
Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable.
Partnership interests.

However, you might have a nontaxable exchange under other rules. See Other Nontaxable Exchanges in chapter 1 of Publication 544.

Like-kind property.

To qualify as a nontaxable exchange, the properties exchanged must be of like kind as defined in the income tax regulations. Generally, real property exchanged for real property qualifies as an exchange of like-kind property.

Personal property.

Depreciable tangible personal property can be either like kind or like class to qualify for nontaxable exchange treatment. Like-class properties are depreciable tangible personal properties within the same General Asset Class or Product Class. Property classified in any General Asset Class may not be classified within a Product Class.

General Asset Classes.

General Asset Classes describe the types of property frequently used in many businesses. They include the following property.

Office furniture, fixtures, and equipment (asset class 00.11).
Information systems, such as computers and peripheral equipment (asset class 00.12).
Data handling equipment except computers (asset class 00.13).
Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) (asset class 00.21).
Automobiles and taxis (asset class 00.22).
Buses (asset class 00.23).
Light general purpose trucks (asset class 00.241).
Heavy general purpose trucks (asset class 00.242).
Railroad cars and locomotives except those owned by railroad transportation companies (asset class 00.25).
Tractor units for use over the road (asset class 00.26).
Trailers and trailer-mounted containers (asset class 00.27).
Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction (asset class 00.28).
Industrial steam and electric generation or distribution systems (asset class 00.4).

Product Classes.

Product Classes include property listed in a 4-digit product class (except any ending in 9, a miscellaneous category) in Division D of the Standard Industrial Classification codes of the Executive Office of the President, Office of Management and Budget, Standard Industrial Classification Manual (SIC Manual). Copies of the manual may be obtained from the National Technical Information Service, an agency of the U.S. Department of Commerce. To order the manual, call 1–800– 553–NTIS (1–800–553–6847). The cost of the manual is $39 (plus shipping and handling) and the order number is PB87–100012.

Partially nontaxable exchange.

If, in addition to like-kind property, you receive money or unlike property in an exchange on which you realize gain, you have a partially nontaxable exchange. You are taxed on the gain you realize, but only to the extent of the money and the fair market value of the unlike property you receive. A loss is not deductible.

Example 1.

You trade farmland that cost $30,000 for $10,000 cash and other land to be used in farming with a fair market value of $50,000. You have a realized gain of $30,000, but only $10,000, the cash received, is recognized (included in income).

Example 2.

Assume the same facts as in Example 1, except that, instead of money, you received a tractor with a fair market value of $10,000. Your recognized gain is still limited to $10,000, the value of the tractor (the unlike property).

Example 3.

Assume in Example 1 that the fair market value of the land you received was only $15,000. Your $5,000 loss is not deductible.

Unlike property given up.

If, in addition to like-kind property, you give up unlike property, you must recognize gain or loss on the unlike property you give up. The gain or loss is the difference between the fair market value of the unlike property and the adjusted basis of the unlike property.

Like-kind exchanges between related persons.

Special rules apply to like-kind exchanges between related persons. These rules affect both direct and indirect exchanges. Under these rules, if either person disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition. The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange.

Related persons.

Under these rules, related persons include, for example, you and a member of your family (spouse, brother, sister, parent, child, etc.), you and a corporation in which you have more than 50% ownership, you and a partnership in which you directly or indirectly own more than a 50% interest of the capital or profits, and two partnerships in which you directly or indirectly own more than 50% of the capital interests or profits.

For the complete list of related persons, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2 of Publication 544.

Example.

You used a 1998 pickup truck in your farming business. Your sister used a 1999 pickup truck in her landscaping business. In December 2002, you exchanged your 1998 pickup truck, plus $200, for your sister's 1999 pickup truck. At that time, the fair market value (FMV) of your 1998 pickup truck was $7,000 and its adjusted basis was $6,000. The FMV of your sister's 1999 pickup truck was $7,200 and its adjusted basis was $1,000. You realized a gain of $1,000 (the $7,200 FMV of the 1999 pickup truck minus the $200 you paid, minus the $6,000 adjusted basis of the 1998 pickup truck). Your sister realized a gain of $6,200 (the $7,000 FMV of your 1998 pickup truck plus the $200 you paid, minus the $1,000 adjusted basis of the 1999 pickup truck).

However, because this was a like-kind exchange, you recognized no gain. Your basis in the 1999 pickup truck was $6,200 (the $6,000 adjusted basis of the 1998 pickup truck plus the $200 you paid). Your sister recognized gain only to the extent of the money she received, $200. Her basis in the 1998 pickup truck was $1,000 (the $1,000 adjusted basis of the 1999 pickup truck minus the $200 received, plus the $200 gain recognized).

In 2003, you sold the 1999 pickup truck to a third party for $7,000. Because you sold it within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. On your tax return for 2003, you must report your $1,000 gain on the exchange in 2002. You also report a loss on the sale of $200 (the adjusted basis of the 1999 pickup truck, $7,200 (its $6,200 basis plus the $1,000 gain recognized), minus the $7,000 realized from the sale).

In addition, your sister must report on her tax return for 2003 the $6,000 balance of her gain on the 2002 exchange. Her adjusted basis in the 1998 pickup truck is increased to $7,000 (its $1,000 basis plus the $6,000 gain recognized).

Exceptions to the rules for related persons.

The following property dispositions are excluded from these rules.

Dispositions due to the death of either related person.
Involuntary conversions.
Dispositions where it is established to the satisfaction of the IRS that neither the exchange nor the disposition has as a main purpose the avoidance of federal income tax.

Multiple property exchanges.

Under the like-kind exchange rules, you must generally make a property-by-property comparison to figure your recognized gain and the basis of the property you receive in the exchange. However, for exchanges of multiple properties, you do not make a property-by-property comparison if you do either of the following.

Transfer and receive properties in two or more exchange groups.
Transfer or receive more than one property within a single exchange group.

For more information, see Multiple Property Exchanges in chapter 1 of Publication 544.

Deferred exchange.

