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					               Publication 225
               Cat. No. 11049L                                                    Contents

               Farmer's
                                                                                  Introduction . . . . . . . . . . . . . . . . . . 1
Department
of the                                                                            What's New for 2012 . . . . . . . . . . . . . 2


               Tax Guide
Treasury
Internal                                                                          What's New for 2013 . . . . . . . . . . . . . 2
Revenue
Service                                                                           Reminders . . . . . . . . . . . . . . . . . . . 2

                                                                                  Chapter 1. Importance of
               For use in preparing                                                   Records . . . . . . . . . . . . . . . . . 3


               2012 Returns                                                       Chapter 2. Accounting Methods . . . . . 5

                                                                                  Chapter 3. Farm Income . . . . . . . . . . 8

                                                                                  Chapter 4. Farm Business
               Acknowledgment: The valuable advice and assistance given us each       Expenses . . . . . . . . . . . . . . . . 19
               year by the National Farm Income Tax Extension Committee is
               gratefully acknowledged.                                           Chapter 5. Soil and Water
                                                                                      Conservation Expenses . . . . . . . 28

                                                                                  Chapter 6. Basis of Assets         . . . . . . . 30
                                                                                  Chapter 7. Depreciation, Depletion,
                                                                                      and Amortization . . . . . . . . . . . 36

                                                                                  Chapter 8. Gains and Losses . . . . . . 48

                                                                                  Chapter 9. Dispositions of
                                                                                      Property Used in Farming           . . . . . 56

                                                                                  Chapter 10. Installment Sales          . . . . . 59
                                                                                  Chapter 11. Casualties, Thefts, and
                                                                                      Condemnations . . . . . . . . . . . . 64

                                                                                  Chapter 12. Self-Employment Tax . . . 72

                                                                                  Chapter 13. Employment Taxes             . . . . 76

                                                                                  Chapter 14. Excise Taxes . . . . . . . . 81

                                                                                  Chapter 15. Estimated Tax          . . . . . . . 84

                                                                                  Chapter 16. How To Get Tax Help . . . 85

                                                                                  Index    . . . . . . . . . . . . . . . . . . . . . 88

                                                                                  Introduction
                                                                                  You are in the business of farming if you culti­
                                                                                  vate, operate, or manage a farm for profit, either
                                                                                  as owner or tenant. A farm includes livestock,
                                                                                  dairy, poultry, fish, fruit, and truck farms. It also
                                                                                  includes plantations, ranches, ranges, and or­
                                                                                  chards.
                                                                                      This publication explains how the federal tax
                                                                                  laws apply to farming. Use this publication as a
                                                                                  guide to figure your taxes and complete your
                                                                                  farm tax return. If you need more information on
                                                                                  a subject, get the specific IRS tax publication
                                                                                  covering that subject. We refer to many of these
                                                                                  free publications throughout this publication.
                                                                                  See chapter 16 for information on ordering
                                                                                  these publications.
                                                                                      The explanations and examples in this publi­
                                                                                  cation reflect the Internal Revenue Service's in­
                Get forms and other Information                                   terpretation of tax laws enacted by Congress,
                faster and easier by:                                             Treasury regulations, and court decisions. How­
                                                                                  ever, the information given does not cover ev­
                Internet IRS.gov                                                  ery situation and is not intended to replace the


Oct 23, 2012
law or change its meaning. This publication             409 3rd Street, S.W.                            expire for most property placed in service after
covers subjects on which a court may have               Washington, DC 20416                            December 31, 2012. See chapter 7.
made a decision more favorable to taxpayers             Send an email to ombudsman@sba.gov,
than the interpretation of the Service. Until           or                                              Tax rates. For tax years beginning in 2012, the
these differing interpretations are resolved by         Download the appraisal form at                  social security part of the self­employment tax
higher court decisions, or in some other way,           www.sba.gov/ombudsman.                          remains at 10.4%. The Medicare part of the tax
this publication will continue to present the in­                                                       remains at 2.9%. As a result, the self­employ­
terpretation of the Service.                        Treasury Inspector General for Tax Admin-           ment tax is 13.3%. See chapter 12.
                                                    istration. If you want to confidentially report     Maximum net earnings. The maximum net
The IRS Mission. Provide America's taxpay­          misconduct, waste, fraud, or abuse by an IRS        self­employment earnings subject to the social
ers top quality service by helping them under­      employee, you can call 1­800­366­4484               security part (10.4%) of the self­employment tax
stand and meet their tax responsibilities and by    (1­800­877­8339 for TTY/TDD users). You can         increased to $110,100 for 2012. There is no
applying the tax law with integrity and fairness    remain anonymous.
                                                                                                        maximum limit on earnings subject to the Medi­
to all.                                                                                                 care part (2.9%). See chapter 12.
                                                    Farm tax classes. Many state Cooperative
Comments and suggestions. We welcome                Extension Services conduct farm tax work­           Social security and Medicare tax for 2012.
your comments about this publication and your       shops in conjunction with the IRS. Contact your     The employee tax rate for social security is
suggestions for future editions.                    county extension office for more information.       4.2% and the employer tax rate for social secur­
   You can write to us at the following address:                                                        ity is 6.2%, unchanged from 2011. The Medi­
                                                    Rural tax education website. The Rural Tax          care tax rate is 1.45% each for employers and
     Internal Revenue Service                       Education website is a source for information       employees. See chapter 13.
     Business Forms and Publications Branch         concerning agriculturally related income and
     SE:W:CAR:MP:T:B                                deductions and self­employment tax. The web­        VOW to Hire Heroes Act of 2011. On No­
     1111 Constitution Ave. NW, IR­6526             site is available for farmers and ranchers, other   vember 21, 2011, the President signed into law
     Washington, DC 20224                           agricultural producers, Extension educators,        the VOW to Hire Heroes Act of 2011. This new
                                                    and any one interested in learning about the tax    law provides an expanded work opportunity tax
                                                    side of the agricultural community. Members of      credit to businesses that hire eligible unem­
    We respond to many letters by telephone.
                                                    the National Farm Income Tax Extension Com­         ployed veterans and, for the first time, also
Therefore, it would be helpful if you would in­
                                                    mittee are contributors for the website and the     makes part of the credit available to certain
clude your daytime phone number, including
                                                    website is hosted by Utah State University Co­      tax­exempt organizations. Businesses claim the
the area code, in your correspondence.
                                                    operative Extension. You can visit the website      credit as part of the general business credit and
    You can email us at taxforms@irs.gov.
                                                    at www.ruraltax.org.                                tax­exempt organizations claim it against their
Please put “Publications Comment” on the sub­
                                                                                                        payroll tax liability. See chapter 13.
ject line. You can also send us comments from
www.irs.gov/formspubs/, select “Comment on
Tax Forms and Publications” under “More Infor­      Future Developments
mation.”
                                                    The IRS has created a page on IRS.gov for
                                                                                                        What's New for 2013
    Although we cannot respond individually to
each comment received, we do appreciate your        information about Publication 225, at               Maximum net earnings. The maximum net
feedback and will consider your comments as         www.irs.gov/pub225. Information about recent        self­employment earnings subject to the social
we revise our tax products.                         developments affecting Publication 225 will be      security part of the self­employment tax for
                                                    posted on that page.                                2013 will be discussed in the 2012 Publication
   Ordering forms and publications. Visit                                                               334, Tax Guide for Small Business. See chap­
www.irs.gov/formspubs/ to download forms and                                                            ter 12.
publications,       call      1­800­TAX­FORM
(1­800­829­3676), or write to the address below     What's New for 2012                                 Social security and Medicare tax for 2013.
and receive a response within 10 days after                                                             The employee and employer tax rates for social
your request is received.                           The following items highlight a number of           security and the maximum amount of wages
                                                    administrative and tax law changes for 2012.        subject to social security tax for 2013 will be
     Internal Revenue Service                       They are discussed in more detail throughout        discussed in Publication 51 (Circular A), Agri­
     1201 N. Mitsubishi Motorway                    the publication.                                    cultural Employer's Tax Guide (For use in
     Bloomington, IL 61705­6613                     Standard mileage rate. For 2012, the stand­         2013). The Medicare tax rate for 2013 will also
                                                    ard mileage rate for the cost of operating your     be discussed in Publication 51 (Circular A) (For
    Tax questions. If you have a tax question,      car, van, pickup, or panel truck for each mile of   use in 2013). There is no limit on the amount of
check the information available on IRS.gov or       business use is 55.5 cents. See chapter 4.          wages subject to Medicare tax. See chapter 13.
call 1­800­829­1040. We cannot answer tax           Decreased section 179 expense deduction
questions sent to either of the above ad­           dollar limits. The maximum amount you can
dresses.                                            elect to deduct for most section 179 property
                                                    you placed in service in 2012 is $139,000. This
                                                                                                        Reminders
Comments on IRS enforcement actions.                limit is reduced by the amount by which the cost    The following reminders and other items may
The Small Business and Agricultural Regulatory      of the property placed in service during the tax    help you file your tax return.
Enforcement Ombudsman and 10 Regional               year exceeds $560,000. See chapter 7.
Fairness Boards were established to receive         Expiration of special depreciation allow-
comments from small business about federal          ance for certain qualified property acquired
agency enforcement actions. The Ombudsman           after September 8, 2010. The 100% special           IRS e-file (Electronic Filing)
will annually evaluate the enforcement activities   depreciation allowance will only apply to certain
of each agency and rate its responsiveness to       property with a long production period and cer­
small business. If you wish to comment on the       tain aircraft placed in service before January 1,
enforcement actions of the IRS, you can:            2013. See chapter 7.
      Call 1­888­734­3247,
                                                    Expiration of special depreciation allow-
    Fax your comments to 202­481­5719,                                                                       You can file your tax returns electronically
                                                    ance for certain qualified property acquired
                                                                                                        using an IRS e-file option. The benefits of IRS
    Write to                                        after December 31, 2007. The 50% special
                                                                                                        e-file include faster refunds, increased accu­
    Office of the National Ombudsman                depreciation allowance for certain qualified
                                                                                                        racy, and acknowledgment of IRS receipt of
    U.S. Small Business Administration              property acquired after December 31, 2007, will

Page 2                                                                                                                         Publication 225 (2011)
your return. You can use one of the following         Children. Photographs of missing children se­
IRS e-file options.                                   lected by the Center may appear in this publica­
    Use an authorized IRS e-file provider.            tion on pages that would otherwise be blank.         Benefits of Recordkeeping
     Use a personal computer.                         You can help bring these children home by
                                                      looking at the photographs and calling               Everyone in business, including farmers, must
     Visit a Volunteer Income Tax Assistance          1­800­THE­LOST (1­800­843­5678) if you rec­          keep appropriate records. Recordkeeping will
     (VITA) or Tax Counseling for the Elderly         ognize a child.                                      help you do the following.
     (TCE) site.
For details on these fast filing methods, see                                                              Monitor the progress of your farming busi-
your income tax package.                                                                                   ness. You need records to monitor the pro­
                                                                                                           gress of your farming business. Records can
Principal agricultural activity codes. You                                                                 show whether your business is improving,
must enter on line B of Schedule F (Form 1040)                                                             which items are selling, or what changes you
a code that identifies your principal agricultural
activity. It is important to use the correct code     1.                                                   need to make. Records can help you make bet­
                                                                                                           ter decisions that may increase the likelihood of
because this information will identify market                                                              business success.
segments of the public for IRS Taxpayer Educa­
tion programs. The U.S. Census Bureau also
uses this information for its economic census.
                                                      Importance of                                        Prepare your financial statements. You
                                                                                                           need records to prepare accurate financial
See the list of Principal Agricultural Activity Co-                                                        statements. These include income (profit and
des on page 2 of Schedule F (Form 1040).              Records                                              loss) statements and balance sheets. These
Publication on employer identification num-                                                                statements can help you in dealing with your
bers (EIN). Publication 1635, Understanding                                                                bank or creditors and help you to manage your
Your Employer Identification Number, provides
general information on employer identification
                                                      Introduction                                         farm business.

numbers. Topics include how to apply for an           A farmer, like other taxpayers, must keep re­        Identify source of receipts. You will receive
EIN and how to complete Form SS­4.                    cords to prepare an accurate income tax return       money or property from many sources. Your re­
                                                      and determine the correct amount of tax. This        cords can identify the source of your receipts.
Change of address. If you change your home                                                                 You need this information to separate farm from
                                                      chapter explains the benefits of keeping re­
address, you should use Form 8822, Change of                                                               nonfarm receipts and taxable from nontaxable
                                                      cords, what kinds of records you must keep,
Address, to notify the IRS. If you change your                                                             income.
                                                      and how long you must keep them for federal
business address, you should use Form
                                                      tax purposes.
8822­B, Change of Address — Business, to no­                                                               Keep track of deductible expenses. You
                                                          Tax records are not the only type of records
tify the IRS. Be sure to include your suite, room,                                                         may forget expenses when you prepare your
                                                      you need to keep for your farming business.
or other unit number.                                                                                      tax return unless you record them when they
                                                      You should also keep records that measure
Reportable transactions. You must file Form           your farm's financial performance. This publica­     occur.
8886, Reportable Transaction Disclosure State­        tion only discusses tax records.
ment, to report certain transactions. You may                                                              Prepare your tax returns. You need records
                                                          The Farm Financial Standards Council has
have to pay a penalty if you are required to file                                                          to prepare your tax return. For example, your
                                                      produced a publication that provides a detailed
Form 8886 but do not do so. Reportable trans­                                                              records must support the income, expenses,
                                                      explanation of the recommendations of the
actions include (1) transactions the same as or                                                            and credits you report. Generally, these are the
                                                      Council for financial reporting and analysis. For
substantially similar to tax avoidance transac­                                                            same records you use to monitor your farming
                                                      information on recordkeeping, you can pur­
tions identified by the IRS, (2) transactions of­                                                          business and prepare your financial statements.
                                                      chase and download Financial Guidelines for
fered to you under conditions of confidentiality      Agricultural Producers at www.ffsc.org. For
and for which you paid an advisor a minimum                                                                Support items reported on tax returns. You
                                                      more information, contact Countryside Market­
fee, (3) transactions for which you have or a re­                                                          must keep your business records available at all
                                                      ing, Inc. in the following manner.
lated party has a right to a full or partial refund                                                        times for inspection by the IRS. If the IRS exam­
                                                            Call 262­253­6902.
of fees if all or part of the intended tax conse­                                                          ines any of your tax returns, you may be asked
                                                          Send a fax to 262­253­6903.                      to explain the items reported. A complete set of
quences from the transaction are not sustained,
(4) transactions that result in losses of at least        Write to:                                        records will speed up the examination.
$2 million in any single year or $4 million in any        Farm Financial Standards Council
combination of years, and (5) transactions with           N78 W14573 Appleton Ave., #287
asset holding periods of 45 days or less and              Menomonee Falls, WI 53051.                       Kinds of Records
that result in a tax credit of more than $250,000.                                                         To Keep
For more information, see the Instructions for        Topics
Form 8886.                                            This chapter discusses:                              Except in a few cases, the law does not require
Form W-4 for 2013. You should make new                                                                     any specific kind of records. You can choose
Forms W­4 available to your employees and en­             Benefits of recordkeeping                        any recordkeeping system suited to your farm­
courage them to check their income tax with­              Kinds of records to keep                         ing business that clearly shows, for example,
holding for 2012. Those employees who owed                                                                 your income and expenses.
                                                          How long to keep records
a large amount of tax or received a large refund                                                              You should set up your recordkeeping sys­
for 2012 may need to file a new Form W­4. See                                                              tem using an accounting method that clearly
Publication 919, How Do I Adjust My Tax With­         Useful Items                                         shows your income for your tax year. See
holding.                                              You may want to see:                                 chapter 2. If you are in more than one business,
Form 1099-MISC. Generally, file Form                                                                       you should keep a complete and separate set
1099­MISC if you pay at least $600 in rents,            Publication                                        of records for each business. A corporation
services, and other miscellaneous payments in              51   (Circular A), Agricultural Employer's      should keep minutes of board of directors'
your farming business to an individual (for ex­                 Tax Guide                                  meetings.
ample, an accountant, an attorney, or a veteri­
                                                           463 Travel, Entertainment, Gift, and Car           Your recordkeeping system should include a
narian) who is not your employee.                                                                          summary of your business transactions. This
                                                               Expenses
Photographs of missing children. The Inter­                                                                summary is ordinarily made in accounting jour­
nal Revenue Service is a proud partner with the       See chapter 16 for information about getting         nals and ledgers. For example, they must show
National Center for Missing and Exploited             publications.                                        your gross income, as well as your deductions

                                                                                                          Chapter 1   Importance of Records         Page 3
and credits. In addition, you must keep support­     Assets. Assets are the property, such as ma­              turns such as Form 1099, Schedule K­1, and
ing documents. Purchases, sales, payroll, and        chinery and equipment, you own and use in                 Form W­2.
other transactions you have in your business         your business. You must keep records to verify
generate supporting documents such as invoi­         certain information about your business assets.
ces and receipts. These documents contain the        You need records to figure your annual depreci­           How Long To Keep Records
information you need to record in your journals      ation deduction and the gain or (loss) when you
and ledgers.                                         sell the assets. Your records should show all             You must keep your records as long as they
    It is important to keep these documents be­      the following.                                            may be needed for the administration of any
cause they support the entries in your journals            When and how you acquired the asset.                provision of the Internal Revenue Code. Keep
and ledgers and on your tax return. Keep them               Purchase price.                                    records that support an item of income or a de­
in an orderly fashion and in a safe place. For in­                                                             duction appearing on a return until the period of
                                                            Cost of any improvements.
stance, organize them by year and type of in­                                                                  limitations for the return runs out. A period of
come or expense.                                            Section 179 deduction taken.                       limitations is the period of time after which no le­
                                                            Deductions taken for depreciation.                 gal action can be brought. Generally, that
Electronic records. All requirements that ap­               Deductions taken for casualty losses, such         means you must keep your records for at least
ply to hard copy books and records also apply               as losses resulting from fires or storms.          3 years from when your tax return was due or
to electronic storage systems that maintain tax             How you used the asset.                            filed or within 2 years of the date the tax was
books and records. When you replace hard                                                                       paid, whichever is later. However, certain re­
                                                            When and how you disposed of the asset.            cords must be kept for a longer period of time,
copy books and records, you must maintain the
electronic storage systems for as long as they              Selling price.                                     as discussed below.
are material to the administration of tax law. An           Expenses of sale.
electronic storage system is any system for pre­                                                               Employment taxes. If you have employees,
paring or keeping your records either by elec­         The following are examples of records that              you must keep all employment tax records for at
tronic imaging or by transfer to an electronic       may show this information.                                least 4 years after the date the tax becomes
storage media. The electronic storage system             Purchase and sales invoices.                          due or is paid, whichever is later.
must index, store, preserve, retrieve and repro­            Real estate closing statements.
duce the electronically stored books and re­                                                                   Assets. Keep records relating to property until
                                                            Canceled checks.                                   the period of limitations expires for the year in
cords in legible format. All electronic storage
systems must provide a complete and accurate                Bank statements.                                   which you dispose of the property in a taxable
record of your data that is accessible to the IRS.                                                             disposition. You must keep these records to fig­
Electronic storage systems are also subject to       Financial account statements as proof of                  ure any depreciation, amortization, or depletion
the same controls and retention guidelines as        payment. If you do not have a canceled check,             deduction and to figure your basis for comput­
those imposed on your original hard copy             you may be able to prove payment with certain             ing gain or (loss) when you sell or otherwise dis­
books and records. The original hard copy            financial account statements prepared by finan­           pose of the property.
books and records may be destroyed provided          cial institutions. These include account state­               You may need to keep records relating to
that the electronic storage system has been          ments prepared for the financial institution by a         the basis of property longer than the period of
tested to establish that the hard copy books and     third party. These account statements must be             limitation. Keep those records as long as they
records are being reproduced in compliance           legible. The following table lists acceptable ac­         are important in figuring the basis of the original
with IRS requirements for an electronic storage      count statements.                                         or replacement property. Generally, this means
system and procedures are established to en­                                                                   as long as you own the property and, after you
sure continued compliance with all applicable                                                                  dispose of it, for the period of limitations that ap­
                                                                              THEN the statement must
rules and regulations. You still have the respon­     IF payment is by...     show the...
                                                                                                               plies to you. For example, if you received prop­
sibility of retaining any other books and records                                                              erty in a nontaxable exchange, you must keep
that are required to be retained. The IRS may         Check                       Check number.                the records for the old property, as well as for
test your electronic storage system, including                                    Amount.                      the new property, until the period of limitations
the equipment used, indexing methodology,                                         Payee's name.
                                                                                                               expires for the year in which you dispose of the
software and retrieval capabilities. This test is                                                              new property in a taxable disposition. For more
                                                                                  Date the check amount
not considered an examination and the results                                     was posted to the
                                                                                                               information on basis, see chapter 6.
must be shared with you. If your electronic stor­                                 account by the financial
age system meets the requirements mentioned                                       institution.                 Records for nontax purposes. When your
earlier, you will be in compliance. If not, you                                                                records are no longer needed for tax purposes,
may be subject to penalties for non­compliance,       Electronic funds            Amount transferred.          do not discard them until you check to see if
                                                      transfer                    Payee's name.                you have to keep them longer for other purpo­
unless you continue to maintain your original
hard copybooks and records in a manner that                                       Date the transfer was        ses. For example, your insurance company or
allows you and the IRS to determine your cor­                                     posted to the account by     creditors may require you to keep them longer
rect tax. For details on electronic storage sys­                                  the financial institution.   than the IRS does.
tem requirements, see Rev. Proc. 97­22. You           Credit card                 Amount charged.
can find Rev. Proc. 97­22 on page 9 of Internal
                                                                                  Payee's name.
Revenue Bulletin 1997­13 at
                                                                                  Transaction date.
www.irs.gov/pub/irs-irbs/irb97-13.pdf.

