Farming Tax Deductions and IRS Hobby Loss Rules

Farmers who have sustained losses over many years should be aware of the IRS’ hobby loss rules which limit farm loss tax deductions. Hobby losses are one of the most frequently litigated issues in tax.

In order to deduct a loss from a business activity, the taxpayer must be able to demonstrate that the activity was carried on with a profit motive.

Under Internal Revenue Code Sec. 183, taxpayers bear the burden of proving that they engaged in the activity with an actual and honest objective of realizing a profit.

The rationale for the hobby loss rule is clear – the government is not interested in subsidizing hobbies.

Safe harbor rule

IRC § 183(d) is a safe harbor for the taxpayer. It allows a presumption that the taxpayer is engaged in for profit if in 3 of 5 consecutive years (2 of 7 in the case of breeding, training, showing or racing of horses), the activity is profitable.

If a taxpayer is audited before the 5 years (or 7 years for equine-related activities), IRC § 183(e) allows the taxpayer to elect to postpone the determination as to whether the IRC § 183(d) presumption applies.

Farming activity and farmland appreciation

Often a taxpayer will have dual motives for purchasing farmland: 1. to realize appreciation on the value of the land and 2. to earn profits on the farming activity.

In such cases, the farming and the holding of the land will be considered a single activity only if the farming activity reduces the net cost of carrying the land for its appreciation in value.

The 9 factor test

If the activity has losses for more than 2 out 5 years or (or 5 out of the past 7 for equine-related activities), the taxpayer will not be able to show a presumption of profit under the safe harbor. Further review of whether the activity operates with an actual and honest profit motive must be undertaken.

Deciding whether a taxpayer operates an activity with an actual and honest profit motive involves applying the nine non-exclusive factors contained in Treas. Reg. § 1.183-2(b). Those factors are:

  1. the manner in which the taxpayer carried on the activity,
  2. the expertise of the taxpayer or his or her advisers,
  3. the time and effort expended by the taxpayer in carrying on the activity,
  4. the expectation that the assets used in the activity may appreciate in value,
  5. the success of the taxpayer in carrying on other similar or dissimilar activities,
  6. the taxpayer’s history of income or loss with respect to the activity,
  7. the amount of occasional profits, if any, which are earned,
  8. the financial status of the taxpayer, and
  9. elements of personal pleasure or recreation.

No single factor controls, other factors may be considered, and the mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective (or vice versa) is not conclusive.

Tips for preparing for a potential hobby loss issue

If you feel that your loss-generating activity is carried on with an actual and profit motive, you should keep good documents and records to help establish a business motive.

Be able to show the activity was conducted in a business-like manner

The fact that the taxpayer carries on an activity in a businesslike manner may indicate a profit motive.

  • maintain complete and accurate books and records for the activity
  • after having a loss, you should document what you did to improve profitability – e.g., changes in operating procedures, new techniques, or abandonment of unprofitable methods
  • prepare a formal business plan
  • in the case of horse breeding and sales, have a consistent and concentrated advertising program

Be able to demonstrate expertise

The taxpayer’s expertise, research, and extensive study of an activity, as well as his or her consultation with experts, may indicate a profit motive

  • consider taking courses to improve your skills and knowledge in your activity
  • have documentation to show that you sought expert advice and followed the advice

Document how much time you put into the activity

The taxpayer’s devotion of much of his or her personal time and effort to carrying on an activity may indicate motive, particularly if the activity does not involve substantial personal or recreational aspects.

  • keep a journal of the time you spend on the activity

Abandon other activities if they are generating losses

The IRS will review other activities and determine if those also have losses.

  • if you engaged in similar activities in the past and converted them from unprofitable to profitable enterprises it may help show that you are engaged in the present activity for profit, even though the activity is presently unprofitable
  • if you abandoned other activities after they was proven to be unsuccessful, that may help show profit motive with the current activity

It’s difficult to show an intent to profit where there several years of losses, unless there are at least a few periods of solid profits. It is especially the case when the taxpayer’s financial status allows them to sustain losses and there appears to be a significant recreational element to the activity.

What happens if the activity is deemed a hobby?

In this example, the IRS examiner audited a horse breeding activity and made the determination that it is not engaged in for profit.

The adjusted gross income (AGI) on the return is $125,000 which includes the Schedule F loss of $64,000.

The examiner will remove the gross income and all expenses from Schedule F.

The income will be moved to ‘other income’ on Form 1040. Expenses will be allowed as miscellaneous expenses on Schedule A.

Depending on the 2% misc. expense AGI limitation, the amount of additional taxable income will be around $60,000. Penalties and interest will apply.

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