A deferred exchange is one in which you transfer property you use in business or hold for investment and later receive like-kind property you will use in business or hold for investment. (The property you receive is replacement property.) The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property unless the money is held by a qualified intermediary (defined later).

A deferred exchange for like-kind property may qualify for nonrecognition of gain or loss if the like-kind property is identified in writing and transferred within the following time limits.

You must identify the property to be received within 45 days after the date you transfer the property given up in the exchange.
The property must be received by the earlier of the following dates.
1. The 180th day after the date on which you transfer the property given up in the exchange.
2. The due date, including extensions, for your tax return for the tax year in which the transfer of the property given up occurs.

To comply with the 45-day written notice requirement to identify property to be received, you must designate and clearly describe the replacement property in a written document signed by you. For more information, see Identifying replacement property in chapter 1 of Publication 544.

A qualified intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. A qualified intermediary cannot be your agent at the time of the transaction or certain persons related to you or your agent.

A taxpayer who transfers property given up to a qualified intermediary in exchange for replacement property formerly owned by a related person is not entitled to nonrecognition treatment if the related person receives cash or unlike property for the replacement property.

For more information, see Deferred Exchange in chapter 1 of Publication 544.

No gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse, or a former spouse if incident to divorce. This rule does not apply if the recipient is a nonresident alien. Nor does this rule apply to a transfer in trust to the extent the liabilities assumed and the liabilities on the property are more than the property's adjusted basis.

Any transfer of property to a spouse or former spouse on which gain or loss is not recognized is not considered a sale or exchange. The recipient's basis in the property will be the same as the adjusted basis of the giver immediately before the transfer. This carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than either its fair market value at the time of transfer or any consideration paid by the recipient. This rule applies for determining loss as well as gain. Any gain recognized on a transfer in trust increases the basis.

For more information on transfers of property incident to divorce, see Property Settlements in Publication 504, Divorced or Separated Individuals.

You must classify your gains and losses as either ordinary or capital (and your capital gains or losses as either short-term or long-term). You must do this to figure your net capital gain or loss.

Your net capital gains may be taxed at a lower tax rate than ordinary income. See Capital Gains Tax Rates, later. Your deduction for a net capital loss may be limited. See Treatment of Capital Losses, later.

Capital gain or loss.

Generally, you will have a capital gain or loss if you sell or exchange a capital asset. You may also have a capital gain if your section 1231 transactions result in a net gain.

Section 1231 transactions.

Section 1231 transactions are sales and exchanges of property held longer than 1 year and either used in a trade or business or held for the production of rents or royalties. They also include certain involuntary conversions of business or investment property, including capital assets. See Section 1231 Gains and Losses in chapter 11 for more information.

Almost everything you own and use for personal purposes or investment is a capital asset.

Personal-use property.

Property held for personal use is a capital asset. Gain from a sale or exchange of that property is a capital gain and is taxable. Loss from the sale or exchange of that property is not deductible. You can deduct a loss relating to personal-use property only if it results from a casualty or theft. For information about casualties and thefts, see chapter 13.

Where you report a capital gain or loss depends on how long you own the asset before you sell or exchange it. The time you own an asset before disposing of it is the holding period.

If you hold a capital asset 1 year or less, the gain or loss resulting from its disposition is short term. Report it in Part I of Schedule D. If you hold a capital asset longer than 1 year, the gain or loss resulting from its disposition is long term. Report it in Part II of Schedule D.

Holding period.

To figure if you held property longer than 1 year, start counting on the day after the day you acquired the property. The day you disposed of the property is part of your holding period.

Example.

If you bought an asset on June 19, 2002, you should start counting on June 20, 2002. If you sold the asset on June 19, 2003, your holding period is not longer than 1 year, but if you sold it on June 20, 2003, your holding period is longer than 1 year.

Inherited property.

If you inherit property, you are considered to have held the property longer than 1 year, regardless of how long you actually held it. This rule does not apply to livestock used in a farm business. See Holding period under Livestock, later.

Nonbusiness bad debt.

A nonbusiness bad debt is a short-term capital loss. See chapter 4 of Publication 550.

Nontaxable exchange.

If you acquire an asset in exchange for another asset and your basis for the new asset is figured, in whole or in part, by using your basis in the old property, the holding period of the new property includes the holding period of the old property. That is, it begins on the same day as your holding period for the old property.

Gift.

If you receive a gift of property and your basis in it is figured using the donor's basis, your holding period includes the donor's holding period.

Real property.

To figure how long you held real property, start counting on the day after you received title to it or, if earlier, on the day after you took possession of it and assumed the burdens and privileges of ownership.

However, taking possession of real property under an option agreement is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. The holding period of the seller cannot end before that time.

The totals for short-term capital gains and losses and the totals for long-term capital gains and losses must be figured separately.

Net short-term capital gain or loss.

Combine your short-term capital gains and losses. Do this by adding all your short-term capital gains. Then add all your short-term capital losses. Subtract the lesser total from the other. The result is your net short-term capital gain or loss.

Net long-term capital gain or loss.

Follow the same steps to combine your long-term capital gains and losses. The result is your net long-term capital gain or loss.

Net gain.

If the total of your capital gains is more than the total of your capital losses, the difference is taxable. However, part of your gain (but not more than your net capital gain) may be taxed at a lower rate than the rate of tax on your ordinary income. See Capital Gains Tax Rates, later.

Net loss.

If the total of your capital losses is more than the total of your capital gains, the difference is deductible. But there are limits on how much loss you can deduct and when you can deduct it. See Treatment of Capital Losses, next.

If your capital losses are more than your capital gains, you must claim the difference even if you do not have ordinary income to offset it. The yearly limit on the capital loss you can deduct is $3,000 ($1,500 if you are married and file a separate return). If your other income is low, you may not be able to use the full $3,000. The part of the $3,000 you cannot use becomes part of your capital loss carryover.

Capital loss carryover.

Generally, you have a capital loss carryover if either of the following situations applies to you.

Your net loss on line 17 of Schedule D is more than the yearly limit.
The amount shown on line 38, Form 1040 (your taxable income without your deduction for exemptions), is less than zero.