Travel, transportation, entertainment, and                     Proof of payment of an amount, by it-
gift expenses. Specific recordkeeping rules             !      self, does not establish you are enti-
apply to these expenses. For more information,        CAUTION  tled to a tax deduction. You should
see Publication 463.                                 also keep other documents, such as credit card
                                                     sales slips and invoices, to show that you also
Employment taxes. There are specific em­             incurred the cost.
ployment tax records you must keep. For a list,
see Publication 51 (Circular A).                     Tax returns. Keep copies of your filed tax re­
                                                     turns. They help in preparing future tax returns
Excise taxes. See How To Claim a Credit or
                                                     and making computations if you file an amen­
Refund in chapter 14 for the specific records
                                                     ded return. Keep copies of your information re­
you must keep to verify your claim for credit or
refund of excise taxes on certain fuels.

Page 4      Chapter 1     Importance of Records
                                                   Types of accounting methods. Generally,                   Delaying receipt of income. You cannot
                                                   you can use any of the following accounting           hold checks or postpone taking possession of
2.                                                 methods.
                                                       Cash method.
                                                                                                         similar property from one tax year to another to
                                                                                                         avoid paying tax on the income. You must re­
                                                        Accrual method.                                  port the income in the year the money or prop­
                                                                                                         erty is received or made available to you with­
Accounting                                              Special methods of accounting for certain
                                                        items of income and expenses.
                                                                                                         out restriction.
                                                        Combination (hybrid) method using ele­               Example. Frances Jones, a farmer, was
Methods                                                 ments of two or more of the above.               entitled to receive a $10,000 payment on a
                                                       You cannot use the crop method for any tax        grain contract in December 2012. She was told
                                                   return, including your first tax return, unless you   in December that her payment was available.

Introduction                                       receive approval from the IRS. The crop
                                                   method of accounting is discussed later under
                                                                                                         She requested not to be paid until January
                                                                                                         2013. However, she must still include this pay­
                                                   Special Methods of Accounting.                        ment in her 2012 income because it was made
    You must use an accounting method that                                                               available to her in 2012.
clearly shows your income and expenses. You        Business and other items. You can account
                                                   for business and personal items using different          Debts paid by another person or can-
must also figure your taxable income and file an
                                                   accounting methods. For example, you can fig­         celed. If your debts are paid by another person
income tax return for an annual accounting pe­
                                                   ure your business income under an accrual             or are canceled by your creditors, you may
riod called a tax year. Only accounting methods
                                                   method, even if you use the cash method to fig­       have to report part or all of this debt relief as in­
are discussed in this chapter. For information
                                                   ure personal items.                                   come. If you receive income in this way, you
on accounting periods, see Publication 538, Ac­
                                                                                                         constructively receive the income when the
counting Periods and Methods, and the Instruc­
                                                   Two or more businesses. If you operate two            debt is canceled or paid. See Cancellation of
tions for Form 1128, Application To Adopt,
                                                   or more separate and distinct businesses, you         Debt in chapter 3.
Change, or Retain a Tax Year.
                                                   can use a different accounting method for each            Deferred payment contract. If you sell an
                                                   business. Generally, no business is separate
Topics                                             and distinct unless a complete and separate set
                                                                                                         item under a deferred payment contract that
This chapter discusses:                                                                                  calls for payment in a future year, there is no
                                                   of books and records is maintained for each           constructive receipt in the year of sale. How­
                                                   business.                                             ever, if the sales contract states that you have
    Cash method
                                                                                                         the right to the proceeds of the sale from the
    Accrual method
                                                   Cash Method                                           buyer at any time after delivery of the item, then
    Farm inventory                                                                                       you must include the sales price in income in
    Special methods of accounting                                                                        the year of the sale, regardless of when you ac­
                                                   Most farmers use the cash method because
                                                                                                         tually receive payment.
    Changes in methods of accounting               they find it easier to keep records using the
                                                   cash method. However, certain farm corpora­
                                                                                                             Example. You are a farmer who uses the
                                                   tions and partnerships and all tax shelters must
Useful Items                                       use an accrual method of accounting. See Ac-
                                                                                                         cash method and a calendar tax year. You sell
You may want to see:                                                                                     grain in December 2012 under a bona fide
                                                   crual Method Required, later.
                                                                                                         arm's­length contract that calls for payment in
                                                                                                         2013. You include the proceeds from the sale in
  Publication                                      Income                                                your 2013 gross income since that is the year
    538 Accounting Periods and Methods                                                                   payment is received. However, if the contract
                                                   Under the cash method, include in your gross          states that you have the right to the proceeds
    535 Business Expenses                          income all items of income you actually or con­       from the buyer at any time after the grain is de­
                                                   structively received during the tax year. Items of    livered, you must include the sales price in your
  Form (and Instructions)
                                                   income include money received as well as              2012 income, regardless of when you actually
    1128 Application To Adopt, Change, or          property or services received. If you receive         receive payment.
        Retain a Tax Year                          property or services, you must include the fair
    3115 Application for Change in                 market value (FMV) of the property or services        Repayment of income. If you include an
        Accounting Method                          in income. See chapter 3 for information on how       amount in income and in a later year you have
                                                   to report farm income on your income tax re­          to repay all or part of it, then you can usually de­
See chapter 16 for information about getting       turn.                                                 duct the repayment in the year repaid. If the re­
publications and forms.                                                                                  payment is more than $3,000, a special rule ap­
                                                   Constructive receipt. Income is construc­             plies. For details, see Repayments in
                                                   tively received when an amount is credited to         chapter 11 of Publication 535, Business Expen­
Accounting Methods                                 your account or made available to you without         ses.
                                                   restriction. You do not need to have possession
An accounting method is a set of rules used to     of the income. If you authorize someone to be
                                                   your agent and receive income for you, you are
                                                                                                         Expenses
determine when and how your income and ex­
penses are reported on your tax return. Your       considered to have received the income when
                                                                                                         Under the cash method, generally you deduct
accounting method includes not only your over­     your agent receives it. Income is not construc­
                                                                                                         expenses in the tax year you pay them. This in­
all method of accounting, but also the account­    tively received if your receipt of the income is
                                                                                                         cludes business expenses for which you con­
ing treatment you use for any material item.       subject to substantial restrictions or limitations.
                                                                                                         test liability. However, you may not be able to
   You generally choose an accounting                  Direct payments and counter-cyclical              deduct an expense paid in advance or you may
method for your farm business when you file        payments. If you received direct payments or          be required to capitalize certain costs, as ex­
your first income tax return that includes a       counter­cyclical payments under Subtitle A or C       plained under Uniform Capitalization Rules in
Schedule F (Form 1040), Profit or Loss From        of the Farm Security and Rural Investment Act         chapter 6. See chapter 4 for information on how
Farming. If you later want to change your ac­      of 2002, you will not be considered to have con­      to deduct farm business expenses on your in­
counting method, you generally must get IRS        structively received a payment merely because         come tax return.
approval. How to obtain IRS approval is dis­       you had the option to receive it in the year be­
cussed later under Changes in Methods of           fore it is required to be paid.                       Prepayment. Generally, you cannot deduct
Accounting.                                                                                              expenses paid in advance. This rule applies to

                                                                                                         Chapter 2      Accounting Methods            Page 5
any expense paid far enough in advance to, in            2. Economic performance has occurred.               Family corporation. A family corporation is
effect, create an asset with a useful life extend­                                                           generally a corporation that meets one of the
ing substantially beyond the end of the current        Economic performance. Generally, you can­             following ownership requirements.
tax year.                                              not deduct or capitalize a business expense un­            Members of the same family own at least
                                                       til economic performance occurs. If your ex­               50% of the total combined voting power of
    Example. On November 1, 2012, you                  pense is for property or services provided to              all classes of stock entitled to vote and at
signed and paid $3,600 for a 3­year (36­month)         you, or for your use of property, economic per­            least 50% of the total shares of all other
insurance contract for equipment. In 2012, you         formance occurs as the property or services are            classes of stock of the corporation.
are allowed to deduct only $200 (2/36 x $3,600)        provided or as the property is used. If your ex­           Members of two families have owned, di­
of the cost of the policy that is attributable to      pense is for property or services you provide to           rectly or indirectly, since October 4, 1976,
2012. In 2013, you'll be able to deduct $1,200         others, economic performance occurs as you                 at least 65% of the total combined voting
(12/36 x $3,600); in 2014, you'll be able to de­       provide the property or services.                          power of all classes of voting stock and at
duct $1,200 (12/36 x $3,600); and in 2015 you'll                                                                  least 65% of the total shares of all other
be able to deduct the remaining balance of                 Example. Jane, who is a farmer, uses a                 classes of the corporation's stock.
$1,000.                                                calendar tax year and an accrual method of ac­             Members of three families have owned, di­
    See chapter 4 for special rules for prepaid        counting. She enters into a contract with ABC              rectly or indirectly, since October 4, 1976,
farm supplies and prepaid livestock feed.              Farm Consulting in 2012. The contract states               at least 50% of the total combined voting
                                                       that Jane must pay ABC Farm Consulting                     power of all classes of voting stock and at
                                                       $2,000 in December 2012. It further stipulates             least 50% of the total shares of all other
Accrual Method                                         that ABC Farm Consulting will develop a plan               classes of the corporation's stock.
                                                       for integrating her farm with a larger farm opera­
Under an accrual method of accounting, gener­                                                                For more information on family corporations,
                                                       tion based in a neighboring state by January 1,
ally you report income in the year earned and                                                                see Internal Revenue Code section 447.
                                                       2013. She pays ABC Farm Consulting $2,000 in
deduct or capitalize expenses in the year incur­       December 2012. Integration of operations ac­
red. The purpose of an accrual method of ac­                                                                 Tax shelter. A tax shelter is a partnership,
                                                       cording to the plan begins in May 2013 and they
counting is to correctly match income and ex­                                                                noncorporate enterprise, or S corporation that
                                                       complete the integration in December 2013.
penses. Certain businesses engaged in farming                                                                meets either of the following tests.
                                                           Economic performance for Jane's liability in
must use an accrual method of accounting for           the contract occurs as the property and serv­           1. Its principal purpose is the avoidance or
its farm business and for sales and purchases          ices are provided. Jane incurs the $2,000 cost             evasion of federal income tax.
of inventory items. See Accrual Method Re-             in 2013.
quired and Farm Inventory, later.                                                                              2. It is a farming syndicate. A farming syndi­
                                                           An exception to the economic performance
                                                                                                                  cate is an entity that meets either of the
                                                       rule allows certain recurring items to be treated
                                                                                                                  following tests.
Income                                                 as incurred during a tax year even though eco­
                                                       nomic performance has not occurred. For more                a. Interests in the activity have been of­
Generally, you include an amount in income for         information, see Economic Performance in Pub­                  fered for sale in an offering required to
the tax year in which all events that fix your right   lication 538.                                                  be registered with a federal or state
to receive the income have occurred, and you                                                                          agency with the authority to regulate
can determine the amount with reasonable ac­           Special rule for related persons. Business                     the offering of securities for sale.
curacy. Under this rule, include an amount in in­      expenses and interest owed to a related person
                                                                                                                   b. More than 35% of the losses during
come on the earliest of the following dates.           who uses the cash method of accounting are
                                                                                                                      the tax year are allocable to limited
     When you receive payment.                         not deductible until you make the payment and
                                                                                                                      partners or limited entrepreneurs.
                                                       the corresponding amount is includible in the
     When the income amount is due to you.
                                                       related person's gross income. Determine the              A “limited partner” is one whose personal li­
     When you earn the income.                         relationship for this rule as of the end of the tax   ability for partnership debts is limited to the
     When title passes.                                year for which the expense or interest would          money or other property the partner contributed
                                                       otherwise be deductible. For more information,        or is required to contribute to the partnership.
                                                       see Internal Revenue Code section 267.                    A “limited entrepreneur” is one who has an
   If you use an accrual method of accounting,
complete Part III of Schedule F (Form 1040) to                                                               interest in an enterprise other than as a limited
report your income.                                    Accrual Method Required                               partner and does not actively participate in the
                                                                                                             management of the enterprise.
Inventory. If you keep an inventory, generally         The following businesses, if engaged in farm­
you must use an accrual method of accounting           ing, must use an accrual method of accounting.        Farm Inventory
to determine your gross income. An inventory is          1. A corporation (other than a family corpora­
necessary to clearly show income when the                   tion) that had gross receipts of more than       If you are required to keep an inventory, you
production, purchase, or sale of merchandise is             $1,000,000 for any tax year beginning af­        should keep a complete record of your inven­
an income­producing factor. See Publication                 ter 1975.                                        tory as part of your farm records. This record
538 for more information. Also see Farm Inven-                                                               should show the actual count or measurement
tory, later, for more information on items that          2. A family corporation that had gross re­          of the inventory. It should also show all factors
must be included in inventory by farmers and in­            ceipts of more than $25,000,000 for any          that enter into its valuation, including quality and
ventory valuation methods for farmers.                      tax year beginning after 1985.                   weight, if applicable.
                                                         3. A partnership with a corporation as a part­
Expenses                                                    ner.                                             Hatchery business. If you are in the hatchery
                                                                                                             business, and use an accrual method of ac­
                                                         4. A tax shelter.                                   counting, you must include in inventory eggs in
Under an accrual method of accounting, you
generally deduct or capitalize a business ex­                                                                the process of incubation.
                                                           Note. Items (1), (2), and (3) above do not
pense when both of the following apply.
                                                       apply to an S corporation or a business operat­       Products held for sale. All harvested and pur­
  1. The all­events test has been met. This test       ing a nursery or sod farm, or the raising or har­     chased farm products held for sale or for feed
     is met when:                                      vesting of trees (other than fruit and nut trees).    or seed, such as grain, hay, silage, concen­
      a. All events have occurred that fix the                                                               trates, cotton, tobacco, etc., must be included in
         fact that you have a liability, and                                                                 inventory.

      b. The amount of the liability can be de­
         termined with reasonable accuracy.

Page 6      Chapter 2      Accounting Methods
Supplies. Supplies acquired for sale or that          marketing costs. If you use this method, you         Cash Versus Accrual Method
become a physical part of items held for sale         must use it for your entire inventory, except that
must be included in inventory. Deduct the cost        livestock can be inventoried under the unit­live­
                                                                                                           The following examples compare the cash and
of supplies in the year used or consumed in op­       stock­price method.
                                                                                                           accrual methods of accounting.
erations. Do not include incidental supplies in
                                                          Unit-livestock-price method. This method
inventory as these are deductible in the year of
                                                      recognizes the difficulty of establishing the ex­       Example 1. You are a farmer who uses an
purchase.
                                                      act costs of producing and raising each animal.      accrual method of accounting. You keep your
                                                      You group or classify livestock according to         books on the calendar year basis. You sell grain
Livestock. Livestock held primarily for sale
                                                      type and age and use a standard unit price for       in December 2012 but you are not paid until
must be included in inventory. Livestock held
                                                      each animal within a class or group. The unit        January 2013. Because the accrual method
for draft, breeding, or dairy purposes can either
                                                      price you assign should reasonably approxi­          was used and 2012 was the tax year in which
be depreciated or included in inventory. See
                                                      mate the normal costs incurred in producing the      the grain was sold, you must both include the
also Unit-livestock-price method, later. If you
                                                      animals in such classes. Unit prices and classi­     sales proceeds and deduct the costs incurred in
are in the business of breeding and raising chin­
                                                      fications are subject to approval by the IRS on      producing the grain on your 2012 tax return.
chillas, mink, foxes, or other fur­bearing ani­
                                                      examination of your return. You must annually
mals, these animals are livestock for inventory
                                                      reevaluate your unit livestock prices and adjust        Example 2. Assume the same facts as in
purposes.
                                                      the prices upward or downward to reflect in­         Example 1 except that you use the cash
                                                      creases or decreases in the costs of raising         method and there was no constructive receipt
Growing crops. Generally, growing crops are
                                                      livestock. IRS approval is not required for these    of the sales proceeds in 2012. Under this
not required to be included in inventory. How­
                                                      adjustments. Any other changes in unit prices        method, you include the sales proceeds in in­
ever, if the crop has a preproductive period of
                                                      or classifications do require IRS approval.          come for 2013, the year you receive payment.
more than 2 years, you may have to capitalize
                                                          If you use this method, include all raised       Deduct the costs of producing the grain in the
(or include in inventory) costs associated with
                                                      livestock in inventory, regardless of whether        year you pay for them.
the crop. See Uniform capitalization rules be­
                                                      they are held for sale or for draft, breeding,
low. Also see Uniform Capitalization Rules in
chapter 6.
                                                      sport, or dairy purposes. This method accounts
                                                      only for the increase in cost of raising an animal
                                                                                                           Special Methods
                                                      to maturity. It does not provide for any decrease    of Accounting
Items to include in inventory. Your inventory
                                                      in the animal's market value after it reaches ma­
should include all items held for sale, or for use
                                                      turity. Also, if you raise cattle, you are not re­   There are special methods of accounting for
as feed, seed, etc., whether raised or pur­
                                                      quired to inventory hay you grow to feed your        certain items of income and expense.
chased, that are unsold at the end of the year.
                                                      herd.
                                                          Do not include sold or lost animals in the       Crop method. If you do not harvest and dis­
Uniform capitalization rules. The following
                                                      year­end inventory. If your records do not show      pose of your crop in the same tax year that you
applies if you are required to use an accrual
                                                      which animals were sold or lost, treat the first     plant it, you can, with IRS approval, use the
method of accounting.
                                                      animals acquired as sold or lost. The animals        crop method of accounting. Under this method,
     The uniform capitalization rules apply to all
                                                      on hand at the end of the year are considered        you deduct the entire cost of producing the
     costs of raising a plant, even if the prepro­
                                                      those most recently acquired.                        crop, including the expense of seed or young
     ductive period of raising a plant is 2 years
                                                          You must include in inventory all livestock      plants, in the year you realize income from the
     or less.
                                                      purchased primarily for sale. You can choose         crop. See chapter 4 for details on deducting the
     The costs of animals are subject to the uni­
                                                      either to include in inventory or depreciate live­   costs of operating a farm. Also see Regulations
     form capitalization rules.
                                                      stock purchased for draft, breeding, sport or        section 1.162­12.
                                                      dairy purposes. However, you must be consis­
Inventory valuation methods. The following
                                                      tent from year to year, regardless of the method     Other special methods. Other special meth­
methods, described below, are those generally
                                                      you have chosen. You cannot change your              ods of accounting apply to the following items.
available for valuing inventory. The method you
                                                      method without obtaining approval from the               Amortization, see chapter 7.
use must conform to generally accepted ac­
                                                      IRS.                                                     Casualties, see chapter 11.
counting principles for similar businesses and
                                                          You must include in inventory animals pur­
must clearly reflect income.                                                                                   Condemnations, see chapter 11.
                                                      chased after maturity or capitalize them at their
     Cost.
                                                      purchase price. If the animals are not mature at         Depletion, see chapter 7.
     Lower of cost or market.                         purchase, increase the cost at the end of each           Depreciation, see chapter 7.
     Farm­price method.                               tax year according to the established unit price.
                                                      However, in the year of purchase, do not in­             Farm business expenses, see chapter 4.
     Unit­livestock­price method.
                                                      crease the cost of any animal purchased during           Farm income, see chapter 3.
                                                      the last 6 months of the year. This “no increase”        Installment sales, see chapter 10.
   Cost and lower of cost or market meth-
                                                      rule does not apply to tax shelters which must
ods. See Publication 538 for information on                                                                    Soil and water conservation expenses, see
                                                      make an adjustment for any animal purchased
these valuation methods.                                                                                       chapter 5.
                                                      during the year. It also does not apply to taxpay­
                                                      ers that must make an adjustment to reasona­             Thefts, see chapter 11.
           If you value your livestock inventory at
 TIP       cost or the lower of cost or market, you   bly reflect the particular period in the year in
           do not need IRS approval to change to      which animals are purchased, if necessary to
                                                      avoid significant distortions in income.
                                                                                                           Combination Method
the unit-livestock-price method. However, if you
value your livestock inventory using the
                                                         Uniform capitalization rules. A farmer            Generally, you can use any combination of
farm-price method, then you must obtain per-
                                                      can determine costs required to be allocated         cash, accrual, and special methods of account­
mission from the IRS to change to the unit-live-
                                                      under the uniform capitalization rules by using      ing if the combination clearly shows your in­
stock-price method.
                                                      the farm­price or unit­livestock­price inventory     come and expenses and you use it consistently.
                                                      method. This applies to any plant or animal,         However, the following restrictions apply.
    Farm-price method. Under this method,             even if the farmer does not hold or treat the             If you use the cash method for figuring
each item, whether raised or purchased, is val­       plant or animal as inventory property.                    your income, you must use the cash
ued at its market price less the direct cost of
                                                                                                                method for reporting your expenses.
disposition. Market price is the current price at
                                                                                                                If you use an accrual method for reporting
the nearest market in the quantities you usually
                                                                                                                your expenses, you must use an accrual
sell. Cost of disposition includes broker's com­
                                                                                                                method for figuring your income.
missions, freight, hauling to market, and other