If either of these situations applies to you for 2003, see Capital Losses under Reporting Capital Gains and Losses in chapter 4 of Publication 550 to figure the amount you can carry over to 2004.

To figure your capital loss carryover from 2003 to 2004, you will need a copy of your 2003 Form 1040 and Schedule D.

The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower rates are called the maximum capital gains rates.

The term net capital gain means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss.

You will need to use Part IV of Schedule D (Form 1040), and the Schedule D Tax Worksheet in certain cases, to figure your tax using the capital gains rates if both the following are true.

The maximum capital gains rate before May 6, 2003 can be 8%, 10%, 20%, 25%, or 28%. After May 5, 2003, the maximum capital gains rate can be 5%, 15%, 25%, or 28%. The 8% capital gains rate has been eliminated after May 5, 2003. The 10% and 20% capital gains tax rates have been lowered to 5% and 15%, respectively. See Table 10–1.

The maximum capital gains rate does not apply if it is higher than your regular tax rate.

Using the capital gains rates.

The part of a net capital gain subject to each rate is determined by first netting long-term capital gains with long-term capital losses in the following tax rate groups.

A 28% group, consisting of all the following gains and losses.
1. Collectibles gains and losses.
2. The part of the gain on qualified small business stock equal to the section 1202 exclusion.
3. Any long-term capital loss carryover.
A 25% group, consisting of unrecaptured section 1250 gain.
A 20% group, consisting of gains and losses not in the 28% or 25% group. The 20% group is lowered to 15% after May 5, 2003.

If any group has a net loss, the following rules apply.

A net loss from the 28% group reduces any gain from the 25% group, and then any net gain from the 20% (15% after May 5, 2003) group.
A net loss from the 20% (15% after May 5, 2003) group reduces any net gain from the 28% group, and then any gain from the 25% group.

If you have a net short-term capital loss, it reduces any net gain from the 28% group, then any gain from the 25% group, and finally any net gain from the 20% (15% after May 5, 2003) group.

The resulting net gain (if any) from each group is subject to the tax rate for that group. (The 10% (5% after May 5, 2003) rate applies to a net gain from the 20% (15% after May 5, 2003) group to the extent that, if there were no capital gain rates, the net capital gain would be taxed at the 10% or 15% regular tax rate.)

Collectibles gain or loss.

This is gain or loss from the sale or exchange of a work of art, rug, antique, metal, gem, stamp, coin, or alcoholic beverage held longer than 1 year. Collectibles gain includes gain from the sale of an interest in a partnership, S corporation, or trust attributable to an increase in value of the collectibles whether you sold them or not.

Gain on qualified small business stock.

If you realized a gain from qualified small business stock you held longer than 5 years, you exclude up to one-half of your gain from your income. The taxable part of your gain equal to your section 1202 exclusion is a 28% rate gain. See Sales of Small Business Stock in chapter 1 of Publication 544.

Unrecaptured section 1250 gain.

This is the part of any long-term capital gain on section 1250 property (real property) due to straight-line depreciation minus any net loss in the 28% group. Unrecaptured section 1250 gain cannot be more than the net section 1231 gain or include any gain that is otherwise treated as ordinary income. Use the worksheet in the Schedule D instructions to figure your unrecaptured section 1250 gain. For more information about section 1250 property and net section 1231 gain, see chapter 3 of Publication 544.

The 8% maximum tax rate for qualified 5-year gain applies to property disposed of before May 6, 2003. Qualified 5-year gain is long-term capital gain from the sale of property you held longer than 5 years that would otherwise be subject to the 10% or 20% capital gains rate.

Table 10-1. What Is Your Maximum Capital Gains Rate?

IF your net capital gain is from...		THEN your maximum capital gains rate is...
Collectibles gain		28%
Gain on qualified small business stock equal to the section 1202 exclusion		28%
Unrecaptured section 1250 gain		25%
Other gain, ¹ and the regular tax rate that would apply is 25% or higher		20% for sales or other dispositions before May 6, 2003
		15% for sales or other dispositions after May 5, 2003
Other gain, ¹ and the regular tax rate that would apply is lower than 25%		8% ² or 10% for sales or other dispositions before May 6, 2003
		5% for sales and other dispositions after May 5, 2003
¹“Other gain” means any gain that is not collectibles gain, gain on qualified small business stock, or unrecaptured section 1250 gain.
²The rate is 8% only for qualified 5-year gain.

Net capital gain from disposition of investment property.

If you choose to include any part of a net capital gain from a disposition of investment property in investment income for figuring your investment interest deduction, you must reduce the net capital gain eligible for the capital gains tax rates by the same amount. You make this choice on Form 4952, Investment Interest Expense Deduction. For information on making this choice, see the instructions to Form 4952. For information on the investment interest deduction, see chapter 3 in Publication 550.

Noncapital assets include property such as inventory and depreciable property used in a trade or business. A list of properties that are not capital assets is provided in the Schedule D instructions.

Property held for sale in the ordinary course of your farm business.

Property you hold mainly for sale to customers, such as livestock, poultry, livestock products, and crops, is a noncapital asset. Gain or loss from sales or other dispositions of this property is reported on Schedule F (not on Schedule D or Form 4797). The treatment of this property is discussed in chapter 4.

Land and depreciable properties.

Land and depreciable property you use in farming are not capital assets. They also include livestock held for draft, breeding, dairy, or sporting purposes. However, your gains and losses from sales and exchanges of your farmland and depreciable properties must be considered together with certain other transactions to determine whether the gains and losses are treated as capital or ordinary gains and losses. The sales of these business assets are reported on Form 4797. See chapter 11 for more information.

Hedging transactions are transactions that you enter into in the normal course of business primarily to manage the risk of interest rate or price changes, or currency fluctuations, with respect to borrowings, ordinary property, or ordinary obligations. (Ordinary property or obligations are those that cannot produce capital gain or loss if sold or exchanged.)

A commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity at a future date for a fixed price. The holder of an option on a futures contract has the right (but not the obligation) for a specified period of time to enter into a futures contract to buy or sell at a particular price. A forward contract is generally similar to a futures contract except that the terms are not standardized and the contract is not exchange traded.

Businesses may enter into commodity futures contracts or forward contracts and may acquire options on commodity futures contracts as either of the following.

Futures transactions with exchange-traded commodity futures contracts that are not hedging transactions, generally, result in capital gain or loss and are, generally, subject to the mark-to-market rules discussed in Publication 550. There is a limit on the amount of capital losses you can deduct each year. Hedging transactions are not subject to the mark-to-market rules.

If, as a farmer-producer, to protect yourself from the risk of unfavorable price fluctuations, you enter into commodity forward contracts, futures contracts, or options on futures contracts and the contracts cover an amount of the commodity within your range of production, the transactions are generally considered hedging transactions. They can take place at any time you have the commodity under production, have it on hand for sale, or reasonably expect to have it on hand.

The gain or loss on the termination of these hedges is generally ordinary gain or loss. Farmers who file their income tax returns on the cash method report any profit or loss on the hedging transaction on line 10 of Schedule F.

Gain or loss on transactions that hedge supplies of a type regularly used or consumed in the ordinary course of its trade or business may be ordinary.

If you have numerous transactions in the commodity futures market during the year, you must be able to show which transactions are hedging transactions. Clearly identify a hedging transaction on your books and records before the end of the day you entered into the transaction. It may be helpful to have separate brokerage accounts for your hedging and speculation transactions.

The identification must not only be on, and retained as part of, your books and records but must specify both the hedging transaction and the item, items, or aggregate risk that is being hedged. Although the identification of the hedging transaction must be made before the end of the day it was entered into, you have 35 days after entering into the transaction to identify the hedged item, items, or risk.

For more information on the tax treatment of futures and options contracts, see Commodity Futures and Section 1256 Contracts Marked to Market in Publication 550.

Accounting methods for hedging transactions.

The accounting method you use for a hedging transaction must clearly reflect income. This means that your accounting method must reasonably match the timing of income, deduction, gain, or loss from a hedging transaction with the timing of income, deduction, gain, or loss from the item or items being hedged. There are requirements and limits on the method you can use for certain hedging transactions. See section 1.446-4(e) of the regulations for those requirements and limits.

Hedging transactions must be accounted for under the rules stated above unless the transaction is subject to mark-to-market accounting under section 475 of the Internal Revenue Code or you use an accounting method other than the following methods.

Cash method.
Farm-price method.
Unit-livestock-price method.

Once you adopt a method, you must apply it consistently and must have IRS approval before changing it.

Your books and records must describe the accounting method used for each type of hedging transaction. They must also contain any additional identification necessary to verify the application of the accounting method you used for the transaction. You must make the additional identification no more than 35 days after entering into the hedging transaction.

Example of a hedging transaction.

You file your income tax returns on the cash method. On July 2, 2003, you anticipate a yield of 50,000 bushels of corn this crop year. The present December futures price is $2.75 a bushel, but there are indications that by harvest time the price will drop. To protect yourself against a drop in the sales price of your corn inventory, you enter into the following hedging transaction. You sell 10 December futures contracts of 5,000 bushels each for a total of 50,000 bushels of corn at $2.75 a bushel.

The price did not drop as anticipated but rose to $3 a bushel. In November, you sell your crop at a local elevator for $3 a bushel. You also close out your futures position by buying 10 December contracts for $3 a bushel. You paid a broker's commission of $700 ($70 per contract) for the complete in and out position in the futures market.

The result is that the price of corn rose 25 cents a bushel and the actual selling price is $3 a bushel. Your loss on the hedge is 25 cents a bushel. In effect, the net selling price of your corn is $2.75 a bushel.

Report the results of your futures transactions and your sale of corn separately on Schedule F.

The loss on your futures transactions is $13,200, figured as follows.

July 2, 2003—Sold Dec. corn futures (50,000 bu. @$2.75)	$137,500
Nov. 6, 2003—Bought Dec. corn futures (50,000 bu. @$3 plus broker's commission)	150,700
Futures loss	($13,200)

This loss is reported as a negative figure on line 10, Part I of Schedule F.

The proceeds from your corn sale at the local elevator are $150,000 (50,000 bu. × $3). Report it on line 4, Part I of Schedule F.

Assume you were right and the price went down 25 cents a bushel. In effect, you would still net $2.75 a bushel, figured as follows.

Sold cash corn, per bushel	$2.50
Gain on hedge, per bushel	.25
	$2.75

The gain on your futures transactions would have been $11,800, figured as follows.

July 2, 2003—Sold Dec. corn futures (50,000 bu. @$2.75)	$137,500
Nov. 6, 2003—Bought Dec. corn futures (50,000 bu. @$2.50 plus broker's commission)	125,700
Futures gain	$11,800

The $11,800 is reported on line 10, Part I of Schedule F.

The proceeds from the sale of your corn at the local elevator, $125,000, are reported on line 4, Part I of Schedule F.

This part discusses the sale or exchange of livestock used in your farm business. Gain or loss from the sale or exchange of this livestock may qualify as a section 1231 gain or loss. However, any part of the gain that is ordinary income from the recapture of depreciation is not included as section 1231 gain. See chapter 11 for more information on section 1231 gains and losses and the recapture of depreciation under section 1245.

The rules discussed here do not apply to the sale of livestock held primarily for sale to customers. The sale of this livestock is reported on Schedule F. See chapter 4.

Holding period.

The sale or exchange of livestock used in your farm business (defined later) qualifies as a section 1231 transaction if you held the livestock for 12 months or more (24 months or more for horses and cattle).

Livestock.

For section 1231 transactions, livestock includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals (such as mink), and other mammals. Livestock does not include chickens, turkeys, pigeons, geese, emus, ostriches, rheas, or other birds, fish, frogs, reptiles, etc.

Livestock used in farm business.