                                                                                                           Chapter 2    Accounting Methods          Page 7
Changes in Methods of                                   Income averaging for farmers                      clude gains or losses from sales or other dispo­
Accounting                                                                                                sitions of the following farm assets.
                                                                                                                Land.
                                                   Useful Items
A change in your method of accounting in­          You may want to see:                                        Depreciable farm equipment.
cludes a change in:                                                                                            Buildings and structures.
    Your overall method, such as from the            Publication                                               Livestock held for draft, breeding, sport, or
    cash method to an accrual method, and
                                                                                                               dairy purposes.
    Your treatment of any material item, such           525 Taxable and Nontaxable Income
    as a change in your method of valuing in­
                                                        550 Investment Income and Expenses                   Gains and losses from most dispositions of
    ventory (for example, a change from the
                                                                                                          farm assets are discussed in chapters 8 and 9.
    farm­price method to the unit­live­                 908 Bankruptcy Tax Guide
                                                                                                          Gains and losses from casualties, thefts, and
    stock­price method).
                                                        925 Passive Activity and At­Risk Rules            condemnations are discussed in chapter 11.
Generally, once you have set up your account­
ing method, you must receive approval from the          4681 Canceled Debts, Foreclosures,
IRS before you can change to another method                 Repossessions, and Abandonments
                                                                                                          Sales of Farm Products
of accounting. You may also have to pay a fee.
                                                     Form (and Instructions)
However, there are instances when you can ob­                                                             Where to report. Table 3­1 shows where to
tain automatic consent to change certain meth­          982 Reduction of Tax Attributes Due to            report the sale of farm products on your tax re­
ods of accounting.                                          Discharge of Indebtedness (and                turn.
                                                            Section 1082 Basis Adjustment)
   To obtain approval, you must generally file
Form 3115. For more information, see Form               Sch E (Form 1040) Supplemental                        Schedule F. Amounts received from the
3115 and the Instructions for Form 3115. Also               Income and Loss                               sales of products you raised on your farm for
see Publication 538.                                                                                      sale (or bought for resale), such as livestock,
                                                        Sch J (Form 1040) Income Averaging for
                                                            Farmers and Fishermen                         produce, or grains, are reported on Schedule F.
                                                                                                          This includes money and the fair market value
                                                        1099-G Certain Government Payments                of any property or services you receive. When
                                                        1099-PATR Taxable Distributions                   you sell farm products bought for resale, your
                                                            Received From Cooperatives                    profit or loss is the difference between your sell­

3.                                                      4797 Sales of Business Property
                                                                                                          ing price (money plus the fair market value of
                                                                                                          any property) and your basis in the item (usually
                                                        4835 Farm Rental Income and                       the cost). See chapter 6 for information on the
                                                            Expenses                                      basis of assets. You generally report these
Farm Income                                        See chapter 16 for information about getting
                                                                                                          amounts on Schedule F for the year you receive
                                                                                                          payment.
                                                   publications and forms.
                                                                                                              Example. In 2011, you bought 20 feeder
Introduction                                       Schedule F (Form 1040)
                                                                                                          calves for $11,000 for resale. You sold them in
                                                                                                          2012 for $21,000. You report the $21,000 sales
You may receive income from many sources.                                                                 price on Schedule F, line 1b, subtract your
You must report the income from all the differ­    Individuals, trusts, and partnerships report farm      $11,000 basis on line 1d, and report the result­
ent sources on your tax return, unless it is ex­   income on Schedule F (Form 1040), Profit or            ing $10,000 profit on line 1e.
cluded by law. Where you report the income on      Loss From Farming. Use this schedule to figure
your tax return depends on its source.             the net profit or loss from regular farming opera­         Form 4797. Sales of livestock held for
   This chapter discusses farm income you re­      tions.                                                 draft, breeding, sport, or dairy purposes may re­
port on Schedule F (Form 1040), Profit or Loss                                                            sult in ordinary or capital gains or losses, de­
From Farming. For information on where to re­          Income from farming reported on Sched­             pending on the circumstances. In either case,
port other income, see the Instructions for Form   ule F includes amounts you receive from culti­         you should always report these sales on Form
1040, U.S. Individual Income Tax Return.           vating, operating, or managing a farm for gain         4797 instead of Schedule F. See Livestock un­
                                                   or profit, either as owner or tenant. This in­         der Ordinary or Capital Gain or Loss in chap­
Accounting method. The rules discussed in          cludes income from operating a stock, dairy,           ter 8. Animals you do not hold primarily for sale
this chapter assume you use the cash method        poultry, fish, fruit, or truck farm and income from    are considered business assets of your farm.
of accounting. Under the cash method, you          operating a plantation, ranch, range, or orchard.
generally include an item of income in gross in­   It also includes income from the sale of crop          Sale by agent. If your agent sells your farm
come in the year you receive it. See Cash          shares if you materially participate in producing      products, you have constructive receipt of the
Method in chapter 2.                               the crop. See Rents (Including Crop Shares),           income when your agent receives payment and
    If you use an accrual method of accounting,    later.                                                 you must include the net proceeds from the sale
different rules may apply to your situation. See                                                          in gross income for the year the agent receives
                                                       Income received from operating a nursery,
Accrual Method in chapter 2.                                                                              payment. This applies even if your agent pays
                                                   which specializes in growing ornamental plants,
                                                                                                          you in a later year. For a discussion on con­
                                                   is considered to be income from farming.
                                                                                                          structive receipt of income, see Cash Method
Topics
This chapter discusses:                               Income reported on Schedule F does not in­          under Accounting Methods in chapter 2.


    Schedule F
                                                   Table 3­1. Where To Report Sales of Farm Products
    Sales of farm products                                                Item Sold                              Schedule F                Form 4797
    Rents (including crop shares)
                                                    Farm products raised for sale                                     X
    Agricultural program payments
                                                    Farm products bought for resale                                   X
    Income from cooperatives
    Cancellation of debt                            Farm assets not held primarily for sale, such as
                                                    livestock held for draft, breeding, sport, or dairy
    Income from other sources
                                                    purposes (bought or raised)                                                                X

Page 8     Chapter 3       Farm Income
Sales Caused by                                            stock sold. For this purpose, do not treat
                                                           any postponed gain from the previous
Weather-Related Conditions                                 year as income received from the sale of        Rents (Including Crop
If you sell or exchange more livestock, including
                                                           livestock.                                      Shares)
poultry, than you normally would in a year be­          2. Multiply the result in (1) by the excess
cause of a drought, flood, or other weather­rela­          number of such livestock sold solely be­        The rent you receive for the use of your farm­
ted condition, you may be able to postpone re­             cause of weather­related conditions.            land is generally rental income, not farm in­
porting the gain from the additional animals until                                                         come. However, if you materially participate in
the next year. You must meet all the following            Example. You are a calendar year taxpayer        farming operations on the land, the rent is farm
conditions to qualify.                                and you normally sell 100 head of beef cattle a      income. See Landlord Participation in Farming
      Your principal trade or business is farming.    year. As a result of drought, you sold 135 head      in chapter 12.
     You use the cash method of accounting.           during 2011. You realized $70,200 from the
                                                      sale. On August 9, 2011, as a result of drought,     Pasture income and rental. If you pasture
     You can show that, under your usual busi­        the affected area was declared a disaster area       someone else's livestock and take care of them
     ness practices, you would not have sold or       eligible for federal assistance. The income you      for a fee, the income is from your farming busi­
     exchanged the additional animals this year       can postpone until 2012 is $18,200 [($70,200 ÷       ness. You must enter it as Other income on
     except for the weather­related condition.        135) × 35].                                          Schedule F. If you simply rent your pasture for a
     The weather­related condition caused an                                                               flat cash amount without providing services, re­
     area to be designated as eligible for assis­     How to postpone gain. To postpone gain, at­          port the income as rent on Part I of Schedule E
     tance by the federal government.                 tach a statement to your tax return for the year     (Form 1040), Supplemental Income and Loss.
   Sales or exchanges made before an area             of the sale. The statement must include your
became eligible for federal assistance qualify if     name and address and give the following infor­
                                                      mation for each class of livestock for which you
                                                                                                           Crop Shares
the weather­related condition that caused the
sale or exchange also caused the area to be           are postponing gain.                                 You must include rent you receive in the form of
designated as eligible for federal assistance.             A statement that you are postponing gain        crop shares in income in the year you convert
The designation can be made by the President,              under Internal Revenue Code (IRC) sec­          the shares to money or the equivalent of
the Department of Agriculture (or any of its               tion 451(e).                                    money. It does not matter whether you use the
agencies), or by other federal departments or              Evidence of the weather­related conditions
                                                                                                           cash method of accounting or an accrual
agencies.                                                  that forced the early sale or exchange of
                                                                                                           method of accounting.
                                                           the livestock and the date, if known, on
         A weather-related sale or exchange of             which an area was designated as eligible            If you materially participate in operating a
 TIP     livestock (other than poultry) held for           for assistance by the federal government        farm from which you receive rent in the form of
         draft, breeding, or dairy purposes may            because of weather­related conditions.          crop shares or livestock, the rental income is in­
be an involuntary conversion. See Other Invol-             A statement explaining the relationship of      cluded in self­employment income. See Land-
untary Conversions in chapter 11.                          the area affected by the weather­related        lord Participation in Farming in chapter 12. Re­
                                                           condition to your early sale or exchange of     port the rental income on Schedule F.
Usual business practice. You must deter­                   the livestock.
                                                           The number of animals sold in each of the           If you do not materially participate in operat­
mine the number of animals you would have
                                                           3 preceding years.                              ing the farm, report this income on Form 4835
sold had you followed your usual business
                                                           The number of animals you would have            and carry the net income or loss to Schedule E
practice in the absence of the weather­related
                                                           sold in the tax year had you followed your      (Form 1040). The income is not included in
condition. Do this by considering all the facts
                                                           normal business practice in the absence of      self­employment income.
and circumstances, but do not take into account
your sales in any earlier year for which you               weather­related conditions.
                                                           The total number of animals sold and the        Crop shares you use to feed livestock.
postponed the gain. If you have not yet estab­                                                             Crop shares you receive as a landlord and feed
lished a usual business practice, rely on the              number sold because of weather­related
                                                           conditions during the tax year.                 to your livestock are considered converted to
usual business practices of similarly situated                                                             money when fed to the livestock. You must in­
farmers in your general region.                            A computation, as described above, of the
                                                           income to be postponed for each class of        clude the fair market value of the crop shares in
                                                           livestock.                                      income at that time. You are entitled to a busi­
Connection with affected area. The livestock
                                                                                                           ness expense deduction for the livestock feed
does not have to be raised or sold in an area af­         Generally, you must file the statement and       in the same amount and at the same time you
fected by a weather­related condition for the         the return by the due date of the return, includ­    include the fair market value of the crop share
postponement to apply. However, the sale must         ing extensions. However, for sales or ex­            as rental income. Although these two transac­
occur solely because of a weather­related con­        changes treated as an involuntary conversion         tions cancel each other for figuring adjusted
dition that affected the water, grazing, or other     from weather­related sales of livestock in an        gross income on Form 1040, they may be nec­
requirements of the livestock. This requirement       area eligible for federal assistance (discussed      essary to figure your self­employment tax. See
generally will not be met if the costs of feed, wa­   in chapter 11), you can file this statement at any   chapter 12.
ter, or other requirements of the livestock affec­    time during the replacement period. For other
ted by the weather­related condition are not          sales or exchanges, if you timely filed your re­     Crop shares you give to others (gift). Crop
substantial in relation to the total costs of hold­   turn for the year without postponing gain, you       shares you receive as a landlord and give to
ing the livestock.                                    can still postpone gain by filing an amended re­     others are considered converted to money
                                                      turn within 6 months of the due date of the re­      when you make the gift. You must report the fair
Classes of livestock. You must figure the             turn (excluding extensions). Attach the state­       market value of the crop share as income, even
amount to be postponed separately for each            ment to the amended return and write “Filed          though someone else receives payment for the
generic class of animals—for example, hogs,           pursuant to section 301.9100­2” at the top of        crop share.
sheep, and cattle. Do not separate animals into       the amended return. File the amended return at
classes based on age, sex, or breed.                  the same address you filed the original return.          Example. A tenant farmed part of your land
                                                      Once you have filed the statement, you can           under a crop­share arrangement. The tenant
Amount to be postponed. Follow these steps            cancel your postponement of gain only with the       harvested and delivered the crop in your name
to figure the amount of gain to be postponed for      approval of the IRS.                                 to an elevator company. Before selling any of
each class of animals.
                                                                                                           the crop, you instructed the elevator company
  1. Divide the total income realized from the                                                             to cancel your warehouse receipt and make out
     sale of all livestock in the class during the                                                         new warehouse receipts in equal amounts of
     tax year by the total number of such live­                                                            the crop in the names of your children. They sell

                                                                                                                    Chapter 3     Farm Income         Page 9
their crop shares in the following year and the                You can request income tax withhold-           The following examples show how to report
elevator company makes payments directly to            TIP     ing from CCC loan payments you re-           market gain.
your children.                                                 ceive. Use Form W-4V, Voluntary
    In this situation, you are considered to have     Withholding Request. See chapter 16 for infor-            Example 1. Mike Green is a cotton farmer.
received rental income and then made a gift of        mation about ordering the form.                       He uses the cash method of accounting and
that income. You must include the fair market                                                               files his tax return on a calendar year basis. He
value of the crop shares in your income for the           To elect to report a CCC loan as income, in­      has deducted all expenses incurred in produc­
tax year you gave the crop shares to your chil­       clude the loan proceeds as income on Sched­           ing the cotton and has a zero basis in the com­
dren.                                                 ule F, line 7a, for the year you receive it. Attach   modity. In 2011, Mike pledged 1,000 pounds of
                                                      a statement to your return showing the details of     cotton as collateral for a CCC loan of $2,000 (a
Crop share loss. If you are involved in a rental      the loan.                                             loan rate of $2.00 per pound). In 2012, he re­
or crop­share lease arrangement, any loss from                                                              paid the loan and redeemed the cotton for
these activities may be subject to the limits un­         You must file the statement and the return        $1,500 when the world price was $1.50 per
der the passive loss rules. See Publication 925       by the due date of the return, including exten­       pound (lower than the loan amount). Later in
for information on these rules.                       sions. If you timely filed your return for the year   2012, he sold the cotton for $2,500.
                                                      without making the election, you can still make           The market gain on the redemption was
                                                      the election by filing an amended return within 6     $.50 ($2.00 – $1.50) per pound. Mike realized
Agricultural Program                                  months of the due date of the return (excluding       total market gain of $500 ($.50 x 1,000 pounds).
                                                      extensions). Attach the statement to the amen­        How he reports this market gain and figures his
Payments                                              ded return and write “Filed pursuant to section       gain or loss from the sale of the cotton depends
                                                      301.9100­2” at the top of the return. File the        on whether he included CCC loans in income in
You must include in income most government            amended return at the same address you filed          2011.
payments, such as those for approved conser­          the original return.
vation practices, direct payments, and coun­                                                                    Included CCC loan. Mike reported the
ter­cyclical payments, whether you receive                When you make this election, the amount           $2,000 CCC loan as income for 2011 on
them in cash, materials, services, or commodity       you report as income becomes your basis in the        Schedule F, line 1b, so he is treated as if he
certificates. However, you can exclude from in­       commodity. See chapter 6 for information on           sold the cotton for $2,000 when he pledged it
come some payments you receive under cer­             the basis of assets. If you later repay the loan,     and repurchased the cotton for $1,500 when he
tain cost­sharing conservation programs. See          redeem the pledged commodity, and sell it, you        redeemed it. The $500 market gain is not rec­
Cost-Sharing Exclusion (Improvements), later.         report as income at the time of sale the sale         ognized on the redemption. He reports it for
                                                      proceeds minus your basis in the commodity. If        2012 as an agricultural program payment on
    Report the agricultural program payment on                                                              Schedule F, line 4a, but does not include it as a
                                                      the sale proceeds are less than your basis in
the appropriate line of Schedule F, Part I. Re­                                                             taxable amount on line 4b.
                                                      the commodity, you can report the difference as
port the full amount even if you return a govern­                                                               Mike's basis in the cotton after he redeemed
                                                      a loss on Schedule F.
ment check for cancellation, refund any of the                                                              it was $1,500, which is the redemption (re­
payment you receive, or the government col­                If you forfeit the pledged crops to the CCC in   purchase) price paid for the cotton. His gain
lects all or part of the payment from you by re­      full payment of the loan, the forfeiture is treated   from the sale is $1,000 ($2,500 – $1,500). He
ducing the amount of some other payment or            for tax purposes as a sale of the crops. If you       reports the $1,000 gain as income for 2012 on
Commodity Credit Corporation (CCC) loan.              did not report the loan proceeds as income for        Schedule F, line 1b.
However, you can deduct the amount you re­            the year you received them, you must include
fund or return or that reduces some other pay­        them in your income for the year of the forfei­           Excluded CCC loan. Mike has income of
ment or loan to you. Claim the deduction on           ture.                                                 $500 from market gain in 2012. He reports it on
Schedule F for the year of repayment or reduc­                                                              Schedule F, lines 4a and 4b. His basis in the
tion.                                                 Form 1099-A. If you forfeit pledged crops to          cotton is zero, so his gain from its sale is
                                                      the CCC in full payment of a loan, you may re­        $2,500. He reports the $2,500 gain as income
Commodity Credit                                      ceive a Form 1099­A, Acquisition or Abandon­          for 2012 on Schedule F, line 1b.
Corporation (CCC) Loans                               ment of Secured Property. “CCC” should be
                                                      shown in box 6. The amount of any CCC loan                Example 2. The facts are the same as in
                                                      outstanding when you forfeited your commodity         Example 1 except that, instead of selling the
Generally, you do not report loans you receive                                                              cotton for $2,500 after redeeming it, Mike en­
as income. However, if you pledge part or all of      should also be indicated on the form.
                                                                                                            tered into an option­to­purchase contract with a
your production to secure a CCC loan, you can                                                               cotton buyer before redeeming the cotton. Un­
treat the loan as if it were a sale of the crop and   Market Gain                                           der that contract, Mike authorized the cotton
report the loan proceeds as income in the year                                                              buyer to pay the CCC loan on Mike's behalf. In
you receive them. You do not need approval            Under the CCC nonrecourse marketing assis­            2012, the cotton buyer repaid the loan for
from the IRS to adopt this method of reporting        tance loan program, your repayment amount for         $1,500 and immediately exercised his option,
CCC loans.                                            a loan secured by your pledge of an eligible          buying the cotton for $1,500. How Mike reports
                                                      commodity is generally based on the lower of          the $500 market gain on the redemption of the
    Once you report a CCC loan as income for          the loan rate or the prevailing world market
the year received, you generally must report all                                                            cotton and figures his gain or loss from its sale
                                                      price for the commodity on the date of repay­         depends on whether he included CCC loans in
CCC loans in that year and later years in the         ment. If you repay the loan when the world price
same way. However, you can obtain for your                                                                  income in 2011.
                                                      is lower, the difference between that repayment
tax year an automatic consent to change your          amount and the original loan amount is market             Included CCC loan. As in Example 1, Mike
method of accounting for loans received from          gain. Whether you use cash or CCC certificates        is treated as though he sold the cotton for
the CCC, from including the loan amount in            to repay the loan, you will receive a Form            $2,000 when he pledged it and repurchased the
gross income for the tax year in which the loan       1099­G showing the market gain you realized.          cotton for $1,500 when the cotton buyer re­
is received to treating the loan amount as a          Market gain should be reported as follows.            deemed it for him. The $500 market gain is not
loan. For more information, see Part I of the In­          If you elected to include the CCC loan in        recognized on the redemption. Mike reports it
structions for Form 3115 and Revenue Proce­                income in the year you received it, do not       for 2012 as an Agricultural program payment on
dure 2008­52. Revenue Procedure 2008­52,                   include the market gain in income. How­          Schedule F, line 4a, but does not include it as a
2008­36 I.R.B. 587, is available at                        ever, adjust the basis of the commodity for      taxable amount on line 4b.
www.irs.gov/irb/2008-36_IRB/ar09.html.                     the amount of the market gain.                       Also, as in Example 1, Mike's basis in the
                                                           If you did not include the CCC loan in in­       cotton when the cotton buyer redeemed it for
                                                           come in the year received, include the           him was $1,500. Mike has no gain or loss on its
                                                           market gain in your income.                      sale to the cotton buyer for that amount.