If livestock is held primarily for draft, breeding, dairy, or sporting purposes, it is used in your farm business. The purpose for which an animal is held ordinarily is determined by a farmer's actual use of the animal. An animal is not held for draft, breeding, dairy, or sporting purposes merely because it is suitable for that purpose, or because it is held for sale to other persons for use by them for that purpose. However, a draft, breeding, or sporting purpose may be present if an animal is disposed of within a reasonable time after it is prevented from its intended use or made undesirable as a result of an accident, disease, drought, or unfitness of the animal.

Example 1.

You discover an animal that you intend to use for breeding purposes is sterile. You dispose of it within a reasonable time. This animal was held for breeding purposes.

Example 2.

You retire and sell your entire herd, including young animals that you would have used for breeding or dairy purposes had you remained in business. These young animals were held for breeding or dairy purposes. Also, if you sell young animals to reduce your breeding or dairy herd because of drought, these animals are treated as having been held for breeding or dairy purposes.

Example 3.

You are in the business of raising hogs for slaughter. Customarily, before selling your sows, you obtain a single litter of pigs that you will raise for sale. You sell the brood sows after obtaining the litter. Even though you hold these brood sows for ultimate sale to customers in the ordinary course of your business, they are considered to be held for breeding purposes.

Example 4.

You are in the business of raising registered cattle for sale to others for use as breeding cattle. The business practice is to breed the cattle before sale to establish their fitness as registered breeding cattle. Your use of the young cattle for breeding purposes is ordinary and necessary for selling them as registered breeding cattle. Such use does not demonstrate that you are holding the cattle for breeding purposes. However, those cattle you held as additions or replacements to your own breeding herd to produce calves are considered to be held for breeding purposes, even though they may not actually have produced calves. The same applies to hog and sheep breeders.

Example 5.

You are in the business of breeding and raising mink that you pelt for the fur trade. You take breeders from the herd when they are no longer useful as breeders and pelt them. Although these breeders are processed and pelted, they are still considered to be held for breeding purposes. The same applies to breeders of other fur-bearing animals.

Example 6.

You breed, raise, and train horses for racing purposes. Every year you cull horses from your racing stable. In 2003, you decided that to prevent your racing stable from getting too large to be effectively operated, you must cull six horses that had been raced at public tracks in 2002. These horses are all considered held for sporting purposes.

Figuring gain or loss on the cash method.

Farmers or ranchers who use the cash method of accounting figure their gain or loss on the sale of livestock used in their farming business as follows.

Raised livestock.

Gain on the sale of raised livestock is generally the gross sales price reduced by any expenses of the sale. Expenses of sale include sales commissions, freight or hauling from farm to commission company, and other similar expenses. The basis of the animal sold is zero if the costs of raising it were deducted during the years the animal was being raised. However, see Uniform Capitalization Rules in chapter 7.

Purchased livestock.

The gross sales price minus your adjusted basis and any expenses of sale is the gain or loss.

Example.

A farmer sold a breeding cow on January 8, 2003, for $1,250. Expenses of the sale were $125. The cow was bought July 2, 2000, for $1,300. Depreciation (not less than the amount allowable) was $759.

Gross sales price		$1,250
Cost (basis)	$1,300
Minus: Depreciation deduction	759
Unrecovered cost (adjusted basis)	$ 541
Expense of sale	125	666
Gain realized		$ 584

Special rules apply to dispositions of land converted to farming use after March 1, 1986. Any gain realized on the disposition of converted wetland or highly erodible cropland is treated as ordinary income. Any loss on the disposition of such property is treated as a long-term capital loss.

Converted wetland.

This is generally land that was drained or filled to make the production of agricultural commodities possible. It includes converted wetland held by the person who originally converted it or held by any other person who used the converted wetland at any time after conversion for farming.

A wetland (before conversion) is land that meets all the following conditions.

It is mostly soil that, in its undrained condition, is saturated, flooded, or ponded long enough during a growing season to develop an oxygen-deficient state that supports the growth and regeneration of plants growing in water.
It is saturated by surface or groundwater at a frequency and duration sufficient to support mostly plants that are adapted for life in saturated soil.
It supports, under normal circumstances, mostly plants that grow in saturated soil.

Highly erodible cropland.

This is cropland subject to erosion that you used at any time for farming purposes other than grazing animals. Generally, highly erodible cropland is land currently classified by the Department of Agriculture as Class IV, VI, VII, or VIII under its classification system. Highly erodible cropland also includes land that would have an excessive average annual erosion rate in relation to the soil loss tolerance level, as determined by the Department of Agriculture.

Successor.

Converted wetland or highly erodible cropland is also land held by any person whose basis in the land is figured by reference to the adjusted basis of a person in whose hands the property was converted wetland or highly erodible cropland.

Standing timber you held as investment property is a capital asset. Gain or loss from its sale is capital gain or loss reported on Schedule D (Form 1040). If you held the timber primarily for sale to customers, it is not a capital asset. Gain or loss on its sale is ordinary business income or loss. It is reported on line 1 (purchased timber) or line 4 (raised timber) of Schedule F.

Farmers who cut timber on their land and sell it as logs, firewood, or pulpwood usually have no cost or other basis for that timber. These sales constitute a very minor part of their farm businesses. Amounts realized from these minor sales, and the expenses incurred in cutting, hauling, etc., are ordinary farm income and expenses reported on Schedule F (Form 1040).

Different rules apply if you owned the timber longer than 1 year and choose to treat timber cutting as a sale or exchange or you enter into a cutting contract, discussed later. Depletion on timber is discussed in chapter 8.

Timber considered cut.

Timber is considered cut on the date when, in the ordinary course of business, the quantity of felled timber is first definitely determined. This is true whether the timber is cut under contract or whether you cut it yourself.

Christmas trees.

Evergreen trees, such as Christmas trees, that are more than 6 years old when severed from their roots and sold for ornamental purposes are included in the term timber. They qualify for both rules discussed below.

Election to treat cutting as a sale or exchange.