Page 10      Chapter 3     Farm Income
   Excluded CCC loan. As in Example 1,              line 6b. Check the box on line 8c and attach a       payments. You can usually take a current de­
Mike has income of $500 from market gain in         statement to your tax return. The statement          duction for the same amount as a feed ex­
2012. He reports it on Schedule F, lines 4a and     must include your name and address and con­          pense.
4b. His basis in the cotton is zero, so his gain    tain the following information.
from its sale is $1,500. He reports the $1,500
gain as income for 2012 on Schedule F, line 1b.
                                                          A statement that you are making an elec­
                                                          tion under IRC section 451(d) and Regula­
                                                                                                         Cost-Sharing Exclusion
                                                          tions section 1.451­6.                         (Improvements)
Conservation Reserve                                      The specific crop or crops physically de­
                                                          stroyed or damaged.                            You can exclude from your income part or all of
Program (CRP)                                             A statement that under your normal busi­       a payment you receive under certain federal or
                                                          ness practice you would have included in­      state cost­sharing conservation, reclamation,
Under the Conservation Reserve Program                    come from some or all of the destroyed or      and restoration programs. A payment is any
(CRP), if you own or operate highly erodible or           damaged crops in gross income for a tax        economic benefit you get as a result of an im­
other specified cropland, you may enter into a            year following the year the crops were de­     provement. However, this exclusion applies
long­term contract with the USDA, agreeing to             stroyed or damaged.                            only to that part of a payment that meets all
convert to a less intensive use of that cropland.         The cause of the physical destruction or       three of the following tests.
You must include the annual rental payments               damage and the date or dates it occurred.        1. It was for a capital expense. You cannot
and any one­time incentive payment you re­                The total payments you received from in­            exclude any part of a payment for an ex­
ceive under the program on Schedule F, lines              surance carriers, itemized for each specific        pense you can deduct in the year you pay
4a and 4b. Cost­share payments you receive                crop, and the date you received each pay­           or incur it. You must include the payment
may qualify for the cost­sharing exclusion. See           ment.                                               for a deductible expense in income, and
Cost-Sharing Exclusion (Improvements), later.             The name of each insurance carrier from             you can take any offsetting deduction. See
CRP payments are reported to you on Form                  whom you received payments.                         chapter 5 for information on deducting soil
1099­G.                                                                                                       and water conservation expenses.
                                                        One election covers all crops representing a
          Individuals who are receiving Social      single trade or business. If you have more than        2. It does not substantially increase your an­
 TIP Security retirement or disability bene-        one farming business, make a separate election            nual income from the property for which it
          fits may exclude CRP payments when        for each one. For example, if you operate two             is made. An increase in annual income is
calculating self-employment tax. See the in-        separate farms on which you grow different                substantial if it is more than the greater of
structions for Schedule SE (Form 1040).             crops and you keep separate books for each                the following amounts.
                                                    farm, you should make two separate elections
                                                                                                               a. 10% of the average annual income
                                                    to postpone reporting insurance proceeds you
Crop Insurance and Crop                             receive for crops grown on each of your farms.
                                                                                                                  derived from the affected property be­
                                                                                                                  fore receiving the improvement.
Disaster Payments                                       An election is binding for the year unless the
                                                    IRS approves your request to change it. To re­             b. $2.50 times the number of affected
                                                    quest IRS approval to change your election,                   acres.
You must include in income any crop insurance
                                                    write to the IRS at the following address giving
proceeds you receive as the result of physical                                                             3. The Secretary of Agriculture certified that
                                                    your name, address, identification number, the
crop damage. You generally include them in the                                                                the payment was primarily made for con­
                                                    year you made the election, and your reasons
year you receive them. Treat as crop insurance                                                                serving soil and water resources, protect­
                                                    for wanting to change it.
proceeds the crop disaster payments you re­                                                                   ing or restoring the environment, improv­
ceive from the federal government as the result                                                               ing forests, or providing a habitat for
                                                         Ogden Submission Processing Center
of destruction or damage to crops, or the inabil­                                                             wildlife.
                                                         P. O. Box 9941
ity to plant crops, because of drought, flood, or
                                                         Ogden, UT 84409
any other natural disaster.                                                                              Qualifying programs. If the three tests listed
                                                                                                         above are met, you can exclude part or all of
         You can request income tax withhold-       Feed Assistance and                                  the payments from the following programs.
         ing from crop disaster payments you
 TIP
         receive from the federal government.       Payments                                                  The rural clean water program authorized
                                                                                                              by the Federal Water Pollution Control Act.
Use Form W-4V, Voluntary Withholding Re-                                                                      The rural abandoned mine program au­
quest. See chapter 16 for information about or-     The Disaster Assistance Act of 1988 authorizes
                                                                                                              thorized by the Surface Mining Control and
dering the form.                                    programs to provide feed assistance, reim­
                                                                                                              Reclamation Act of 1977.
                                                    bursement payments, and other benefits to
                                                                                                              The water bank program authorized by the
                                                    qualifying livestock producers if the Secretary of
Election to postpone reporting until the fol-                                                                 Water Bank Act.
                                                    Agriculture determines that, because of a natu­
lowing year. You can postpone reporting                                                                       The emergency conservation measures
                                                    ral disaster, a livestock emergency exists.
some or all crop insurance proceeds as income                                                                 program authorized by title IV of the Agri­
                                                    These programs include partial reimbursement
until the year following the year the physical                                                                cultural Credit Act of 1978.
                                                    for the cost of purchased feed and for certain            The agricultural conservation program au­
damage occurred if you meet all the following
                                                    transportation expenses. They also include the            thorized by the Soil Conservation and Do­
conditions.
                                                    donation or sale at a below­market price of feed          mestic Allotment Act.
      You use the cash method of accounting.
                                                    owned by the Commodity Credit Corporation.                The great plains conservation program au­
    You receive the crop insurance proceeds
                                                                                                              thorized by the Soil Conservation and Do­
    in the same tax year the crops are dam­            Include in income:
                                                                                                              mestic Policy Act.
    aged.                                                The market value of donated feed,
                                                                                                              The resource conservation and develop­
    You can show that under your normal busi­            The difference between the market value              ment program authorized by the Bank­
    ness practice you would have included in­            and the price you paid for feed you buy at           head­Jones Farm Tenant Act and by the
    come from the damaged crops in any tax               below market prices, and                             Soil Conservation and Domestic Allotment
    year following the year the damage occur­            Any cost reimbursement you receive.                  Act.
    red.
                                                                                                              Certain small watershed programs, listed
   Deferral is not permitted for proceeds re­           You must include these benefits in income             later.
ceived from revenue insurance policies.             in the year you receive them. You cannot post­            Any program of a state, possession of the
   To postpone reporting some or all crop in­       pone reporting them under the rules explained             United States, a political subdivision of any
surance proceeds received in 2012, report the       earlier for weather­related sales of livestock or         of these, or of the District of Columbia un­
amount you received on Schedule F, line 6a,         crop insurance proceeds. Report the benefits              der which payments are made to
but do not include it as a taxable amount on        on Schedule F, Part I, as agricultural program            individuals primarily for conserving soil,

                                                                                                                Chapter 3      Farm Income         Page 11
     protecting or restoring the environment,                Agriculture has not certified as primarily for           The value of the improvement.
     improving forests, or providing a habitat for           conservation.                                            The amount you are excluding.
     wildlife. Several state programs have been              Any government payment to you for rent or
     approved. For information about the status              for your services.                                     Report the total cost­sharing payments you
     of those programs, contact the state offi­                                                                  receive on Schedule F, line 4a, and the taxable
                                                      The denominator of the fraction is the total cost
     ces of the Farm Service Agency (FSA) and                                                                    amount on line 4b.
                                                      of the improvement.
     the Natural Resources and Conservation
     Service (NRCS).                                      Excludable portion. The excludable por­                Recapture. If you dispose of the property
                                                      tion is the present fair market value of the right         within 20 years after you received the excluded
    Small watershed programs. If the three                                                                       payments, you must treat as ordinary income
                                                      to receive annual income from the affected
tests listed earlier are met, you can exclude part                                                               part or all of the cost­sharing payments you ex­
                                                      acreage of the greater of the following amounts.
or all of the payments you receive under the fol­                                                                cluded. In the above example, if the 100 acres
lowing programs for improvements made in                1. 10% of the prior average annual income                were sold within 20 years of the exclusion for a
connection with a watershed.                               from the affected acreage. The prior aver­            gain of $2,000, $1,550 of that amount would be
      The programs under the Watershed Pro­                age annual income is the average of the               included in ordinary income. You must report
      tection and Flood Prevention Act.                    gross receipts from the affected acreage              the recapture on Form 4797. See Section 1255
      The flood prevention projects under the              for the last 3 tax years before the tax year          property under Other Gains in chapter 9.
      Flood Control Act of 1944.                           in which you started to install the improve­
      The Emergency Watershed Protection                   ment.                                                 Electing not to exclude payments. You can
      Program under the Flood Control Act of                                                                     elect not to exclude all or part of any payments
                                                        2. $2.50 times the number of affected acres.
      1950.                                                                                                      you receive under these programs. If you make
      Certain programs under the Colorado                       The calculation of present fair market           this election for all of these payments, none of
      River Basin Salinity Control Act.                         value of the right to receive annual in-
      The Wetlands Reserve Program author­
                                                         !
                                                      CAUTION   come is too complex to discuss in this
                                                                                                                 the above restrictions and rules apply. You
                                                                                                                 must make this election by the due date, includ­
      ized by the Food Security Act of 1985, the      publication. You may need to consult your tax              ing extensions, for filing your return. In the ex­
      Federal Agriculture Improvement and Re­         advisor for assistance.                                    ample above, an election not to exclude pay­
      form Act of 1996 and the Farm Security                                                                     ments results in $5,000 included in income and
      and Rural Investment Act of 2002.                                                                          a $15,000 increase in basis. If you timely filed
                                                          Example. One hundred acres of your land
      The Environmental Quality Incentives Pro­                                                                  your return for the year without making the elec­
                                                      was reclaimed under a rural abandoned mine
      gram (EQIP) authorized by the Federal Ag­                                                                  tion, you can still make the election by filing an
                                                      program contract with the Natural Resources
      riculture Improvement and Reform Act of                                                                    amended return within 6 months of the due date
                                                      Conservation Service of the USDA. The total
      1996.                                                                                                      of the return (excluding extensions). Write
                                                      cost of the improvement was $500,000. The
      The Wildlife Habitat Incentives Program                                                                    “Filed pursuant to section 301.9100­2” at the
                                                      USDA paid $490,000. You paid $10,000. The
      (WHIP) authorized by the Federal Agricul­                                                                  top of the amended return and file it at the same
                                                      value of the cost­sharing improvement is
      ture Improvement and Reform Act of 1996.                                                                   address you filed the original return.
                                                      $15,000.
      The Soil and Water Conservation Assis­
                                                          The present fair market value of the right to
      tance Program authorized by the Agricul­
      tural Risk Protection Act of 2000.
                                                      receive the annual income described in (1)                 Payments Under the Farm
      The Agricultural Management Assistance
                                                      above is $1,380, and the present fair market
                                                      value of the right to receive the annual income
                                                                                                                 Security and Rural
      Program authorized by the Agricultural
                                                      described in (2) is $1,550. The excludable por­            Investment Act of 2002 and
      Risk Protection Act of 2000.
      The Conservation Reserve Program au­            tion is the greater amount, $1,550.                        Under the Food,
      thorized by the Food Security Act of 1985           You figure the amount to include in gross in­          Conservation, and Energy
                                                      come as follows:
      and the Federal Agriculture Improvement                                                                    Act of 2008
      and Reform Act of 1996.
      The Forest Land Enhancement Program              Value of cost­sharing                                     The Farm Security and Rural Investment Act of
      authorized under the Farm Security and             improvement . . . . . . . . . . . . . . . . . $15,000   2002 created two new types of payments—di­
      Rural Investment Act of 2002.                    Minus:    Your share . . . . . $10,000                    rect and counter­cyclical payments. You must
      The Conservation Security Program au­                      Excludable                  1,550 11,550        include these payments on Schedule F, lines 4a
      thorized by the Food Security Act of 1985.                 portion . . . . . . . .                         and 4b. The Food, Conservation, and Energy
      The Forest Health Protection Program                                                                       Act of 2008 provides for direct and counter­cy­
      (FHPP) authorized by the Cooperative For­        Amount included in income . . . . $ 3,450                 clical payments (DCP) as well as Average Crop
      estry Assistance Act of 1978.                                                                              Revenue Election (ACRE) payments. You must
                                                      Effects of the exclusion. When you figure the              include these payments on Schedule F, lines 6a
Income realized. The gross income you real­                                                                      and 6b.
                                                      basis of property you acquire or improve using
ize upon getting an improvement under these
                                                      cost­sharing payments excluded from income,
cost­sharing programs is the value of the im­
provement reduced by the sum of the excluda­
                                                      subtract the excluded payments from your capi­             Tobacco Quota Buyout
ble portion and your share of the cost of the im­
                                                      tal costs. Any payment excluded from income is
                                                      not part of your basis. In the example above,
                                                                                                                 Program Payments
provement (if any).
                                                      the increase in basis is $500,000 ­ $490,000 +             The Fair and Equitable Tobacco Reform Act of
    Value of the improvement. You deter­              $3,450 = $13,450.                                          2004, title VI of the American Jobs Creation Act
mine the value of the improvement by multiply­            In addition, you cannot take depreciation,             of 2004, terminated the tobacco marketing
ing its fair market value (defined in chapter 6) by   amortization, or depletion deductions for the              quota program and the tobacco price support
a fraction. The numerator of the fraction is the      part of the cost of the property for which you re­         program. As a result, the USDA offered to enter
total cost of the improvement (all amounts paid       ceive cost­sharing payments you exclude from               into contracts with eligible tobacco quota hold­
either by you or by the government for the im­        income.                                                    ers and growers to provide compensation for
provement) reduced by the sum of the following                                                                   the lost value of the quotas and related price
items.                                                How to report the exclusion. Attach a state­               support.
      Any government payments under a pro­            ment to your tax return (or amended return) for
      gram not listed earlier.                        the tax year you receive the last government                  If you are an eligible tobacco quota holder,
      Any part of a government payment under a        payment for the improvement. The statement                 your contract entitles you to receive total pay­
      program listed earlier that the Secretary of    must include the following information.                    ments of $7 per pound of quota in 10 equal an­
                                                           The dollar amount of the cost funded by               nual payments in fiscal years 2005 through
                                                           the government payment.                               2014. If you are an eligible tobacco grower,

Page 12      Chapter 3     Farm Income
your contract entitles you to receive total pay­      least one payment after the close of your tax         Tobacco Growers
ments of up to $3 per pound of quota in 10            year. Under the installment method, a portion of
equal annual payments in fiscal years 2005            the gain is taken into account in each year in        Contract payments you receive are determined
through 2014.                                         which a payment is received. See chapter 10           by reference to the amount of quota under
                                                      for more information.                                 which you produced (or planted) quota tobacco
Tobacco Quota Holders                                                                                       during the 2002, 2003, and 2004 tobacco mar­
                                                      Capital or ordinary gain or loss. Whether             keting years and are prorated based on the
Contract payments you receive are considered          your gain or loss is ordinary or capital depends      number of years that you produced (or planted)
proceeds from a sale of your tobacco quota as         on how you used the quota.                            quota tobacco during those years.
of the date on which you and the USDA enter              Quota used in the trade or business of
into the contract. Your taxable gain or loss is the                                                         Taxation of payments to tobacco growers.
                                                      farming. If you used the quota in the trade or        Payments to growers replace ordinary income
total amount received for your quota reduced by       business of farming and you held it for more
any amount treated as interest (discussed be­                                                               that would have been earned had the tobacco
                                                      than one year, you report the transaction as a        marketing quota and price support programs
low), over your adjusted basis. The gain or loss      section 1231 transaction on Form 4797. See
is capital or ordinary depending on how you                                                                 continued. Individuals will generally report the
                                                      Section 1231 transactions in the Instructions for     payments as an Agricultural program payment
used the quota. See Capital or ordinary gain or       Form 4797 for detailed information on reporting
loss, later.                                                                                                on Schedule F. If you are a landowner who
                                                      section 1231 transactions.                            does not materially participate in the operation
                                                                                                            or management of the farm and are receiving
    Report the entire gain on your income tax             Quota held for investment. If you held the
                                                                                                            the grower payment because your farm rental
return for the tax year that includes the date you    quota for investment purposes, any gain or loss
                                                                                                            income is based on the tobacco grown by a ten­
entered into the contract if you elect not to use     is capital gain or loss. The same result also ap­
                                                                                                            ant, the grower payment should be reported on
the installment method.                               plies if you held the quota for the production of
                                                                                                            Form 4835.
                                                      income, though not connected with a trade or
Adjusted basis. The adjusted basis of your            business.
                                                                                                            Self-employment income. Payments to grow­
quota is determined differently depending on
                                                          Gain treated as ordinary income. If you           ers generally represent self­employment in­
how you obtained the quota.
                                                      previously deducted any of the following items,       come. If the grower is an individual carrying on
    The basis of a quota derived from an origi­
                                                      some or all of the capital gain must be recharac­     a trade or business and deriving income (other
    nal grant by the federal government is
                                                      terized and reported as ordinary income. Any          than farm rental income properly reported on
    zero.
                                                      resulting capital gain is taxed as ordinary in­       Form 4835) from that trade or business, the
    The basis of a purchased quota is the pur­
                                                      come up to the amount previously deducted.            payments are net earnings from self­employ­
    chase price.
                                                           The cost of acquiring a quota.                   ment.
    The basis of a quota received as a gift is
    generally the same as the donor's basis.               Amounts for amortization, depletion, or de­      Income averaging for farmers. Payments to
    However, under certain circumstances, the              preciation.                                      growers who are individuals qualify for farm in­
    basis is increased by the amount of gift               Amounts to reflect a reduction in the quota      come averaging.
    taxes paid. If the basis is greater than the           pounds.
    fair market value of the quota at the time of                                                           Form 1099-G. If the amount received in a taxa­
                                                          You should include the ordinary income on
    the gift, the basis for determining loss is                                                             ble year is $600 or more, the amount will gener­
                                                      your return for the tax year even if you use the
    the fair market value.                                                                                  ally be reported by the USDA on a Form
                                                      installment method to report the remainder of
    The basis of an inherited quota is generally                                                            1099­G.
                                                      the gain.
    the fair market value of the quota at the
    time of the decedent's death.
                                                      Self-employment income. The tobacco quota             Other Payments
    Reduction of basis. You are required to           buyout payments are not self­employment in­
reduce the basis of your tobacco quota by the         come.                                                 You must include most other government pro­
following amounts.                                                                                          gram payments in income.
     Deductions you took for amortization, de­        Income averaging for farmers. The gain or
     pletion, or depreciation.                        loss resulting from the quota payments does
     Amounts you previously deducted as a             not qualify for income averaging. A tobacco           Fertilizer and Lime
     loss because of a reduction in the number        quota is considered an interest in land. Income
                                                      averaging is not available for gain or loss arising   Include in income the value of fertilizer or lime
     of pounds of tobacco allowable under the                                                               you receive under a government program. How
     quota.                                           from the sale or other disposition of land.
                                                                                                            to claim the offsetting deduction is explained
     The entire cost of a purchased quota you                                                               under Fertilizer and Lime in chapter 4.
     deducted in an earlier year (which reduces       Involuntary conversion. The buyout of the to­
     your basis to zero).                             bacco quota is not an involuntary conversion.
                                                                                                            Improvements
Amount treated as interest. You must re­              Form 1099-S. A tobacco quota is considered
duce your tobacco quota buyout program pay­           an interest in land, so the USDA will generally       If government payments are based on improve­
ment by the amount treated as interest. The in­       report the total amount you receive under a           ments, such as a pollution control facility, you
terest is reportable as ordinary income. If           contract on Form 1099­S, Proceeds From Real           must include them in income. You must also
payments total $3,000 or less, your total quota       Estate Transactions, if the amount is $600 or         capitalize the full cost of the improvement.
buyout program payment does not include any           more. The USDA will generally report any por­         Since you have included the payments in in­
amount treated as interest and you are not re­        tion of a payment treated as interest of $600 or      come, they do not reduce your basis. However,
quired to reduce the total payment you receive.       more to you on Form 1099­INT, Interest In­            see Cost-Sharing Exclusion (Improvements),
    In all other cases, a portion of each payment     come, for the year in which the payment is            earlier, for additional information.
may be treated as interest for federal tax purpo­     made.
ses. You may be required to reduce your total                                                               National Tobacco Growers'
quota buyout program payment before you cal­          Like-kind exchange of quota. You may post­            Settlement Trust Fund Payments
culate your gain or loss. For more information,       pone reporting the gain or loss from tobacco
see Notice 2005­57, 2005­32 I.R.B. 267, availa­       quota buyout payments by entering into a              If you are a producer, landowner, or tobacco
ble at www.irs.gov/irb/2005-32_IRB/ar13.html.         like­kind exchange if you comply with the re­         quota owner who receives money from the Na­
                                                      quirements of section 1031 and the regulations        tional Tobacco Growers' Settlement Trust Fund,
Installment method. You may use the install­          thereunder. See Notice 2005­57 for more infor­        you must report those payments as income.
ment method to report a gain if you receive at        mation.                                               You should receive a Form 1099­MISC,

                                                                                                                   Chapter 3     Farm Income        Page 13
Miscellaneous Income, that shows the payment            that were not deductible, such as buying per­         clude in income for the tax year of disposition
amount.                                                 sonal or family items, capital assets, or depreci­    any amount you receive from its sale, redemp­
                                                        able property. You must reduce the cost or            tion, or other disposition. Report that amount,
    If you produce a tobacco crop, report the           other basis of these items by the amount of           up to the stated dollar value of the notice, on
payments as income from farming on your                 such patronage dividends received. Personal           Schedule F, lines 3a and 3b. However, do not
Schedule F. If you are a landowner or tobacco           items include fuel purchased for personal use,        include that amount in your income if the notice
quota owner who leases tobacco­related prop­            basic local telephone service, and personal           resulted from buying or selling capital assets or
erty but you do not produce the crop, report the        long distance calls.                                  depreciable property or from buying personal
payments as farm rental income on Form 4835.                                                                  items, as explained in the following discussions.
                                                            If you cannot determine what the dividend is
                                                                                                                  If the amount you receive is more than the
                                                        for, report it as income on lines 3a and 3b.
Payment to More Than One                                                                                      stated dollar value of the notice, report the ex­
                                                                                                              cess as the type of income it represents. For
Person                                                  Qualified written notice of allocation. If you
                                                                                                              example, if it represents interest income, report
                                                        receive a qualified written notice of allocation as
                                                        part of a patronage dividend, you must gener­         it on your return as interest.
The USDA reports program payments to the
IRS. It reports a program payment intended for          ally include its stated dollar value in your in­
                                                                                                              Buying or selling capital assets or depreci-
more than one person as having been paid to             come on Schedule F, lines 3a and 3b, in the
                                                                                                              able property. Do not include in income pa­
the person whose identification number is on            year you receive it. A written notice of allocation
                                                                                                              tronage dividends from buying capital assets or
record for that payment (payee of record). If           is qualified if at least 20% of the patronage divi­
                                                                                                              depreciable property used in your business.
you, as the payee of record, receive a program          dend is paid in money or by qualified check and
                                                                                                              You must, however, reduce the basis of these
payment belonging to someone else, such as              either of the following conditions is met.
                                                                                                              assets by the dividends. This reduction is taken
your landlord, the amount belonging to the                1. The notice must be redeemable in cash            into account as of the first day of the tax year in
other person is a nominee distribution. You                  for at least 90 days after it is issued, and     which the dividends are received. If the divi­
should file Form 1099­G to report the identity of            you must have received a written notice of       dends are more than your unrecovered basis,
the actual recipient to the IRS. You should also             your right of redemption at the same time        reduce the unrecovered basis to zero and in­
give this information to the recipient. You can              as the written notice of allocation.             clude the difference on Schedule F, line 3a, for
avoid the inconvenience of unnecessary inqui­                                                                 the tax year you receive them.
ries about the identity of the recipient if you file      2. You must have agreed to include the sta­
                                                             ted dollar value in income in the year you           This rule and the exceptions explained be­
this form.                                                                                                    low also apply to amounts you receive from the
                                                             receive the notice by doing one of the fol­
    Report the total amount reported to you as               lowing.                                          sale, redemption, or other disposition of a non­
the payee of record on Schedule F, line 4a or                                                                 qualified notice of allocation that resulted from
6a. However, do not report as a taxable amount                a. Signing and giving a written agree­          buying or selling capital assets or depreciable
on line 4b or 6b any amount belonging to some­                   ment to the cooperative.                     property.
one else.                                                     b. Getting or keeping membership in the
                                                                 cooperative after it adopted a bylaw             Example. On July 1, 2011, Mr. Brown, a
    See chapter 16 for information about order­                                                               patron of a cooperative association, bought a
ing Form 1099­G.                                                 providing that membership constitutes
                                                                 agreement. The cooperative must no­          machine for his dairy farm business from the as­
                                                                 tify you in writing of this bylaw and        sociation for $2,900. The machine has a life of 7
                                                                                                              years under MACRS (as provided in the Table
Income From Cooperatives                                         give you a copy.
                                                                                                              of Class Lives and Recovery Periods in Appen­
                                                              c. Endorsing and cashing a qualified            dix B of Publication 946, Depreciation and Am­
If you buy farm supplies through a cooperative,                  check paid as part of the same pa­           ortization). Mr. Brown files his return on a calen­
you may receive income from the cooperative in                   tronage dividend. You must cash the          dar year basis. For 2011, he claimed a
the form of patronage dividends (refunds). If                    check by the 90th day after the close        depreciation deduction of $311, using the
you sell your farm products through a coopera­                   of the payment period for the cooper­        10.71% depreciation rate from the 150% declin­
tive, you may receive either patronage divi­                     ative's tax year for which the patron­       ing balance, half­year convention table (shown
dends or a per­unit retain certificate, explained                age dividend was paid.                       in Table A-14 in Appendix A of Publication 946).
later, from the cooperative.                                                                                  On July 2, 2012, the cooperative association
                                                            Qualified check. A qualified check is any
                                                                                                              paid Mr. Brown a $300 cash patronage divi­
Form 1099-PATR. The cooperative will report             instrument that is redeemable in money and
                                                                                                              dend for buying the machine. Mr. Brown adjusts
the income to you on Form 1099­PATR or a                meets both of the following requirements.
                                                                                                              the basis of the machine and figures his depre­
similar form and send a copy to the IRS. Form                It is part of a patronage dividend that also
                                                                                                              ciation deduction for 2012 (and later years) as
1099­PATR may also show an alternative mini­                 includes a qualified written notice of alloca­
                                                                                                              follows.
mum tax adjustment that you must include on                  tion for which you met condition 2(c),
Form 6251, Alternative Minimum Tax—Individu­                 above.
                                                             It is imprinted with a statement that endors­     Cost of machine on July 1, 2011     . . . . . . . . .     $2,900
als, if you are required to file the form. For infor­                                                          Minus: 2011 depreciation . . .                  $311
mation on the alternative minimum tax, see the               ing and cashing it constitutes the payee's                                           . . . . .
                                                                                                                        2012 cash dividend . .    . . . . .     300        611
Instructions for Form 6251.                                  consent to include in income the stated
                                                             dollar value of any written notices of alloca­    Adjusted basis for
                                                             tion paid as part of the same patronage           depreciation for 2012:                                    $2,289
Patronage Dividends                                          dividend.
                                                                                                               Depreciation rate: 1 ÷ 61 2 (remaining recovery period
You generally report patronage dividends as in­             Loss on redemption. You can deduct on              as of 1/1/2012) = 15.38% × 1.5 = 23.07%
come on Schedule F, lines 3a and 3b, for the            Schedule F, Part II, any loss incurred on the re­
tax year you receive them. They include the fol­        demption of a qualified written notice of alloca­      Depreciation deduction for 2012
                                                        tion you received in the ordinary course of your       ($2,289 × 23.07%) . . . . . . . . . .                      $528
lowing items.                                                                                                                                          . . . . . . . .

     Money paid as a patronage dividend, in­            farming business. The loss is the difference be­
     cluding cash advances received (for exam­          tween the stated dollar amount of the qualified           Exceptions. If the dividends are for buying
     ple, from a marketing cooperative).                written notice you included in income and the         or selling capital assets or depreciable property
     The stated dollar value of qualified written       amount you received when you redeemed it.             you did not own at any time during the year you
     notices of allocation.                                                                                   received the dividends, you must include them
     The fair market value of other property.           Nonqualified notice of allocation. Do not in­         on Schedule F, lines 3a and 3b, unless one of
                                                        clude the stated dollar value of any nonqualified     the following rules applies.
Do not report as income on line 3b any patron­          notice of allocation in income when you receive            If the dividends relate to a capital asset you
age dividends you receive from expenditures             it. Your basis in the notice is zero. You must in­         held for more than 1 year for which a loss

Page 14       Chapter 3      Farm Income
     was or would have been deductible, treat         Debts, Foreclosures,      Repossessions,      and         of the debt would have been deductible as
     them as gain from the sale or exchange of        Abandonments.                                             a business expense.
     a capital asset held for more than 1 year.                                                                 Accrual method — You include the can­
                                                                                                                celed debt in income because the expense
     If the dividends relate to a capital asset for
     which a loss was not or would not have
                                                      General Rule                                              was deductible when you incurred the
     been deductible, do not report them as in­                                                                 debt.
                                                      Generally, if your debt is canceled or forgiven,
     come (ordinary or capital gain).
                                                      other than as a gift or bequest to you, you must
    If the dividends are for selling capital assets   include the canceled amount in gross income          Exclusions
or depreciable property during the year you re­       for tax purposes. Discharge of qualified farm in­
ceived the dividends, treat them as an addi­          debtedness (defined below) is one of the ex­         Do not include canceled debt in income in the
tional amount received on the sale.                   ceptions to the general rule. It is excluded from    following situations.
                                                      taxable income (see Exclusions, later). Report         1. The cancellation takes place in a bank­
Personal purchases. Because you cannot                the canceled amount on Schedule F, line 8b, if            ruptcy case under title 11 of the U.S.
deduct the cost of personal, living, or family        you incurred the debt in your farming business.           Code.
items, such as supplies, equipment, or services       If the debt is a nonbusiness debt, report the
not related to the production of farm income,         canceled amount as other income on Form                2. The cancellation takes place when you are
you can omit from the taxable amount of patron­       1040, line 21.                                            insolvent.
age dividends on Schedule F, line 3b, any divi­
                                                                                                             3. The canceled debt is a qualified farm debt.
dends from buying those items (and you must           Election to defer income from discharge of
reduce the cost or other basis of those items by      indebtedness. You can elect to defer income            4. The canceled debt is a qualified real prop­
the amount of the dividends). This rule also ap­      from a discharge of business indebtedness that            erty business debt (in the case of a tax­
plies to amounts you receive from the sale, re­       occurred after 2008 and before 2011. Gener­               payer other than a C corporation). See
demption, or other disposition of a nonqualified      ally, if the election is made, the deferred income        Publication 334, Tax guide for Small Busi­
written notice of allocation resulting from these     is included in gross income ratably over a 5              ness, chapter 5.
purchases.                                            year period beginning in 2014 (for calendar            5. The canceled debt is qualified principal
                                                      year taxpayers) and the exclusions listed below           residence indebtedness which is dis­
Per-Unit Retain Certificates                          do not apply. See IRC section 108(i) and Publi­
                                                      cation 4681 for details.
                                                                                                                charged after 2006 and before 2013.
                                                                                                               The exclusions do not apply in the following
A per­unit retain certificate is any written notice                                                        situations:
                                                      Form 1099-C. If a federal agency, financial in­
that shows the stated dollar amount of a                                                                        If a canceled debt is excluded from income
                                                      stitution, credit union, finance company, or
per­unit retain allocation made to you by the co­                                                               because it takes place in a bankruptcy
                                                      credit card company cancels or forgives your
operative. A per­unit retain allocation is an                                                                   case, the exclusions in situations (2), (3),
                                                      debt of $600 or more, you will receive a Form
amount paid to patrons for products sold for                                                                    (4), (5), and (6) do not apply.
                                                      1099­C, Cancellation of Debt. The amount of
them that is fixed without regard to the net earn­                                                              If a canceled debt is excluded from income
                                                      debt canceled is shown in box 2.
ings of the cooperative. These allocations can                                                                  because it takes place when you are insol­
be paid in money, other property, or qualified                                                                  vent, the exclusions in situations (3) and
certificates.                                         Exceptions                                                (4) do not apply to the extent you are insol­
     Per­unit retain certificates issued by a coop­                                                             vent.
                                                      The following discussion covers some excep­               If a canceled debt is excluded from income
erative generally receive the same tax treat­         tions to the general rule for canceled debt.
ment as patronage dividends, discussed ear­                                                                     because it is qualified principal residence
                                                      These exceptions apply before the exclusions              indebtedness, the exclusion in situation (2)
lier.                                                 discussed below.                                          does not apply unless you elect to apply
Qualified certificates. Qualified per­unit retain                                                               situation (2) instead of the exclusion for
                                                      Price reduced after purchase. If your pur­                qualified principal residence indebtedness.
certificates are those issued to patrons who          chase of property was financed by the seller
have agreed to include the stated dollar amount       and the seller reduces the amount of the debt at         See Form 982, later, for information on how
of these certificates in income in the year of re­    a time when you are not insolvent and the re­        to claim an exclusion for a canceled debt.
ceipt. The agreement may be made in writing or        duction does not occur in a chapter 11 bank­
by getting or keeping membership in a coopera­        ruptcy case, the amount of the debt reduction        Debt. For this discussion, debt includes any
tive whose bylaws or charter states that mem­         will be treated as a reduction in the purchase       debt for which you are liable or that attaches to
bership constitutes agreement. If you receive         price of the property. Reduce your basis in the      property you hold.
qualified per­unit retain certificates, include the   property by the amount of the reduction in the
stated dollar amount of the certificates in in­       debt. The rules that apply to bankruptcy and in­     Bankruptcy and Insolvency
come on Schedule F, lines 3a and 3b, for the          solvency are explained below under Exclu-
tax year you receive them.                            sions.                                               You can exclude a canceled debt from income
                                                                                                           if you are bankrupt or to the extent you are in­
Nonqualified certificates. Do not include the         Deductible debt. You do not realize income           solvent.
stated dollar value of a nonqualified per­unit re­    from a canceled debt to the extent the payment
tain certificate in income when you receive it.       of the debt would have been a deductible ex­         Bankruptcy. A bankruptcy case is a case un­
Your basis in the certificate is zero. You must in­   pense. This exception applies before the price       der title 11 of the U.S. Code if you are under the
clude in income any amount you receive from           reduction exception discussed above and the          jurisdiction of the court and the cancellation of
its sale, redemption, or other disposition. Re­       bankruptcy and insolvency exclusions dis­            the debt is granted by the court or is the result
port the amount you receive from the disposi­         cussed next.                                         of a plan approved by the court.
tion as ordinary income on Schedule F, lines 3a                                                                Do not include debt canceled in a bank­
and 3b, for the tax year of disposition.                  Example. You get accounting services for         ruptcy case in your income in the year it is can­
                                                      your farm on credit. Later, you have trouble pay­    celed. Instead, you must use the amount can­
                                                      ing your farm debts, but you are not bankrupt or     celed to reduce your tax attributes, explained
Cancellation of Debt                                  insolvent. Your accountant forgives part of the      below under Reduction of tax attributes.
                                                      amount you owe for the accounting services.
This section explains the general rule for includ­    How you treat the canceled debt depends on           Insolvency. You are insolvent to the extent
ing canceled debt in income and the exceptions        your method of accounting.                           your liabilities are more than the fair market
to the general rule. For more information on               Cash method — You do not include the            value of your assets immediately before the
canceled debt, see Publication 4681, Canceled              canceled debt in income because payment         cancellation of debt.

                                                                                                                  Chapter 3     Farm Income         Page 15
    You can exclude canceled debt from gross                    used in your trade or business or held           The amount you apply cannot be more than
income up to the amount by which you are in­                    for investment that secured the can­         the total adjusted basis of all the depreciable
solvent. If the canceled debt is more than this                 celed debt.                                  properties. Depreciable property for this pur­
amount and the debt qualifies, you can apply                                                                 pose means any property subject to deprecia­
                                                             c. Other property (except inventory and
the rules for qualified farm debt or qualified real                                                          tion, but only if a reduction of basis will reduce
                                                                accounts and notes receivable) used
property business debt to the difference. Other­                                                             the depreciation or amortization otherwise al­
                                                                in your trade or business or held for
wise, you include the difference in gross in­                                                                lowable for the period immediately following the
                                                                investment.
come. Use the amount excluded because of in­                                                                 basis reduction.
solvency to reduce any tax attributes, as                   d. Inventory and accounts and notes re­              You make this reduction before reducing the
explained below under Reduction of tax attrib-                 ceivable.                                     other tax attributes listed earlier. If the excluded
utes. You must reduce the tax attributes under                                                               canceled debt is more than the depreciable ba­
the insolvency rules before applying the rules              e. Other property.                               sis you elect to reduce first, use the difference
for qualified farm debt or for qualified real prop­            Reduce the basis one dollar for each          to reduce the other tax attributes. In figuring the
erty business debt.                                        dollar of excluded canceled debt. How­            limit on the basis reduction in (5) under Order of
                                                           ever, the reduction cannot be more than           reduction., earlier, use the remaining adjusted
    Example. You had a $15,000 debt that was               the total basis of property and the amount        basis of your properties after making this elec­
not qualified principal residence debt canceled            of money you hold immediately after the           tion.
outside of bankruptcy. Immediately before the              debt cancellation minus your total liabili­           See Form 982, later, for information on how
cancellation, your liabilities totaled $80,000 and         ties immediately after the cancellation.          to make this election. If you make this election,
your assets totaled $75,000. Since your liabili­               For allocation rules that apply to basis      you can revoke it only with the consent of the
ties were more than your assets, you were in­              reductions for multiple canceled debts,           IRS.
solvent to the extent of $5,000 ($80,000 −                 see Regulations section 1.1017­1(b)(2).
$75,000). You can exclude this amount from in­             Also see Electing to reduce the basis of          Recapture of basis reductions. If you reduce
come. The remaining canceled debt ($10,000)                depreciable property first, later.                the basis of property under these provisions (ei­
may be subject to the qualified farm debt or                                                                 ther the election to reduce basis first or the ba­
qualified real property business debt rules. If         6. Passive activity loss and credit carry-           sis reduction without that election) and later sell
not, you must include it in income.                        overs. Reduce the passive activity loss           or otherwise dispose of the property at a gain,
                                                           and credit carryovers from the tax year of        the part of the gain due to this basis reduction is
Reduction of tax attributes. If you exclude                the debt cancellation. Reduce the loss            taxable as ordinary income under the deprecia­
canceled debt from income in a bankruptcy                  carryover one dollar for each dollar of ex­       tion recapture provisions. Treat any property
case or during insolvency, you must use the ex­            cluded canceled debt. Reduce the credit           that is not section 1245 or section 1250 prop­
cluded debt to reduce certain tax attributes.              carryover 331 3 cents for each dollar of ex­      erty as section 1245 property. For section 1250
                                                           cluded canceled debt.                             property, determine the straight­line deprecia­
    Order of reduction. You must use the ex­
                                                                                                             tion adjustments as though there were no basis
cluded canceled debt to reduce the following            7. Foreign tax credit. Reduce the credit
                                                                                                             reduction for debt cancellation. Sections 1245
tax attributes in the order listed unless you elect        carryover to or from the tax year of the
                                                                                                             and 1250 property and the recapture of gain as
to reduce the basis of depreciable property first,         debt cancellation. Reduce the carryover
                                                                                                             ordinary income are explained in chapter 9.
as explained later.                                        331 3 cents for each dollar of excluded can­
                                                           celed debt.                                       More information. For more information on
  1. Net operating loss (NOL). Reduce any
     NOL for the tax year of the debt cancella­           How to make tax attribute reductions.              debt cancellation in bankruptcy proceedings or
     tion, and then any NOL carryover to that         Always make the required reductions in tax at­         during insolvency, see Publication 908.
     year. Reduce the NOL or NOL carryover            tributes after figuring your tax for the year of the
     one dollar for each dollar of excluded can­      debt cancellation. In making the reductions in         Qualified Principal Residence Debt
     celed debt.                                      (1) and (4) earlier, first reduce the loss for the
  2. General business credit carryover. Re­           tax year of the debt cancellation. Then reduce         You can exclude from income a canceled debt
     duce the credit carryover to or from the tax     any loss carryovers to that year in the order of       that is qualified principal residence debt. The
     year of the debt cancellation. Reduce the        the tax years from which the carryovers arose,         amount excluded from income is applied to re­
     carryover 331 3 cents for each dollar of ex­     starting with the earliest year. In making the re­     duce (but not below zero) the basis of your prin­
     cluded canceled debt.                            ductions in (2) and (7) earlier, reduce the credit     cipal residence.
                                                      carryovers to the tax year of the debt cancella­
  3. Minimum tax credit. Reduce the mini­             tion in the order in which they are taken into ac­     Qualified principal residence. This is your
     mum tax credit available at the beginning        count for that year.                                   main home, which is the home where you ordi­
     of the tax year following the tax year of the                                                           narily live most of the time. You can have only
     debt cancellation. Reduce the credit 331 3       Electing to reduce the basis of depreciable            one main home at any one time.
     cents for each dollar of excluded canceled       property first. You can elect to apply any por­
     debt.                                            tion of the excluded canceled debt first to re­        Qualified principal residence debt. This is
                                                      duce the basis of depreciable property you hold        acquisition debt that is incurred in acquiring,
  4. Capital loss. Reduce any net capital loss
                                                      at the beginning of the tax year following the tax     constructing, or substantially improving your
     for the tax year of the debt cancellation,
                                                      year of the debt cancellation, in the following or­    qualified principal residence and is secured by
     and then any capital loss carryover to that
                                                      der.                                                   that residence. This also includes any debt se­
     year. Reduce the capital loss or loss carry­
                                                                                                             cured by the residence resulting from the refi­
     over one dollar for each dollar of excluded        1. Depreciable real property used in your            nancing of the acquisition debt but only to the
     canceled debt.                                        trade or business or held for investment          extent the amount of the debt resulting from the
  5. Basis. Reduce the basis of the property               that secured the canceled debt.                   refinancing does not exceed the amount of the
     you hold at the beginning of the tax year          2. Depreciable personal property used in             refinanced debt. Qualified principal residence
     following the tax year of the debt cancella­          your trade or business or held for invest­        debt is limited to acquisition debt of $2 million
     tion in the following order.                          ment that secured the canceled debt.              ($1 million if you are married and filing a sepa­
                                                                                                             rate return) with respect to the principal resi­
      a. Real property (except inventory) used          3. Other depreciable property used in your           dence of the taxpayer.
         in your trade or business or held for             trade or business or held for investment.             The exclusion from gross income for cancel­
         investment that secured the canceled
                                                        4. Real property held as inventory if you elect      lation of qualified principal residence debt does
         debt.
                                                           to treat it as depreciable property on Form       not apply if the canceled debt is on account of
      b. Personal property (except inventory               982.                                              services performed for the lender or any other
         and accounts and notes receivable)                                                                  factor not directly related to a decline in the

Page 16      Chapter 3     Farm Income
value of the residence or to your financial condi­       2. Any general business credit carryover to         sions). For more information, see When To File
tion.                                                       or from the year of the debt cancellation,       in the Form 982 instructions.
    If any loan is canceled, in whole or in part,           multiplied by 3.
and only a portion of the loan is qualified princi­
                                                         3. Any minimum tax credit available at the
pal residence debt, the exclusion from gross in­
                                                            beginning of the tax year following the tax
                                                                                                             Income From Other Sources
come for cancellation of qualified principal resi­
                                                            year of the debt cancellation, multiplied by
dence debt will apply only to the amount of the                                                              This section discusses other types of income
                                                            3.
loan (as determined immediately before the                                                                   you may receive.
canceled debt) that is qualified principal resi­         4. Any net capital loss for the tax year of the
dence debt.                                                 debt cancellation and any capital loss car­      Barter income. If you are paid for your work in
                                                            ryover to that year.                             farm products, other property, or services, you
Qualified Farm Debt                                                                                          must report as income the fair market value of
                                                         5. Any passive activity loss and credit carry­
                                                                                                             what you receive. The same rule applies if you
                                                            overs from the tax year of the debt cancel­
You can exclude from income a canceled debt                                                                  trade farm products for other farm products,
                                                            lation. Any credit carryover is multiplied by
that is qualified farm debt owed to a qualified                                                              property, or someone else's labor. This is called
                                                            3.
person. This exclusion applies only if you were                                                              barter income. For example, if you help a neigh­
solvent when the debt was canceled or, if you            6. Any foreign tax credit carryovers to or from     bor build a barn and receive a cow for your
were insolvent, only to the extent the canceled             the tax year of the debt cancellation, multi­    work, you must report the fair market value of
debt is more than the amount by which you                   plied by 3.                                      the cow as ordinary income. Your basis for
were insolvent. This exclusion does not apply to                                                             property you receive in a barter transaction is
                                                           Qualified property. This is any property
a canceled debt excluded from income be­                                                                     usually the fair market value that you include in
                                                       you use or hold for use in your trade or business
cause it relates to your principal residence or it                                                           income. If you pay someone with property, see
                                                       or for the production of income.
takes place in a bankruptcy case.                                                                            Property for services under Labor Hired in
                                                                                                             chapter 4.
                                                       Reduction of tax attributes. If you exclude
    Your debt is qualified farm debt if both the       canceled debt from income under the qualified
                                                                                                             Below-market loans. A below­market loan is
following requirements are met.                        farm debt rules, you must use the excluded
                                                                                                             a loan on which either no interest is charged or
     You incurred it directly in operating a farm­     debt to reduce tax attributes. (If you also exclu­
                                                                                                             interest is charged at a rate below the applica­
     ing business.                                     ded canceled debt under the insolvency rules,
                                                                                                             ble federal rate. If you make a below­market
     At least 50% of your total gross receipts for     you reduce the amount of the tax attributes re­
                                                                                                             loan, you may have to report income from the
     the 3 tax years preceding the year of debt        maining after reduction for the exclusion al­
                                                                                                             loan in addition to any stated interest you re­
     cancellation were from your farming busi­         lowed under the insolvency rules.) You gener­
                                                                                                             ceive from the borrower. See chapter 1 of Publi­
     ness.                                             ally must follow the reduction rules previously
                                                                                                             cation 550 for more information on below­mar­
For more information, see Publication 4681.            explained under Bankruptcy and Insolvency.
                                                                                                             ket loans.
                                                       However, do not follow the rules in (5) under
Qualified person. This is a person who is ac­          Order of reduction., earlier. Instead, follow the     Commodity futures and options. See Hedg-
tively and regularly engaged in the business of        special rules explained next.                         ing (Commodity Futures) in chapter 8 for infor­
lending money. A qualified person includes any             Special rules for reducing the basis of           mation on gains and losses from commodity fu­
federal, state, or local government, or any of         property. You must use special rules to re­           tures and options transactions.
their agencies or subdivisions. The USDA is a          duce the basis of property for excluded can­
qualified person. A qualified person does not in­      celed qualified farm debt. Under these special        Custom hire (machine work). Pay you re­
clude any of the following.                            rules, you only reduce the basis of qualified         ceive for contract work or custom work that you
      A person related to you.                         property (defined earlier). Reduce it in the fol­     or your hired help perform off your farm for oth­
     A person from whom you acquired the               lowing order.                                         ers, or for the use of your property or machines,
     property (or a person related to this per­                                                              is income to you whether or not income tax was
                                                         1. Depreciable qualified property. You may          withheld. This rule applies whether you receive
     son).
                                                            elect on Form 982 to treat real property         the pay in cash, services, or merchandise. Re­
     A person who receives a fee from your in­
                                                            held as inventory as depreciable property.       port this income on Schedule F, line 7b.
     vestment in the property (or a person rela­
     ted to this person).                                2. Land that is qualified property and is used
                                                            or held for use in your farming business.        Easements and rights-of-way. Income you
   For the definition of a related person, see                                                               receive for granting easements or rights­of­way
Related persons under At-Risk Amounts in                 3. Other qualified property.                        on your farm or ranch for flooding land, laying
Publication 925.                                                                                             pipelines, constructing electric or telephone