Under the general rule, the cutting of timber results in no gain or loss. It is not until a sale or exchange occurs that gain or loss is realized. But if you owned or had a contractual right to cut timber, you can elect to treat the cutting of timber as a section 1231 transaction in the year it is cut. Even though the cut timber is not actually sold or exchanged, you report your gain or loss on the cutting for the year the timber is cut. Any later sale results in ordinary business income or loss.

To choose this treatment, you must:

Own or hold a contractual right to cut the timber for a period of more than 1 year before it is cut, and
Cut the timber for sale or use in your trade or business.

Making the election.

You make the election on your return for the year the cutting takes place by including in income the gain or loss on the cutting and including a computation of your gain or loss. You do not have to make the election in the first year you cut the timber. You can make it in any year to which the election would apply. If the timber is partnership property, the election is made on the partnership return. This election cannot be made on an amended return.

Once you have made the election, it remains in effect for all later years unless you cancel it.

Canceling a post-1986 election.

You can cancel an election you made for a tax year beginning after 1986 only if you can show undue hardship and you get the approval of the IRS. Thereafter, you cannot make a new election unless you have the approval of the IRS.

Canceling a pre-1987 election.

You can cancel an election you made for a tax year beginning before 1987 without the approval of the IRS. You can cancel the election by attaching a statement to your tax return for the year the cancellation is to be effective. If you make this cancellation, which can be made only once, you can make a new election without the approval of the IRS. Any further cancellation will require the approval of the IRS.

The statement must include all the following information.

Your name, address, and taxpayer identification number.
The year the cancellation is effective and the timber to which it applies.
That the cancellation being made is of the election to treat the cutting of timber as a sale or exchange under section 631(a) of the Internal Revenue Code.
That the cancellation is being made under section 311(d) of Public Law 99-514.
That you are entitled to make the cancellation under section 311(d) of Public Law 99-514 and temporary regulations section 301.9100-7T.

Gain or loss.

Your gain or loss on the cutting of standing timber is the difference between its adjusted basis for depletion and its fair market value on the first day of your tax year in which it is cut.

Your adjusted basis for depletion of cut timber is based on the number of units ( board feet, log scale, or other units) of timber cut during the tax year and considered to be sold or exchanged. Your adjusted basis for depletion is also based on the depletion unit of timber in the account used for the cut timber, and should be figured in the same manner as shown in section 611 of the Internal Revenue Code and section 1.611-3 of the regulations.

Example.

In April 2003, you owned 4,000 MBF (1,000 board feet) of standing timber longer than 1 year. It had an adjusted basis for depletion of $40 per MBF. You are a calendar year taxpayer. On January 1, 2003, the timber had a fair market value (FMV) of $350 per MBF. It was cut in April for sale. On your 2003 tax return, you choose to treat the cutting of the timber as a sale or exchange. You report the difference between the FMV and your adjusted basis for depletion as a gain. This amount is reported on Form 4797 along with your other section 1231 gains and losses to figure whether it is treated as a capital gain or as ordinary gain. You figure your gain as follows.

FMV of timber January 1, 2003	$1,400,000
Minus: Adjusted basis for depletion	160,000
Section 1231 gain	$1,240,000

The FMV becomes your basis in the cut timber, and a later sale of the cut timber, including any by-product or tree tops, will result in ordinary business income or loss.

Cutting contract.

You must treat the disposal of standing timber under a cutting contract as a section 1231 transaction if all the following apply to you.

You are the owner of the timber.
You held the timber longer than 1 year before its disposal.
You kept an economic interest in the timber.

The difference between the amount realized from the disposal of the timber and its adjusted basis for depletion is treated as gain or loss on its sale. Include this amount on Form 4797 along with your other section 1231 gains and losses to figure whether it is treated as capital or ordinary gain or loss.

Date of disposal.

The date of disposal is the date the timber is cut. However, if you receive payment under the contract before the timber is cut, you can choose to treat the date of payment as the date of disposal.

This choice applies only to figure the holding period of the timber. It has no effect on the time for reporting gain or loss (generally when the timber is sold or exchanged).

To make this choice, attach a statement to the tax return filed by the due date (including extensions) for the year payment is received. The statement must identify the advance payments subject to the choice and the contract under which they were made.

If you timely filed your return for the year you received payment without making the choice, you can still make the choice by filing an amended return within 6 months after the due date for that year's return (excluding extensions). Attach the statement to the amended return and write “Filed pursuant to section 301.9100-2” at the top of the statement. File the amended return at the same address the original return was filed.

Owner.

An owner is any person who owns an interest in the timber, including a sublessor and the holder of a contract to cut the timber. You own an interest in timber if you have the right to cut it for sale on your own account or for use in your business.

Economic interest.

You have kept an economic interest in standing timber if, under the cutting contract, the expected return on your investment is based on the cutting of the timber.

Tree stumps.

Tree stumps are a capital asset if they are on land held by an investor who is not in the timber or stump business as a buyer, seller, or processor. Gain from the sale of stumps sold in one lot by such a holder is taxed as a capital gain. However, tree stumps held by timber operators after the saleable standing timber was cut and removed from the land are considered by-products. Gain from the sale of stumps in lots or tonnage by such operators is taxed as ordinary income.

The sale of your farm will usually involve the sale of both nonbusiness property (your home) and business property (the land and buildings used in the farm operation and perhaps machinery and livestock). If you have a gain from the sale, you may be allowed to exclude the gain on your home. The gain on the sale of your business property is taxable. A loss on the sale of your business property to an unrelated person is deducted as an ordinary loss. Losses from nonbusiness property, other than casualty or theft losses, are not deductible. If you receive payments for your farm in installments, your gain is taxed over the period of years the payments are received, unless you choose not to use the installment method of reporting the gain. See chapter 12 for information about installment sales.

When you sell your farm, the gain or loss on each asset is figured separately. The tax treatment of gain or loss on the sale of each asset is determined by the classification of the asset. Each of the assets sold must be classified as one of the following.

Allocation of consideration paid for a farm.

The sale of a farm for a lump sum is considered a sale of each individual asset rather than a single asset. The residual method is required only if the group of assets sold constitutes a trade or business. This method determines gain or loss from the transfer of each asset. It also determines the buyer's basis in the business assets.