Exclusion limit. The amount of canceled
                                                       Form 982                                              lines, etc., may result in income, a reduction in
                                                                                                             the basis of all or part of your farmland, or both.
qualified farm debt you can exclude from in­
                                                       Use Form 982 to show the amounts of canceled
come is limited. It cannot be more than the sum                                                                  Example. You granted a right­of­way for a
                                                       debt excluded from income and the reduction of
of your adjusted tax attributes and the total ad­                                                            gas pipeline through your property for $10,000.
                                                       tax attributes in the order listed on the form.
justed basis of the qualified property you hold at                                                           Only a specific part of your farmland was affec­
                                                       Also use it if you are electing to apply the exclu­
the beginning of the tax year following the tax                                                              ted. You reserved the right to continue farming
                                                       ded canceled debt to reduce the basis of depre­
year of the debt cancellation. Figure this limit af­                                                         the surface land after the pipe was laid. Treat
                                                       ciable property before reducing tax attributes.
ter taking into account any reduction of tax at­                                                             the payment for the right­of­way in one of the
                                                       You make this election by showing the amount
tributes because of the exclusion of canceled                                                                following ways.
                                                       you elect to apply on line 5 of the form.
debt from gross income during insolvency.
    If the canceled debt is more than this limit,                                                              1. If the payment is less than the basis prop­
                                                       When to file. You must file Form 982 with your             erly allocated to the part of your land affec­
you must include the difference in gross in­           timely filed income tax return (including exten­
come.                                                                                                             ted by the right­of­way, reduce the basis
                                                       sions) for the tax year in which the cancellation          by $10,000.
    Adjusted tax attributes. Adjusted tax at­          of debt occurred. If you timely filed your return
tributes means the sum of the following items.         for the year without electing to apply the exclu­       2. If the payment is equal to or more than the
                                                       ded canceled debt to reduce the basis of depre­            basis of the affected part of your land, re­
  1. Any net operating loss (NOL) for the tax          ciable property first, you can still make the elec­        duce the basis to zero and the rest, if any,
     year of the debt cancellation and any NOL         tion by filing an amended return within 6 months           is gain from a sale. The gain is reported on
     carryover to that year.                           of the due date of the return (excluding exten­            Form 4797 and is treated as section 1231


                                                                                                                    Chapter 3     Farm Income          Page 17
     gain if you held the land for more than 1            Both of these amounts are farm income.             The term “farming business” is defined in the In­
     year. See chapter 9.                             Use Form 4797, Part IV, to figure how much to          structions for Schedule J (Form 1040), Income
                                                      include in income.                                     Averaging for Farmers and Fishermen.
        Easement contracts usually describe
 TIP    the affected land using square feet.          Refund or reimbursement. You generally                 Who can use income averaging? You can
        Your basis may be figured per acre.           must include in income a reimbursement, re­            use income averaging to figure your tax for any
One acre equals 43,560 square feet.                   fund, or recovery of an item for which you took a      year in which you were engaged in a farming
                                                      deduction in an earlier year. Include it for the tax   business as an individual, a partner in a partner­
   If construction of the pipeline damaged            year you receive it. However, if any part of the       ship, or a shareholder in an S corporation. Serv­
growing crops and you later receive a settle­         earlier deduction did not decrease your income         ices performed as an employee are disregar­
ment of $250 for this damage, the $250 is in­         tax, you do not have to include that part of the       ded in determining whether an individual is
come and is included on Schedule F, line 8b. It       reimbursement, refund, or recovery.                    engaged in a farming business. However, if you
does not affect the basis of your land.                                                                      are a shareholder of an S corporation engaged
                                                          Example. A tenant farmer purchased fertil­         in a farming business, you may treat compensa­
Fuel tax credit and refund. Include any credit        izer for $1,000 in April 2010. He deducted             tion received from the corporation that is attrib­
or refund of federal excise taxes on fuels in your    $1,000 on his 2010 Schedule F and the entire           utable to the farming business as farm income.
gross income if you deducted the cost of the          deduction reduced his tax. The landowner reim­         You do not need to have been engaged in a
fuel (including excise tax) as an expense that        bursed him $500 of the cost of the fertilizer in       farming business in any base year.
reduced your income tax. See chapter 14 for           February 2011. The tenant farmer must include              Corporations, partnerships, S corporations,
more information about fuel tax credits and re­       $500 in income on his 2011 tax return because          estates, and trusts cannot use income averag­
funds.                                                the entire deduction decreased his 2010 tax.           ing.

Illegal federal irrigation subsidy. The federal       Sale of soil and other natural deposits. If
government, operating through the Bureau of           you remove and sell topsoil, loam, fill dirt, sand,    Elected Farm Income (EFI)
Reclamation, has made irrigation water from           gravel, or other natural deposits from your prop­
certain reclamation and irrigation projects avail­    erty, the proceeds are ordinary income. A rea­         EFI is the amount of income from your farming
able for agricultural purposes. The excess of         sonable allowance for depletion of the natural         business that you elect to have taxed at base
the amount required to be paid for water from         deposit sold may be claimed as a deduction.            year rates. You can designate as EFI any type
these projects over the amount you actually           See Depletion in chapter 7.                            of income attributable to your farming business.
paid is an illegal subsidy.                                                                                  However, your EFI cannot be more than your
    For example, if the amount required to be             Sod. Report proceeds from the sale of sod          taxable income, and any EFI from a net capital
paid is full cost and you paid less than full cost,   on Schedule F. A deduction for cost depletion is       gain attributable to your farming business can­
the difference is an illegal subsidy and you must     allowed, but only for the topsoil removed with         not be more than your total net capital gain.
include it in income. Report this on Schedule F,      the sod.
line 8b. You cannot take a deduction for the                                                                     Income from your farming business is the
                                                           Granting the right to remove deposits. If         sum of any farm income or gain minus any farm
amount you must include in income.                    you enter into a legal relationship granting
    For more information on reclamation and irri­                                                            expenses or losses allowed as deductions in
                                                      someone else the right to excavate and remove          figuring your taxable income. However, it does
gation projects, contact your local Bureau of         natural deposits from your property, you must
Reclamation.                                                                                                 not include gain or loss from the sale or other
                                                      determine whether the transaction is a sale or
                                                                                                             disposition of land, or from the sale of develop­
                                                      another type of transaction (for example, a
Prizes. Report prizes you win on farm livestock                                                              ment rights, grazing rights, and other similar
                                                      lease).
or products at contests, exhibitions, fairs, etc.,                                                           rights.
                                                           If you receive a specified sum or an amount
on Schedule F, line 8b. If you receive a prize in     fixed without regard to the quantity produced
cash, include the full amount in income. If you                                                              Gains or losses from the sale or other dis-
                                                      and sold from the deposit and you retain no            position of farm property. Gains or losses
receive a prize in produce or other property, in­     economic interest in the deposit, your transac­
clude the fair market value of the property. For                                                             from the sale or other disposition of farm prop­
                                                      tion is a sale. You are considered to retain an        erty other than land can be designated as EFI if
prizes of $600 or more, you should receive a          economic interest if, under the terms of the le­
Form 1099­MISC.                                                                                              you (or your partnership or S corporation) used
                                                      gal relationship, you depend on the income de­         the property regularly for a substantial period in
    See chapter 12 for information about prizes       rived from extraction of the deposit for a return
related to 4­H Club or FFA projects. See Publi­                                                              a farming business. Whether the property has
                                                      of your capital investment in the deposit.             been regularly used for a substantial period de­
cation 525 for information about other prizes.             Your income from the deposit is capital gain      pends on all the facts and circumstances.
                                                      if the transaction is a sale. Otherwise, it is ordi­
Property sold, destroyed, stolen, or con-             nary income subject to an allowance for deple­             Liquidation of a farming business. If you
demned. You may have an ordinary or capital           tion. See chapter 7 for information on depletion       (or your partnership or S corporation) liquidate
gain if property you own is sold or exchanged,        and chapter 8 for the tax treatment of capital         your farming business, gains or losses on prop­
stolen, destroyed by fire, flood, or other casu­      gains.                                                 erty sold within a reasonable time after opera­
alty, or condemned by a public authority. In                                                                 tions stop can be designated as EFI. A period of
some situations, you can postpone the tax on          Timber sales. Timber sales, including sales of         1 year after stopping operations is a reasonable
the gain to a later year. See chapters 8 through      logs, firewood, and pulpwood, are discussed in         time. After that, what is a reasonable time de­
11.                                                   chapter 8.                                             pends on the facts and circumstances.
Recapture of certain depreciation. If you                                                                    EFI and base year rates. If your EFI includes
took a section 179 deduction for property used        Income Averaging for                                   both ordinary income and capital gains, you
in your farming business and at any time during                                                              must use tax rates from each base year to com­
the property's recovery period you do not use it      Farmers                                                pute tax on an equal portion of each type of in­
more than 50% in your business, you must in­                                                                 come. For example, you cannot tax all of the
clude part of the deduction in income. See            If you are engaged in a farming business, you          capital gains at the rate for capital gains from a
chapter 7 for information on the section 179 de­      may be able to average all or some of your farm        single base year.
duction and when to recapture that deduction.         income by using income tax rates from the 3
    In addition, if the percentage of business        prior years (base years) to calculate the tax on
use of listed property (see chapter 7) falls to       that income. This may give you a lower tax if          How To Figure the Tax
50% or less in any tax year during the recovery       your current year income is high and your taxa­
period, you must include in income any excess         ble income which includes income from farming          If you average your farm income, you will figure
depreciation you took on the property.                from one or more of the 3 prior years was low.         your tax on Schedule J (Form 1040).

Page 18      Chapter 3     Farm Income
Negative taxable income for base year. If              Credit for prior year minimum tax. You may           Useful Items
your taxable income for any base year was zero         be able to claim a tax credit if you owed AMT in     You may want to see:
because your deductions were more than your            a prior year. See the Instructions for Form 8801,
income, you may have negative taxable income           Credit for Prior Year Minimum Tax—Individuals,         Publication
for that year to combine with your EFI on              Estates, and Trusts.
Schedule J.                                                                                                       463 Travel, Entertainment, Gift, and Car
                                                                                                                      Expenses
Filing status. You are not prohibited from us­
                                                       Schedule J
                                                                                                                  535 Business Expenses
ing income averaging solely because your filing
                                                       You can use income averaging by filing Sched­
status is not the same as your filing status in the                                                               587 Business Use of Your Home
                                                       ule J (Form 1040) with your timely filed (includ­
base years. For example, if you are married and
                                                       ing extensions) return for the year. You can also          925 Passive Activity and At­Risk Rules
file jointly, but filed as single in all of the base
                                                       use income averaging on a late return, or use,
years, you may still average farm income.                                                                         936 Home Mortgage Interest Deduction
                                                       change, or cancel it on an amended return, if
                                                       the time for filing a claim for refund has not ex­
Effect on Other Tax                                    pired for that election year. You generally must
                                                                                                              Form (and Instructions)

Determinations                                         file the claim for refund within 3 years from the          Sch A (Form 1040) Itemized
                                                       date you filed your original return or 2 years                 Deductions
You subtract your EFI from your taxable income         from the date you paid the tax, whichever is
                                                       later.                                                     Sch F (Form 1040) Profit or Loss From
and add one­third of it to the taxable income of                                                                      Farming
each of the base years to determine the tax rate
to use for income averaging. The allocation of                                                                    1045 Application for Tentative Refund
your EFI to the base years does not affect other                                                                  5213 Election To Postpone
tax determinations. For example, you make the                                                                         Determination as To Whether the
following determinations before subtracting                                                                           Presumption Applies That an
your EFI (or adding it to income in the base
years).                                                4.                                                             Activity Is Engaged in for Profit
     The amount of your self­employment tax.                                                                      8903 Domestic Production Activities
                                                                                                                      Deduction
     Whether, in the aggregate, sales and other
     dispositions of business property (section
     1231 transactions) produce long­term cap­
                                                       Farm Business                                        See chapter 16 for information about getting
                                                                                                            publications and forms.
     ital gain or ordinary loss.
     The amount of any net operating loss car­         Expenses
     ryover or net capital loss carryover applied                                                           Deductible Expenses
     and the amount of any carryover to another
     year.
     The limit on itemized deductions based on         What's New for 2012                                  The ordinary and necessary costs of operating
                                                                                                            a farm for profit are deductible business expen­
     your adjusted gross income.                                                                            ses. Schedule F, Part II, lists some common
     The amount of any net capital loss or net         Standard mileage rate. For 2012, the stand­
                                                                                                            farm expenses that are typically deductible.
     operating loss in a base year.                    ard mileage rate for the cost of operating your
                                                                                                            This chapter discusses many of these expen­
                                                       car, van, pickup, or panel truck for each mile of
                                                                                                            ses, as well as others not listed on Schedule F.
                                                       business use is 55.5 cents. See Truck and Car
Tax for Certain Children Who                           Expenses, later.
Have Investment Income of                                                                                   Reimbursed expenses. If the reimbursement
                                                                                                            is received in the same year that the expense is
More Than $1,900                                                                                            claimed, reduce the expense by the amount of

If your child was under age 19 (or 24 if a
                                                       Introduction                                         the reimbursement. If the reimbursement is re­
                                                                                                            ceived in a year after the expense is claimed,
full­time student) at the end of 2011 and had in­      You can generally deduct the current costs of        include the reimbursement amount in income.
vestment income of more than $1,900, part of           operating your farm. Current costs are expen­        See Refund or reimbursement under Income
that income may be taxed at your tax rate in­          ses you do not have to capitalize or include in      From Other Sources in chapter 3.
stead of your child's tax rate. For more informa­      inventory costs. However, your deduction for
tion, see the Instructions for Form 8615, Tax for      the cost of livestock feed and certain other sup­    Personal and business expenses. Some ex­
Certain Children Who Have Investment Income            plies may be limited. If you have an operating       penses you pay during the tax year may be part
of More Than $1,900.                                   loss, you may not be able to deduct all of it.       personal and part business. These may include
                                                                                                            expenses for gasoline, oil, fuel, water, rent,
    If you use income averaging, figure your
child's tax on investment income using your rate
                                                       Topics                                               electricity, telephone, automobile upkeep, re­
                                                       This chapter discusses:                              pairs, insurance, interest, and taxes.
after allocating EFI. You cannot use any of your                                                                You must allocate these mixed expenses
child's investment income as your EFI, even if it                                                           between their business and personal parts.
is attributable to a farming business. For infor­           Deductible expenses
                                                                                                            Generally, the personal part of these expenses
mation on figuring the tax on your child's invest­          Domestic production activities deduction        is not deductible. The business portion of the
ment income, see Publication 929, Tax Rules                 Capital expenses                                expenses is deductible on Schedule F.
for Children and Dependents.
                                                            Nondeductible expenses
                                                                                                                 Example. You paid $1,500 for electricity
                                                            Losses from operating a farm
Alternative Minimum Tax                                                                                     during the tax year. You used 1 3 of the electric­
                                                            Not­for­profit farming                          ity for personal purposes and 2 3 for farming. Un­
(AMT)                                                                                                       der these circumstances, you can deduct
                                                                                                            $1,000 (2 3 of $1,500) of your electricity expense
You can elect to use income averaging to com­                                                               as a farm business expense.
pute your regular tax liability. However, income
averaging is not used to determine your regular                                                                 Reasonable allocation. It is not always
tax or tentative minimum tax when figuring your                                                             easy to determine the business and nonbusi­
AMT. Using income averaging may reduce your                                                                 ness parts of an expense. There is no method
total tax even if you owe AMT.                                                                              of allocation that applies to all mixed expenses.

                                                                                                      Chapter 4     Farm Business Expenses           Page 19
Any reasonable allocation is acceptable. What              You are a farm­related taxpayer if any of the     expectation of receiving some business benefit
is reasonable depends on the circumstances in          following tests apply.                                from prepaying the cost of livestock feed. The
each case.                                                                                                   following are some examples of business bene­
                                                         1. Your main home is on a farm.
                                                                                                             fits.
Prepaid Farm Supplies                                    2. Your principal business is farming.                    Fixing maximum prices and securing an
                                                                                                                   assured feed supply.
                                                         3. A member of your family meets (1) or (2).
                                                                                                                   Securing preferential treatment in anticipa­
Prepaid farm supplies include the following
                                                       For this purpose, your family includes your                 tion of a feed shortage.
items if paid for during the year.
    Feed, seed, fertilizer, and similar farm sup­      brothers and sisters, half­brothers and half­sis­          Other factors considered in determining the
    plies not used or consumed during the              ters, spouse, parents, grandparents, children,        existence of a business purpose are whether
    year, but not including farm supplies that         grandchildren, and aunts and uncles and their         the prepayment was a condition imposed by the
    you would have consumed during the year            children.                                             seller and whether that condition was meaning­
    if not for a fire, storm, flood, other casualty,             Whether or not the deduction limit for      ful.
    disease, or drought.                                         prepaid farm supplies applies, your
    Poultry (including egg­laying hens and                !      expenses for prepaid livestock feed
                                                                                                             No material distortion of income. The fol­
                                                                                                             lowing are some factors considered in deter­
                                                       CAUTION
    baby chicks) bought for use (or for both           may be subject to the rules for advance pay-
    use and resale) in your farm business.                                                                   mining whether deducting prepaid livestock
                                                       ment of livestock feed, discussed next.
    However, include only the amount that                                                                    feed materially distorts income.
    would be deductible in the following year if                                                                  Your customary business practice in con­
    you had capitalized the cost and deducted          Prepaid Livestock Feed                                     ducting your livestock operations.
    it ratably over the lesser of 12 months or                                                                    The expense in relation to past purchases.
    the useful life of the poultry.                    If you report your income and expenses under               The time of year you made the purchase.
    Poultry bought for resale and not resold           the cash method of accounting, you cannot de­              The expense in relation to your income for
    during the year.                                   duct in the year paid the cost of feed your live­          the year.
                                                       stock will consume in a later year unless you
Deduction limit. If you use the cash method of         meet all the following tests.
accounting to report your income and expen­                                                                  Labor Hired
ses, your deduction for prepaid farm supplies in         1. The payment is for the purchase of feed
the year you pay for them may be limited to                 rather than a deposit.                           You can deduct reasonable wages paid for reg­
50% of your other deductible farm expenses for                                                               ular farm labor, piecework, contract labor, and
                                                         2. The prepayment has a business purpose
the year (all Schedule F deductions except pre­                                                              other forms of labor hired to perform your farm­
                                                            and is not merely for tax avoidance.
paid farm supplies). This limit does not apply if                                                            ing operations. You can pay wages in cash or in
you meet one of the exceptions described later.          3. Deducting the prepayment does not result         noncash items such as inventory, capital as­
See Chapter 2 for a discussion of the cash                  in a material distortion of your income.         sets, or assets used in your business. The cost
method of accounting.                                                                                        of boarding farm labor is a deductible labor
   If the limit applies, you can deduct the ex­           If you meet all three tests, you can deduct
                                                                                                             cost. Other deductible costs you incur for farm
cess cost of farm supplies other than poultry in       the prepaid feed, subject to the limit on prepaid
                                                                                                             labor include health insurance, workers' com­
the year you use or consume the supplies. The          farm supplies discussed earlier.
                                                                                                             pensation insurance, and other benefits.
excess cost of poultry bought for use (or for             If you fail any of these tests, you can deduct
both use and resale) in your farm business is                                                                    If you must withhold social security, Medi­
                                                       the prepaid feed only in the year it is consumed.     care, and income taxes from your employees'
deductible in the year following the year you
pay for it. The excess cost of poultry bought for                 This rule does not apply to the pur-       cash wages, you can still deduct the full amount
resale is deductible in the year you sell or other­               chase of commodity futures contracts.      of wages before withholding. See chapter 13 for
wise dispose of that poultry.
                                                          !
                                                       CAUTION                                               more information on employment taxes. Also,
                                                                                                             deduct the employer's share of the social secur­
    Example. During 2012, you bought fertilizer        Payment for the purchase of feed. Whether             ity and Medicare taxes you must pay on your
($4,000), feed ($1,000), and seed ($500) for           a payment is for the purchase of feed or a de­        employees' wages as a farm business expense
use on your farm in the following year. Your to­       posit depends on the facts and circumstances          on Schedule F, line 29. See Taxes, later.
tal prepaid farm supplies expense for 2012 is          in each case. It is for the purchase of feed if you
$5,500. Your other deductible farm expenses            can show you made it under a binding commit­          Property for services. If you transfer property
totaled $10,000 for 2012. Therefore, your de­          ment to accept delivery of a specific quantity of     to an employee in payment for services, you
duction for prepaid farm supplies cannot be            feed at a fixed price and you are not entitled, by    can deduct as wages paid the fair market value
more than $5,000 (50% of $10,000) for 2012.            contract or business custom, to a refund or re­       of the property on the date of transfer. If the em­
The excess prepaid farm supplies expense of            purchase.                                             ployee pays you anything for the property, de­
$500 ($5,500 − $5,000) is deductible in a later            The following are some factors that show a        duct as wages the fair market value of the prop­
tax year when you use or consume the sup­              payment is a deposit rather than for the pur­         erty minus the payment by the employee for the
plies.                                                 chase of feed.                                        property.
                                                            The absence of specific quantity terms.              Treat the wages deducted as an amount re­
   Exceptions. This limit on the deduction for                                                               ceived for the property. You may have a gain or
prepaid farm supplies expense does not apply if               The right to a refund of any unapplied pay­
                                                                                                             loss to report if the property's adjusted basis on
you are a farm­related taxpayer and either of                 ment credit at the end of the contract.
                                                                                                             the date of transfer is different from its fair mar­
the following apply.                                          The seller's treatment of the payment as a
                                                                                                             ket value. Any gain or loss has the same char­
                                                              deposit.
  1. Your prepaid farm supplies expense is                                                                   acter the exchanged property had in your
                                                              The right to substitute other goods or prod­
     more than 50% of your other deductible                                                                  hands. For more information, see chapter 8.
                                                              ucts for those specified in the contract.
     farm expenses because of a change in
     business operations caused by unusual                 A provision permitting substitution of ingredi­   Child as an employee. You can deduct rea­
     circumstances.                                    ents to vary the particular feed mix to meet your     sonable wages or other compensation you pay
                                                       livestock's current diet requirements will not        to your child for doing farmwork if a true em­
  2. Your total prepaid farm supplies expense          suggest a deposit. Further, a price adjustment        ployer­employee relationship exists between
     for the preceding 3 tax years is less than        to reflect market value at the date of delivery is    you and your child. Include these wages in the
     50% of your total other deductible farm ex­       not, by itself, proof of a deposit.                   child's income. The child may have to file an in­
     penses for those 3 tax years.                                                                           come tax return. These wages may also be
                                                       Business purpose. The prepayment has a                subject to social security and Medicare taxes if
                                                       business purpose only if you have a reasonable        your child is age 18 or older. For more