Consideration.

The buyer's consideration is the cost of the assets acquired. The seller's consideration is the amount realized (money plus the fair market value of property received) from the sale of assets.

Residual method.

The residual method must be used for any transfer of a group of assets that constitutes a trade or business and for which the buyer's basis is determined only by the amount paid for the assets. This applies to both direct and indirect transfers, such as the sale of a business or the sale of a partnership interest in which the basis of the buyer's share of the partnership assets is adjusted for the amount paid under section 743(b) of the Internal Revenue Code. Section 743(b) of the Internal Revenue Code applies if a partnership has an election in effect under section 754 of the Internal Revenue Code.

A group of assets constitutes a trade or business if either of the following applies.

Goodwill or going concern value could, under any circumstances, attach to them.
The use of the assets would constitute an active trade or business under section 355 of the Internal Revenue Code.

The residual method provides for the consideration to be reduced first by the cash, and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). The consideration remaining after this reduction must be allocated among the various business assets in a certain order.

For asset acquisitions occurring after March 15, 2001, make the allocation among the following assets in proportion to (but not more than) their fair market value on the purchase date in the following order.

Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section 1.338–6(b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.
Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
All other assets except section 197 intangibles.
Section 197 intangibles (other than goodwill and going concern value).
Goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a section 197 intangible).

If an asset described in (1) through (6) is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (4) and (6), include it in (4).

Property used in farm operation.

The rules for excluding the gain on the sale of your home, described later under Sale of your home, do not apply to the property used for your farming business. Recognized gains and losses on business property must be reported on your return for the year of the sale. If the property was held longer than 1 year, it may qualify for section 1231 treatment (see chapter 11).

Example.

You sell your farm, including your main home, which you have owned since December 1998. You realize gain on the sale as follows.

	Farm		Farm
	With	Home	Without
	Home	Only	Home
Selling price	$182,000	$58,000	$124,000
Cost (or other basis)	40,000	10,000	30,000
Gain	$142,000	$48,000	$94,000

You must report the $94,000 gain from the sale of the property used in your farm business. All or a part of that gain may have to be reported as ordinary income from the recapture of depreciation or soil and water conservation expenses. Treat the balance as section 1231 gain.

The $48,000 gain from the sale of your home is not taxable as long as you meet the requirements explained later under Gain on sale of your main home.

Partial sale.

If you sell only part of your farm, you must report any recognized gain or loss on the sale of that part on your tax return for the year of the sale. You cannot wait until you have sold enough of the farm to recover its entire cost before reporting gain or loss.

Adjusted basis of the part sold.

This is the properly allocated part of your original cost or other basis of the entire farm plus or minus necessary adjustments for improvements, depreciation, etc., on the part sold. If your home is on the farm, you must properly adjust the basis to exclude those costs from your farm asset costs, as discussed later under Sale of your home.

Example.

You bought a 600-acre farm for $700,000. The farm included land and buildings. The purchase contract designated $600,000 of the purchase price to the land. You later sold 60 acres of land on which you had installed a fence. Your adjusted basis for the part of your farm sold is $60,000 (1/10 of $600,000), plus any unrecovered cost (cost not depreciated) of the fence on the 60 acres at the time of sale. Use this amount to determine your gain or loss on the sale of the 60 acres.

Assessed values for local property taxes.

If you paid a flat sum for the entire farm and no other facts are available for properly allocating your original cost or other basis between the land and the buildings, you can use the assessed values for local property taxes for the year of purchase to allocate the costs.

Example.

Assume that in the preceding example there was no breakdown of the $700,000 purchase price between land and buildings. However, in the year of purchase, local taxes on the entire property were based on assessed valuations of $420,000 for land and $140,000 for improvements, or a total of $560,000. The assessed valuation of the land is ¾ (75%) of the total assessed valuation. Multiply the $700,000 total purchase price by 75% to figure basis of $525,000 for the 600 acres of land. The unadjusted basis of the 60 acres you sold would then be $52,500 (1/10 of $525,000).

Sale of your home.

Your home is a capital asset and not property used in the trade or business of farming. If you sell a farm that includes a house you and your family occupy, you must determine the part of the selling price and the part of the cost or other basis allocable to your home. Your home includes the immediate surroundings and outbuildings relating to it that are not used for business purposes.

If you use part of your home for business, you must make an appropriate adjustment to the basis for depreciation allowed or allowable. For more information on basis, see chapter 7.

Gain on sale of your main home.

If you sell your main home at a gain, you may qualify to exclude from income all or part of the gain. To qualify, you must meet the ownership and use tests.

You can claim the exclusion if, during the 5-year period ending on the date of the sale, you meet both the following requirements.

You owned the home for at least 2 years (the ownership test).
You lived in the home as your main home for at least 2 years (the use test).

You can exclude the entire gain on the sale of your main home up to:

$250,000, or
$500,000, if all the following are true.
1. You are married and file a joint return for the year.
2. Either you or your spouse meets the ownership test.
3. Both you and your spouse meet the use test.
4. During the 2-year period ending on the date of sale, neither you nor your spouse excluded gain from the sale of another home.

In some circumstances, you may be able to claim a reduced exclusion even if you do not meet the above requirements. See Publication 523 for more information.

Gain from condemnation.

If you have a gain from a condemnation or sale under threat of condemnation, you may use the preceding rules for excluding the gain, rather than the rules discussed under Postponing Gain in chapter 13. However, any gain that cannot be excluded (because it is more than the limit) may be postponed under the rules discussed under Postponing Gain in chapter 13.

Loss on your home.

You cannot deduct a loss on your home from a voluntary sale, a condemnation, or a sale under threat of condemnation.

More information.

For more information on selling your home, see Publication 523.

If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. You may also realize ordinary income from cancellation of debt if the loan balance is more than the fair market value of the property.

Buyer's (borrower's) gain or loss.

You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized. See Determining Gain or Loss, earlier.

You can use Table 10–2 to figure your gain or loss from a foreclosure or repossession.