Page 20       Chapter 4     Farm Business Expenses
information, see Family Employees in chap­          machinery. However, repairs to, or overhauls                    If the property that secures the loan is
ter 13.                                             of, depreciable property that substantially pro­       TIP      your home, you generally do not allo-
                                                    long the life of the property, increase its value,              cate the loan proceeds or the related
         A Form W-2, Wage and Tax State-            or adapt it to a different use are capital expen­     interest. The interest is usually deductible as
 TIP     ment, should be issued to the child        ses. For example, if you repair the barn roof, the    qualified home mortgage interest, regardless of
         employee.                                  cost is deductible. But if you replace the roof, it   how the loan proceeds are used. However, you
                                                    is a capital expense. For more information, see       can choose to treat the loan as not secured by
    The fact that your child spends the wages to    Capital Expenses, later.                              your home. For more information, see Publica-
buy clothes or other necessities you normally                                                             tion 936.
furnish does not prevent you from deducting
your child's wages as a farm expense.               Interest                                                 Allocation period. The period for which a
         The amount of wages paid to the child                                                            loan is allocated to a particular use begins on
                                                    You can deduct as a farm business expense in­
         could cause a loss of the dependency                                                             the date the proceeds are used and ends on the
  !                                                 terest paid on farm mortgages and other obliga­
         exemption depending on how the child                                                             earlier of the following dates.
CAUTION                                             tions you incur in your farm business.
uses the money.                                                                                                The date the loan is repaid.
                                                    Cash method. If you use the cash method of                  The date the loan is reallocated to another
Spouse as an employee. You can deduct               accounting, you can generally deduct interest               use.
reasonable wages or other compensation you          paid during the tax year. You cannot deduct in­
                                                    terest paid with funds received from the original     More information. For more information on in­
pay to your spouse if a true employer­employee
                                                    lender through another loan, advance, or other        terest, see chapter 4 in Publication 535.
relationship exists between you and your
spouse. Wages you pay to your spouse are            arrangement similar to a loan. You can, how­
subject to social security and Medicare taxes.      ever, deduct the interest when you start making
                                                    payments on the new loan. For more informa­
                                                                                                          Breeding Fees
For more information, see Family Employees in
chapter 13.                                         tion, see Cash Method in chapter 2.                   You can deduct breeding fees as a farm busi­
                                                       Prepaid interest. Under the cash method,           ness expense. However, if you use an accrual
Nondeductible Pay                                   you generally cannot deduct any interest paid         method of accounting, you must capitalize
                                                    before the year it is due. Interest paid in ad­       breeding fees and allocate them to the cost ba­
You cannot deduct wages paid for certain            vance may be deducted only in the tax year in         sis of the calf, foal, etc. For more information on
household work, construction work, and mainte­      which it is due.                                      who must use an accrual method of accounting,
nance of your home. However, those wages                                                                  see Accrual Method Required under Account-
may be subject to the employment taxes dis­         Accrual method. If you use an accrual method          ing Methods in chapter 2.
cussed in chapter 13.                               of accounting, you can deduct only interest that
                                                    has accrued during the tax year. However, you         Fertilizer and Lime
Household workers. Do not deduct amounts            cannot deduct interest owed to a related person
paid to persons engaged in household work,          who uses the cash method until payment is             You can deduct in the year paid or incurred the
except to the extent their services are used in     made and the interest is includible in the gross      cost of fertilizer, lime, and other materials ap­
boarding or otherwise caring for farm laborers.     income of that person. For more information,          plied to farmland to enrich, neutralize, or condi­
                                                    see Accrual Method in chapter 2.                      tion it if the benefits last a year or less. You can
Construction labor. Do not deduct wages                                                                   also deduct the cost of applying these materials
paid to hired help for the construction of new      Allocation of interest. If you use the proceeds       in the year you pay or incur it. However, see
buildings or other improvements. These wages        of a loan for more than one purpose, you must         Prepaid Farm Supplies, earlier, for a rule that
are part of the cost of the building or other im­   allocate the interest on that loan to each use.       may limit your deduction for these materials.
provement. You must capitalize them.                Allocate the interest to the following categories.
                                                         Trade or business interest.                          If the benefits of the fertilizer, lime, or other
Maintaining your home. If your farm em­                                                                   materials last substantially more than one year,
                                                         Passive activity interest.
ployee spends time maintaining or repairing                                                               you generally capitalize their cost and deduct a
                                                         Investment interest.                             part each year the benefits last. However, you
your home, the wages and employment taxes
you pay for that work are nondeductible per­             Portfolio interest.                              can choose to deduct these expenses in the
sonal expenses. For example, assume you                                                                   year paid or incurred. If you make this choice,
                                                         Personal interest.
have a farm employee for the entire tax year                                                              you will need IRS approval if you later decide to
and the employee spends 5% of the time main­            You generally allocate interest on a loan the     capitalize the cost of previously deducted items.
taining your home. The employee devotes the         same way you allocate the loan proceeds. You          If you sell farmland on which fertilizer or lime
remaining time to work on your farm. You can­       allocate loan proceeds by tracing disburse­           has been applied and if the selling price of the
not deduct 5% of the wages and employment           ments to specific uses.                               land includes part or all of the cost of the fertil­
taxes you pay for that employee.                                                                          izer or lime, you report the sale amount attribut­
                                                             The easiest way to trace disburse-           able to the fertilizer or lime as ordinary income.
                                                     TIP     ments to specific uses is to keep the
Employment Credits                                           proceeds of a particular loan separate           Farmland, for these purposes, is land used
                                                    from any other funds.                                 for producing crops, fruits, or other agricultural
Reduce your deduction for wages by the                                                                    products or for sustaining livestock. It does not
amount of any employment credits you claim              Secured loan. The allocation of loan pro­         include land you have never used previously for
such as the work opportunity credit for qualified   ceeds and the related interest is generally not       producing crops or sustaining livestock. You
tax­exempt organizations hiring qualified veter­    affected by the use of property that secures the      cannot deduct initial land preparation costs.
ans (Form 5884­C).                                  loan.                                                 (See Capital Expenses, later.)
                                                                                                              Include government payments you receive
Repairs and Maintenance                                Example. You secure a loan with property
                                                    used in your farming business. You use the loan
                                                                                                          for lime or fertilizer in income. See Fertilizer and
                                                                                                          Lime under Agricultural Program Payments in
                                                    proceeds to buy a car for personal use. You           chapter 3.
You can deduct most expenses for the repair
                                                    must allocate interest expense on the loan to
and maintenance of your farm property. Com­
                                                    personal use (purchase of the car) even though
mon items of repair and maintenance are re­
                                                    the loan is secured by farm business property.        Taxes
painting, replacing shingles and supports on
farm buildings, and periodic or routine mainte­                                                           You can deduct as a farm business expense
nance of trucks, tractors, and other farm                                                                 the real estate and personal property taxes on

                                                                                                    Chapter 4     Farm Business Expenses             Page 21
farm business assets, such as farm equipment,               they are considered taxes under state           on Schedule F. However, you cannot deduct
animals, farmland, and farm buildings. You also             law).                                           rent you pay in crop shares if you deduct the
can deduct the social security and Medicare                                                                 cost of raising the crops as farm expenses.
taxes you pay to match the amount withheld             Insurance to secure a loan. If you take out a
from the wages of farm employees and any fed­          policy on your life or on the life of another per­   Advance payments. Deduct advance pay­
eral unemployment tax you pay. For information         son with a financial interest in your farm busi­     ments of rent only in the year to which they ap­
on employment taxes, see chapter 13.                   ness to get or protect a business loan, you can­     ply, regardless of your accounting method.
                                                       not deduct the premiums as a business
Allocation of taxes. The taxes on the part of          expense. In the event of death, the proceeds of      Farm home. If you rent a farm, do not deduct
your farm you use as your home (including the          the policy are not taxed as income even if they      the part of the rental expense that represents
furnishings and surrounding land not used for          are used to liquidate the debt.                      the fair rental value of the farm home in which
farming) are nonbusiness taxes. You may be                                                                  you live.
able to deduct these nonbusiness taxes as              Advance premiums. Deduct advance pay­
itemized deductions on Schedule A (Form                ments of insurance premiums only in the year to      Lease or Purchase
1040). To determine the nonbusiness part, allo­        which they apply, regardless of your accounting
cate the taxes between the farm assets and             method.                                              If you lease a farm building or equipment, you
nonbusiness assets. The allocation can be                                                                   must determine whether or not the agreement
done from the assessed valuations. If your tax            Example. On June 28, 2012, you paid a             must be treated as a conditional sales contract
statement does not show the assessed valua­            premium of $3,000 for fire insurance on your         rather than a lease. If the agreement is treated
tions, you can usually get them from the tax as­       barn. The policy will cover a period of 3 years      as a conditional sales contract, the payments
sessor.                                                beginning on July 1, 2012. Only the cost for the     under the agreement (so far as they do not rep­
                                                       6 months in 2012 is deductible as an insurance       resent interest or other charges) are payments
State and local general sales taxes. State             expense on your 2012 calendar year tax return.       for the purchase of the property. Do not deduct
and local general sales taxes on nondeprecia­          Deduct $500, which is the premium for 6              these payments as rent, but capitalize the cost
ble farm business expense items are deductible         months of the 36­month premium period, or 6 36       of the property and recover this cost through
as part of the cost of those items. Include state      of $3,000. In both 2013 and 2014, deduct             depreciation.
and local general sales taxes imposed on the           $1,000 (12 36 of $3,000). Deduct the remaining
purchase of assets for use in your farm busi­          $500 in 2015. Had the policy been effective on       Conditional sales contract. Whether an
ness as part of the cost you depreciate. Also          January 1, 2012, the deductible expense would        agreement is a conditional sales contract de­
treat the taxes as part of your cost if they are im­   have been $1,000 for each of the years 2012,         pends on the intent of the parties. Determine
posed on the seller and passed on to you.              2013, and 2014, based on one­third of the pre­       intent based on the provisions of the agreement
                                                       mium used each year.                                 and the facts and circumstances that exist
State and federal income taxes. Individuals                                                                 when you make the agreement. No single test,
cannot deduct state and federal income taxes           Business interruption insurance. Use and             or special combination of tests, always applies.
as farm business expenses. Individuals can de­         occupancy and business interruption insurance        However, in general, an agreement may be
duct state and local income taxes only as an           premiums are deductible as a business ex­            considered a conditional sales contract rather
itemized deduction on Schedule A (Form 1040).          pense. This insurance pays for lost profits if       than a lease if any of the following is true.
However, you cannot deduct federal income              your business is shut down due to a fire or other         The agreement applies part of each pay­
tax.                                                   cause. Report any proceeds in full on Sched­              ment toward an equity interest you will re­
                                                       ule F, Part I.                                            ceive.
Highway use tax. You can deduct the federal                                                                      You get title to the property after you make
use tax on highway motor vehicles paid on a            Self-employed health insurance deduction.                 a stated amount of required payments.
truck or truck tractor used in your farm busi­         If you are self­employed, you can deduct as an            The amount you must pay to use the prop­
ness. For information on the tax itself, including     adjustment to income on Form 1040 your pay­               erty for a short time is a large part of the
information on vehicles subject to the tax, see        ments for medical, dental, and qualified                  amount you would pay to get title to the
the Instructions for Form 2290, Heavy Highway          long­term care insurance coverage for yourself,           property.
Vehicle Use Tax Return.                                your spouse, and your dependents when figur­              You pay much more than the current fair
                                                       ing your adjusted gross income on your Form               rental value of the property.
Self-employment tax deduction. You can                 1040. Effective March 30, 2010, the insurance             You have an option to buy the property at a
deduct as an adjustment to income on Form              can also cover any child of yours under age 27            nominal price compared to the value of the
1040 one­half of your self­employment tax in           at the end of 2012, even if the child was not             property when you may exercise the op­
figuring your adjusted gross income. For more          your dependent. Generally, this deduction can­            tion. Determine this value when you make
information, see chapter 12.                           not be more than the net profit from the busi­            the agreement.
                                                       ness under which the plan was established.                You have an option to buy the property at a
                                                           If you or your spouse is also an employee of          nominal price compared to the total
Insurance                                              another person, you cannot take the deduction             amount you have to pay under the agree­
                                                       for any month in which you are eligible to partic­        ment.
You generally can deduct the ordinary and nec­         ipate in a subsidized health plan maintained by           The agreement designates part of the pay­
essary cost of insurance for your farm business        your employer or your spouse's employer.                  ments as interest, or part of the payments
as a business expense. This includes premiums              Generally, use the Self-Employed Health In-           can be easily recognized as interest.
you pay for the following types of insurance.          surance Deduction Worksheet in the Instruc­
     Fire, storm, crop, theft, liability, and other    tions for Form 1040 to figure your deduction. In­       Example. You lease new farm equipment
     insurance on farm business assets.                clude the remaining part of the insurance            from a dealer who both sells and leases. The
     Health and accident insurance on your             payment in your medical expenses on Sched­           agreement includes an option to purchase the
     farm employees.                                   ule A (Form 1040) if you itemize your deduc­         equipment for a specified price. The lease pay­
     Workers' compensation insurance set by            tions.                                               ments and the specified option price equal the
     state law that covers any claims for job­re­          For more information, see Deductible Premi-      sales price of the equipment plus interest. Un­
     lated bodily injuries or diseases suffered        ums in Publication 535, chapter 6.                   der the agreement, you are responsible for
     by employees on your farm, regardless of                                                               maintenance, repairs, and the risk of loss. For
     fault.                                                                                                 federal income tax purposes, the agreement is
     Business interruption insurance.                  Rent and Leasing                                     a conditional sales contract. You cannot deduct
     State unemployment insurance on your                                                                   any of the lease payments as rent. You can de­
     farm employees (deductible as taxes if            If you lease property for use in your farm busi­     duct interest, repairs, insurance, depreciation,
                                                       ness, you can generally deduct the rent you pay      and other expenses related to the equipment.

Page 22       Chapter 4     Farm Business Expenses
Motor vehicle leases. Special rules apply to         deduction for certain expenses for the use of         Business use percentage. You can claim
lease agreements that have a terminal rental         your home in your farming business is limited.        75% of the use of a car or light truck as busi­
adjustment clause. In general, this is a clause         Your deduction for otherwise nondeductible         ness use without any records if you used the
that provides for a rental price adjustment          expenses, such as utilities, insurance, and de­       vehicle during most of the normal business day
based on the amount the lessor is able to sell       preciation (with depreciation taken last), cannot     directly in connection with the business of farm­
the vehicle for at the end of the lease. If your     be more than the gross income from farming            ing. You choose this method of substantiating
rental agreement contains a terminal rental ad­      minus the following expenses.                         business use the first year the vehicle is placed
justment clause, treat the agreement as a lease           The business part of expenses you could          in service. Once you make this choice, you may
if the agreement otherwise qualifies as a lease.          deduct even if you did not use your home         not change to another method later. The follow­
For more information, see Internal Revenue                for business (such as deductible mortgage        ing are uses directly connected with the busi­
Code (IRC) section 7701(h).                               interest, real estate taxes, and casualty        ness of farming.
                                                          and theft losses).                                    Cultivating land.
Leveraged leases. Special rules apply to                  Farm expenses other than expenses that                 Raising or harvesting any agricultural or
leveraged leases of equipment (arrangements               relate to the use of your home. If you are             horticultural commodity.
in which the equipment is financed by a nonre­            self­employed, do not include your deduc­              Raising, shearing, feeding, caring for,
course loan from a third party). For more infor­          tion for half of your self­employment tax.             training, and managing animals.
mation, see Publication 535, chapter 3, and                                                                      Driving to the feed or supply store.
                                                        Deductions over the current year's limit can
Revenue Procedure 2001­28, which begins on
                                                     be carried over to your next tax year. They are          If you keep records and they show that your
page 1156 of Internal Revenue Bulletin 2001­19
                                                     subject to the deduction limit for the next tax       business use was more than 75%, you may be
at www.irs.gov/pub/irs-irbs/irb01-19.pdf.
                                                     year.                                                 able to claim more. See Recordkeeping require-
                                                                                                           ments under Travel Expenses below.
Depreciation                                         More information. See Publication 587 for
                                                     more information on deducting expenses for the        More information. For more information on
If property you acquire to use in your farm busi­    business use of your home.                            deductible truck and car expenses, see Publi­
ness is expected to last more than one year,                                                               cation 463, chapter 4. If you pay your employ­
you generally cannot deduct the entire cost in       Telephone expense. You cannot deduct the              ees for the use of their truck or car in your farm
the year you acquire it. You must recover the        cost of basic local telephone service (including      business, see Reimbursements to employees
cost over more than one year and deduct part         any taxes) for the first telephone line you have      under Travel Expenses next.
of it each year on Schedule F as depreciation or     in your home, even if you have an office in your
amortization. However, you can choose to de­         home. However, charges for business long­dis­
duct part or all of the cost of certain qualifying   tance phone calls on that line, as well as the        Travel Expenses
property, up to a limit, as a section 179 deduc­     cost of a second line into your home used ex­
tion in the year you place it in service.            clusively for your farm business, are deductible      You can deduct ordinary and necessary expen­
                                                     business expenses. Cell phone charges for             ses you incur while traveling away from home
   Depreciation, amortization, and the section       calls relating to your farm business are deducti­     for your farm business. You cannot deduct lav­
179 deduction are discussed in chapter 7.            ble. If the cell phone you use for your farm busi­    ish or extravagant expenses. Usually, the loca­
                                                     ness is part of a family cell phone plan, you         tion of your farm business is considered your
                                                                                                           home for tax purposes. You are traveling away
Business Use of Your Home                            must allocate and deduct only the portion of the
                                                     charges attributable to farm business calls.          from home if:
                                                                                                                Your duties require you to be absent from
You can deduct expenses for the business use                                                                    your farm substantially longer than an ordi­
of your home if you use part of your home ex­        Truck and Car Expenses                                     nary work day, and
clusively and regularly:                                                                                        You need to get sleep or rest to meet the
     As the principal place of business for any      You can deduct the actual cost of operating a              demands of your work while away from
     trade or business in which you engage,          truck or car in your farm business. Only expen­            home.
     As a place to meet or deal with patients,       ses for business use are deductible. These in­
     clients, or customers in the normal course                                                               If you meet these requirements and can
                                                     clude such items as gasoline, oil, repairs, li­
     of your trade or business, or                                                                         prove the time, place, and business purpose of
                                                     cense tags, insurance, and depreciation
     In connection with your trade or business,                                                            your travel, you can deduct your ordinary and
                                                     (subject to certain limits).
     if you are using a separate structure that is                                                         necessary travel expenses.
     not attached to your home.                      Standard mileage rate. Instead of using ac­               The following are some types of deductible
                                                     tual costs, under certain conditions you can use      travel expenses.
    Your home office will qualify as your princi­    the standard mileage rate. The standard mile­              Air, rail, bus, and car transportation;
pal place of business for deducting expenses         age rate for each mile of business use is 55.5
for its use if you meet both of the following re­                                                                Meals and lodging;
                                                     cents in 2012. You can use the standard mile­
quirements.                                          age rate for a car or a light truck, such as a van,         Dry cleaning and laundry;
      You use it exclusively and regularly for the   pickup, or panel truck, you own or lease.                   Telephone and fax;
      administrative or management activities of         You cannot use the standard mileage rate if
      your trade or business.                                                                                    Transportation between your hotel and
                                                     you operate five or more cars or light trucks at            your temporary work or business meeting
      You have no other fixed location where         the same time. You are not using five or more
      you conduct substantial administrative or                                                                  location; and
                                                     vehicles at the same time if you alternate using            Tips for any of the above expenses.
      management activities of your trade or         the vehicles (you use them at different times)
      business.                                      for business.
                                                                                                           Meals. You ordinarily can deduct only 50% of
   If you use part of your home for business,                                                              your business­related meals expenses. You
                                                         Example. Maureen owns a car and four
you must divide the expenses of operating your                                                             can deduct the cost of your meals while travel­
                                                     pickup trucks that are used in her farm busi­
home between personal and business use.                                                                    ing on business only if your business trip is
                                                     ness. Her farm employees use the trucks and
                                                                                                           overnight or long enough to require you to stop
                                                     she uses the car for business. Maureen cannot
Deduction limit. If your gross income from                                                                 for sleep or rest to properly perform your duties.
                                                     use the standard mileage rate for the car or the
farming equals or exceeds your total farm ex­                                                              You cannot deduct any of the cost of meals if it
                                                     trucks. This is because all five vehicles are
penses (including expenses for the business                                                                is not necessary for you to rest, unless you
                                                     used in Maureen's farm business at the same
use of your home), you can deduct all your farm                                                            meet the rules for business entertainment. For
                                                     time. She must use actual expenses for all vehi­
expenses. But if your gross income from farm­                                                              information on entertainment expenses, see
                                                     cles.
ing is less than your total farm expenses, your                                                            Publication 463, chapter 2.