Amount realized on a nonrecourse debt.

If you are not personally liable for repaying the debt (nonrecourse debt) secured by the transferred property, the amount you realize includes the full amount of the debt canceled by the transfer. The total canceled debt is included in the amount realized even if the fair market value of the property is less than the canceled debt.

Example 1.

Ann paid $200,000 for land used in her farming business. She paid $15,000 down and borrowed the remaining $185,000 from a bank. Ann is not personally liable for the loan (nonrecourse debt), but pledges the land as security. The bank foreclosed on the loan 2 years after Ann stopped making payments. When the bank foreclosed, the balance due on the loan was $180,000 and the fair market value of the land was $170,000. The amount Ann realized on the foreclosure was $180,000, the debt canceled by the foreclosure. She figures her gain or loss in Part I, Form 4797, by comparing the amount realized ($180,000) with her adjusted basis ($200,000). She has a $20,000 deductible loss.

Example 2.

Assume the same facts as in Example 1 except the fair market value of the land was $210,000. The result is the same. The amount Ann realized on the foreclosure is $180,000, the debt canceled by the foreclosure. Because her adjusted basis is $200,000, she has a deductible loss of $20,000, which she reports in Part I, Form 4797.

Amount realized on a recourse debt.

If you are personally liable for repaying the debt (recourse debt), the amount realized on the foreclosure or repossession does not include the canceled debt that is income from cancellation of debt. However, if the fair market value of the transferred property is less than the canceled debt, the amount realized includes the canceled debt up to the fair market value of the property. You are treated as receiving ordinary income from the canceled debt for the part of the debt that is more than the fair market value. See Cancellation of debt, later.

Example 3.

Assume the same facts as in Example 1 earlier except Ann is personally liable for the loan (recourse debt). In this case, the amount she realizes is $170,000. This is the canceled debt ($180,000) up to the fair market value of the land ($170,000). Ann figures her gain or loss on the foreclosure by comparing the amount realized ($170,000) with her adjusted basis ($200,000). She has a $30,000 deductible loss, which she figures in Part I, Form 4797. She is also treated as receiving ordinary income from cancellation of debt. That income is $10,000 ($180,000 - $170,000). This is the part of the canceled debt not included in the amount realized. She reports this income on line 10 of Schedule F.

Seller's (lender's) gain or loss on repossession.

If you finance a buyer's purchase of property and later acquire an interest in it through foreclosure or repossession, you may have a gain or loss on the acquisition. For more information, see Repossession in Publication 537.

Cancellation of debt.

If property that is repossessed or foreclosed upon secures a debt for which you are personally liable (recourse debt), you generally must report as ordinary income the amount by which the canceled debt is more than the fair market value of the property. This income is separate from any gain or loss realized from the foreclosure or repossession. Report the income from cancellation of a business debt on Schedule F, line 10. Report the income from cancellation of a nonbusiness debt as miscellaneous income on line 21, Form 1040.

You can use Table 10–2 to figure your income from cancellation of debt.

However, income from cancellation of debt is not taxed if any of the following apply.

The cancellation is intended as a gift.
The debt is qualified farm debt (see chapter 4).
The debt is qualified real property business debt (see chapter 5 of Publication 334).
You are insolvent or bankrupt (see chapter 4).

The abandonment of property is a disposition of property. You abandon property when you voluntarily and permanently give up possession and use of the property with the intention of ending your ownership, but without passing it on to anyone else.

Business or investment property.

Loss from abandonment of business or investment property is deductible as an ordinary loss, even if the property is a capital asset. The loss is the property's adjusted basis when abandoned. This rule also applies to leasehold improvements the lessor made for the lessee that were abandoned. However, if the property is later foreclosed on or repossessed, gain or loss is figured as discussed, earlier, under Foreclosure or Repossession.

The abandonment loss is deducted in the tax year in which the loss is sustained. Report the loss on Form 4797, Part II, line 10.

Personal-use property.

You cannot deduct any loss from abandonment of your home or other property held for personal use.

Canceled debt.

If the abandoned property secures a debt for which you are personally liable and the debt is canceled, you will realize ordinary income equal to the canceled debt. This income is separate from any loss realized from abandonment of the property. Report income from cancellation of a debt related to a business or rental activity as business or rental income. Report income from cancellation of a nonbusiness debt as miscellaneous income on line 21, Form 1040.

However, income from cancellation of debt is not taxed in certain circumstances. See Cancellation of debt, earlier, under Foreclosure or Repossession.

Forms 1099–A and 1099–C.

A lender who acquires an interest in your property in a foreclosure, repossession, or abandonment should send you Form 1099–A showing the information you need to figure your loss from the foreclosure, repossession, or abandonment. However, if your debt is canceled and the lender must file Form 1099–C, the lender may include the information about the foreclosure, repossession, or abandonment on that form instead of Form 1099–A. The lender must file Form 1099–C and send you a copy if the canceled debt is $600 or more and the lender is a financial institution, credit union, federal government agency, or any organization that has a significant trade or business of lending money. For foreclosures, repossessions, or abandonments of property and debt cancellations occurring in 2003, these forms should be sent to you by February 2, 2004.

Table 10–2. Worksheet for Foreclosures and Repossessions

(Keep for your records)

Part 1. Figure your income from cancellation of debt. (Note: If you are not personally liable for the debt, you do not have income from cancellation of debt. Skip Part 1 and go to Part 2.)
1.	Enter amount of debt canceled by the transfer of property
2.	Enter the fair market value of the transferred property
3.	Income from cancellation of debt.* Subtract line 2 from line 1. If less than zero, enterzero
Part 2. Figure your gain or loss from foreclosure or repossession.
4.	Enter the smaller of line 1 or line 2. Also include any proceeds you receivedfrom the foreclosure sale. (If you are not personally liable for the debt, enterthe amount of debt cancelled by the transfer of property.)
5.	Enter the adjusted basis of the transferred property
6.	Gain or loss from foreclosure or repossession. Subtract line 5 from line 4

*The income may not be taxable. See Cancellation of debt.