                                                                                                     Chapter 4     Farm Business Expenses           Page 23
    The expense of a meal includes amounts           Items Purchased for Resale                            plants. Once you use a particular method for
you spend for your food, beverages, taxes, and                                                             any of these items, use it for those items until
tips relating to the meal. You can deduct either                                                           you get IRS approval to change your method.
                                                     If you use the cash method of accounting, you
50% of the actual cost or 50% of a standard                                                                For more information, see Change in Account-
                                                     ordinarily deduct the cost of livestock and other
meal allowance that covers your daily meal and                                                             ing Method in chapter 2.
                                                     items purchased for resale only in the year of
incidental expenses.
                                                     sale. You deduct this cost, including freight
          Recordkeeping requirements.You             charges for transporting the livestock to the         Other Expenses
          must be able to prove your deductions      farm, on Schedule F, Part I. However, see
RECORDS   for travel by adequate records or other    Chickens, seeds, and young plants below.              The following list, while not all­inclusive, shows
evidence that will support your own statement.                                                             some expenses you can deduct as other farm
Estimates or approximations do not qualify as            Example. You use the cash method of ac­           expenses on Schedule F, Part II. These expen­
proof of an expense.                                 counting. In 2012, you buy 50 steers you will         ses must be for business purposes and
                                                     sell in 2013. You cannot deduct the cost of the       (1) paid, if you use the cash method of account­
    You should keep an account book or similar       steers on your 2012 tax return. You deduct their      ing, or (2) incurred, if you use an accrual
record, supported by adequate documentary            cost on your 2013 Schedule F, Part I.                 method of accounting.
evidence, such as receipts, that together sup­                                                                  Accounting fees.
port each element of an expense. Generally, it       Chickens, seeds, and young plants. If you
                                                                                                                Advertising.
is best to record the expense and get documen­       are a cash method farmer, you can deduct the
                                                     cost of hens and baby chicks bought for com­               Business travel and meals.
tation of it at the time you pay it.
    If you choose to deduct a standard meal al­      mercial egg production, or for raising and re­             Commissions.
lowance rather than the actual expense, you do       sale, as an expense on Schedule F, Part I, in              Consultant fees.
not have to keep records to prove amounts            the year paid if you do it consistently and it does
                                                     not distort income. You also can deduct the                Crop scouting expenses.
spent for meals and incidental items. However,
you must still keep records to prove the actual      cost of seeds and young plants bought for fur­             Dues to cooperatives.
amount of other travel expenses, and the time,       ther development and cultivation before sale as            Educational expenses (to maintain and im­
place, and business purpose of your travel.          an expense on Schedule F, Part I, when paid if             prove farming skills).
                                                     you do this consistently and you do not figure             Farm­related attorney fees.
More information. For detailed information on        your income on the crop method. However, see
                                                                                                                Farm magazines.
travel, recordkeeping, and the standard meal al­     Prepaid Farm Supplies, earlier, for a rule that
lowance, see Publication 463.                        may limit your deduction for these items.                  Ginning.
                                                         If you deduct the cost of chickens, seeds,             Insect sprays and dusts.
Reimbursements to employees. You gener­              and young plants as an expense, report their               Litter and bedding.
ally can deduct reimbursements you pay to your       entire selling price as income. You cannot also
employees for travel and transportation expen­       deduct the cost from the selling price.                    Livestock fees.
ses they incur in the conduct of your business.          You cannot deduct the cost of seeds and                Marketing fees.
Employees may be reimbursed under an ac­             young plants for Christmas trees and timber as             Milk assessment.
countable or nonaccountable plan. Under an           an expense. Deduct the cost of these seeds
accountable plan, the employee must provide                                                                     Recordkeeping expenses.
                                                     and plants through depletion allowances. For
evidence of expenses. Under a nonaccountable         more information, see Depletion in chapter 7.              Service charges.
plan, no evidence of expenses is required. If            The cost of chickens and plants used as                Small tools expected to last one year or
you reimburse expenses under an accountable          food for your family is never deductible.                  less.
plan, deduct them as travel and transportation           Capitalize the cost of plants with a prepro­           Stamps and stationery.
expenses. If you reimburse expenses under a          ductive period of more than 2 years, unless you
                                                                                                                Subscriptions to professional, technical,
nonaccountable plan, you must report the reim­       can elect out of the uniform capitalization rules.
                                                                                                                and trade journals that deal with farming.
bursements as wages on Form W­2 and deduct           These rules are discussed in chapter 6.
                                                                                                                Tying material and containers.
them as wages. For more information, see Pub­
lication 535, chapter 11.                                Example. You use the cash method of ac­
                                                     counting. In 2012, you buy 500 baby chicks to         Loan expenses. You prorate and deduct loan
                                                                                                           expenses, such as legal fees and commissions,
Marketing Quota Penalties                            raise for resale in 2013. You also buy 50 bush­
                                                     els of winter wheat seed in 2012 that you sow in      you pay to get a farm loan over the term of the
                                                     the fall. Unless you previously adopted the           loan.
You can deduct as Other expenses on Sched­
ule F penalties you pay for marketing crops in       method of deducting these costs in the year you
                                                     sell the chickens or the harvested crops, you         Tax preparation fees. You can deduct as a
excess of farm marketing quotas. However, if                                                               farm business expense on Schedule F the cost
you do not pay the penalty, but instead the pur­     can deduct the cost of both the baby chicks and
                                                     the seed wheat in 2012.                               of preparing that part of your tax return relating
chaser of your crop deducts it from the payment                                                            to your farm business. You may be able to de­
to you, include in gross income only the amount          Election to use crop method. If you use           duct the remaining cost on Schedule A (Form
you received. Do not take a separate deduction       the crop method, you can delay deducting the          1040) if you itemize your deductions.
for the penalty.                                     cost of seeds and young plants until you sell             You also can deduct on Schedule F the
                                                     them. You must get IRS approval to use the            amount you pay or incur in resolving tax issues
Tenant House Expenses                                crop method. If you follow this method, deduct        relating to your farm business.
                                                     the cost from the selling price to determine your
You can deduct the costs of maintaining houses       profit on Schedule F, Part I. For more informa­
and their furnishings for tenants or hired help as   tion, see Crop method under Special Methods           Domestic Production
                                                     of Accounting in chapter 2.
farm business expenses. These costs include
repairs, utilities, insurance, and depreciation.
                                                                                                           Activities Deduction
                                                         Choosing a method. You can adopt either
    The value of a dwelling you furnish to a ten­    the crop method or the cash method for deduct­        Generally, you are allowed a deduction for in­
ant under the usual tenant­farmer arrangement        ing the cost in the first year you buy egg­laying     come attributable to domestic production activi­
is not taxable income to the tenant.                 hens, pullets, chicks, or seeds and young             ties. You can deduct 9% of the lesser of your
                                                     plants.                                               qualified production activities income or your
                                                         Although you must use the same method for         taxable income (adjusted gross income for indi­
                                                     egg­laying hens, pullets, and chicks, you can         viduals) for the tax year. Your deduction is limi­
                                                     use a different method for seeds and young            ted to 50% of the Form W­2 wages you paid for

Page 24      Chapter 4     Farm Business Expenses
the tax year that are properly allocable to do­             increase their value, or adapt them to dif­             a. Girdling,
mestic production gross receipts.                           ferent use.
                                                                                                                    b. Applying herbicide,
    For this purpose, Form W­2 wages do not              8. Water wells, including drilling and equip­
                                                                                                                    c. Baiting rodents, and
include noncash wages paid for agricultural la­             ping costs.
bor, such as compensation paid as commodi­                                                                          d. Clearing and controlling brush.
                                                         9. Land preparation costs, such as:
ties. Also, excluded from Form W­2 wages are                                                                   2. The cost of seed or seedlings.
wages paid to your children under age 18 and                 a. Clearing land for farming,
nontaxable fringe benefits.                                                                                    3. Labor and tool expenses.
                                                             b. Leveling and conditioning land,
                                                                                                               4. Depreciation on equipment used in plant­
Income from cooperatives. If you receive a                   c. Purchasing and planting trees,
                                                                                                                  ing or seeding.
patronage dividend or qualified per­unit retain              d. Building irrigation canals and ditches,
allocation from a cooperative which is engaged                                                                 5. Costs incurred in replanting to replace lost
in the manufacturing, production, growth, or ex­             e. Laying irrigation pipes,                          seedlings.
traction in whole or in significant part of any ag­           f. Installing drain tile,                      You can choose to capitalize certain indirect re­
ricultural or horticultural product or in the mar­                                                           forestation costs.
keting of agricultural or horticultural products,            g. Modifying channels or streams,
                                                                                                                 These capitalized amounts are your basis
your income from the cooperative can give rise               h. Constructing earthen, masonry, or            for the timber. Recover your basis when you
to a domestic production activities deduction.                  concrete tanks, reservoirs, or dams,         sell the timber or take depletion allowances
This deduction amount is reported on Form                       and                                          when you cut the timber. See Depletion in chap­
1099­PATR, box 6. In order for you to qualify for                                                            ter 7.
the deduction, the cooperative is required to                 i. Building roads.
send you a written notice designating your por­                                                                  Forestation and reforestation costs. You
tion of the domestic production activities deduc­      Business start-up and organizational costs.           can elect to deduct up to $10,000 ($5,000 if
tion.                                                  You can elect to deduct up to $5,000 of busi­         married filing separately; $0 for a trust) of quali­
                                                       ness start­up costs and $5,000 of organiza­           fying reforestation costs paid or incurred after
More information. For more information on              tional costs paid or incurred after October 22,       October 22, 2004, for each qualified timber
the domestic production activities deduction,          2004. The $5,000 deduction is reduced by the          property. Any remaining costs can be amortized
see the Instructions for Form 8903.                    amount your total start­up or organizational          over an 84­month period. See chapter 7. If you
                                                       costs exceed $50,000. Any remaining costs             make an election to deduct or amortize qualify­
                                                       must be amortized. See chapter 7.                     ing reforestation costs, you should create and
Capital Expenses                                           You elect to deduct start­up or organiza­         maintain separate timber accounts for each
                                                       tional costs by claiming the deduction on the in­     qualified timber property. The accounts should
A capital expense is a payment, or a debt incur­       come tax return filed by the due date (including      include all reforestation treatments and the
red, for the acquisition, improvement, or resto­       extensions) for the tax year in which the active      dates they were applied. Any qualified timber
ration of an asset that is expected to last more       trade or business begins. However, if you timely      property that is subject to the deduction or am­
than one year. You include the expense in the          filed your return for the year without making the     ortization election cannot be included in any
basis of the asset. Uniform capitalization rules       election, you can still make the election by filing   other timber account for which depletion is al­
also require you to capitalize or include in in­       an amended return within 6 months of the due          lowed. The timber account should be main­
ventory certain other expenses. See chapters 2         date of the return (excluding extensions).            tained until the timber is disposed of. For more
and 6.                                                 Clearly indicate the election on your amended         information, see Notice 2006­47, 2006­20 I.R.B.
                                                       return and write “Filed pursuant to section           892, available at
    Capital expenses are generally not deducti­        301.9100­2” at the top of the amended return.         www.irs.gov/irb/2006-20_IRB/ar11.html.
ble, but they may be depreciable. However, you         File the amended return at the same address               You elect to deduct forestation and refores­
can elect to deduct certain capital expenses,          you filed the original return. The election applies   tation costs by claiming the deduction on the in­
such as the following.                                 when figuring taxable income for the current tax      come tax return filed by the due date (including
     The cost of fertilizer, lime, etc. (See Fertil-   year and all subsequent years.                        extensions) for the tax year in which the expen­
     izer and Lime under Deductible Expenses,              You can choose to forgo the election by           ses were paid or incurred. If you are filing Form
     earlier.)                                         clearly electing to capitalize your start­up or or­   T (Timber), Forest Activities Schedule, also
     Soil and water conservation expenses.             ganizational costs on an income tax return filed      complete Form T (Timber), Part IV. If you are
     (See chapter 5.)                                  by the due date (including extensions) for the        not filing Form T (Timber), attach a statement to
     The cost of property that qualifies for a de­     tax year in which the active trade or business        your return with the following information.
     duction under section 179. (See chap­             begins. For more information about start­up and             The unique stand identification numbers.
     ter 7.)                                           organizational costs, see chapter 7.
                                                                                                                   The total number of acres reforested dur­
     Business start­up costs. (See Business                                                                        ing the tax year.
     start-up and organizational costs, later.)        Crop production expenses. The uniform
                                                                                                                   The nature of the reforestation treatments.
     Forestation and reforestation costs. (See         capitalization rules generally require you to cap­
     Forestation and reforestation costs, later.)      italize expenses incurred in producing plants.              The total amounts of the qualified refores­
                                                       However, except for certain taxpayers required              tation expenditures eligible to be amortized
    Generally, the costs of the following items,       to use an accrual method of accounting, the                 or deducted.
including the costs of material, hired labor, and      capitalization rules do not apply to plants with a         However, if you timely filed your return for
installation, are capital expenses.                    preproductive period of 2 years or less. For          the year without making the election, you can
  1. Land and buildings.                               more information, see Uniform Capitalization          still make the election by filing an amended re­
                                                       Rules in chapter 6.                                   turn within 6 months of the due date of the re­
  2. Additions, alterations, and improvements                                                                turn (excluding extensions). Clearly indicate the
     to buildings, etc.                                Timber. Capitalize the cost of acquiring timber.      election on your amended return and write
                                                       Do not include the cost of land in the cost of the    “Filed pursuant to section 301.9100­2” at the
  3. Cars and trucks.
                                                       timber. You must generally capitalize direct          top of the amended return. File the amended re­
  4. Equipment and machinery.                          costs incurred in reforestation. However, you         turn at the same address you filed the original
                                                       can elect to deduct some forestation and refor­       return.
  5. Fences.
                                                       estation costs. See Forestation and reforesta-             For more information about forestation and
  6. Draft, breeding, sport, and dairy livestock.      tion costs next. Reforestation costs include the      reforestation costs, see chapter 7.
                                                       following.
  7. Repairs to machinery, equipment, trucks,
     and cars that prolong their useful life,            1. Site preparation costs, such as:

                                                                                                       Chapter 4     Farm Business Expenses            Page 25
          For more information about timber,          Repayment of loans. You cannot deduct the                    Trade associations.
          see Agriculture Handbook Number             repayment of a loan. However, if you use the                 Real estate boards.
          718, Forest Landowners' Guide to the        proceeds of a loan for farm business expenses,
Federal Income Tax. You can view this publica­        you can deduct the interest on the loan. See In-
                                                                                                            Fines and penalties. You cannot deduct fines
tion on the Internet at                               terest, earlier.
                                                                                                            and penalties, except penalties for exceeding
www.fs.fed.us/publications.
                                                      Estate, inheritance, legacy, succession,              marketing quotas, discussed earlier.
                                                      and gift taxes. You cannot deduct estate, in­
Christmas tree cultivation. If you are in the
                                                      heritance, legacy, succession, and gift taxes.
business of planting and cultivating Christmas                                                              Losses From Operating a
trees to sell when they are more than 6 years
old, capitalize expenses incurred for planting
                                                      Loss of livestock. You cannot deduct as a             Farm
                                                      loss the value of raised livestock that die if you
and stump culture and add them to the basis of
                                                      deducted the cost of raising them as an ex­           If your deductible farm expenses are more than
the standing trees. Recover these expenses as
                                                      pense.                                                your farm income, you have a loss from the op­
part of your adjusted basis when you sell the
standing trees or as depletion allowances when                                                              eration of your farm. The amount of the loss you
                                                      Losses from sales or exchanges between                can deduct when figuring your taxable income
you cut the trees. For more information, see          related persons. You cannot deduct losses
Timber Depletion under Depletion in chapter 7.                                                              may be limited. To figure your deductible loss,
                                                      from sales or exchanges of property between           you must apply the following limits.
    You can deduct as business expenses the           you and certain related persons, including your
costs incurred for shearing and basal pruning of                                                                 The at­risk limits.
                                                      spouse, brother, sister, ancestor, or lineal de­
these trees. Expenses incurred for silvicultural      scendant. For more information, see chapter 2                The passive activity limits.
practices, such as weeding or cleaning, and           of Publication 544, Sales and Other Disposi­
noncommercial thinning are also deductible as                                                               The following discussions explain these limits.
                                                      tions of Assets.
business expenses.
                                                                                                                If your deductible loss after applying these
    Capitalize the cost of land improvements,         Cost of raising unharvested crops. You                limits is more than your other income for the
such as road grading, ditching, and fire breaks,      cannot deduct the cost of raising unharvested         year, you may have a net operating loss. See
that have a useful life beyond the tax year. If the   crops sold with land owned more than one year         Publication 536, Net Operating Losses (NOLs)
improvements do not have a determinable use­          if you sell both at the same time and to the          for Individuals, Estates, and Trusts.
ful life, add their cost to the basis of the land.    same person. Add these costs to the basis of
The cost is recovered when you sell or other­         the land to determine the gain or loss on the                  If you do not carry on your farming ac-
wise dispose of it. If the improvements have a        sale. For more information, see Section 1231             !     tivity to make a profit, your loss deduc-
determinable useful life, recover their cost          Gains and Losses in chapter 9.                        CAUTION  tion may be limited by the not-for-profit
through depreciation. Capitalize the cost of                                                                rules. See Not­for­Profit Farming, later.
equipment and other depreciable assets, such          Cost of unharvested crops bought with
as culverts and fences, to the extent you do not      land. Capitalize the purchase price of land, in­
use them in planting Christmas trees. Recover         cluding the cost allocable to unharvested crops.      At-Risk Limits
these costs through depreciation.                     You cannot deduct the cost of the crops at the
                                                      time of purchase. However, you can deduct this        The at­risk rules limit your deduction for losses
                                                      cost in figuring net profit or loss in the tax year   from most business or income­producing activi­
Nondeductible Expenses                                you sell the crops.                                   ties, including farming. These rules limit the los­
                                                                                                            ses you can deduct when figuring your taxable
You cannot deduct personal expenses and cer­          Cost related to gifts. You cannot deduct              income. The deductible loss from an activity is
tain other items on your tax return even if they      costs related to your gifts of agricultural prod­     limited to the amount you have at risk in the ac­
relate to your farm.                                  ucts or property held for sale in the ordinary        tivity.
                                                      course of your business. The costs are not de­
                                                                                                               You are at risk in any activity for:
                                                      ductible in the year of the gift or any later year.
Personal, Living, and Family                          For example, you cannot deduct the cost of              1. The money and adjusted basis of property
Expenses                                              raising cattle or the cost of planting and raising         you contribute to the activity, and
                                                      unharvested wheat on parcels of land given as
                                                                                                              2. Amounts you borrow for use in the activity
You cannot deduct certain personal, living, and       a gift to your children.
                                                                                                                 if:
family expenses as business expenses. These
include rent and insurance premiums paid on           Club dues and membership fees. Generally,                     a. You are personally liable for repay­
property used as your home, life insurance pre­       you cannot deduct amounts you pay or incur for                   ment, or
miums on yourself or your family, the cost of         membership in any club organized for business,
                                                      pleasure, recreation, or any other social pur­                b. You pledge property (other than prop­
maintaining cars, trucks, or horses for personal
                                                      pose. This includes country clubs, golf and ath­                 erty used in the activity) as security for
use, allowances to minor children, attorneys'                                                                          the loan.
fees and legal expenses incurred in personal          letic clubs, hotel clubs, sporting clubs, airline
matters, and household expenses. Likewise,            clubs, and clubs operated to provide meals un­           You are not at risk, however, for amounts
the cost of purchasing or raising produce or          der circumstances generally considered to be          you borrow for use in a farming activity from a
livestock consumed by you or your family is not       conducive to business discussions.                    person who has an interest in the activity (other
deductible.                                                                                                 than as a creditor) or a person related to some­
                                                          Exception. The following organizations will
                                                                                                            one (other than you) having such an interest.
                                                      not be treated as a club organized for business,
Other Nondeductible Items                             pleasure, recreation, or other social purposes,          For more information, see Publication 925.
                                                      unless one of its main purposes is to conduct
                                                      entertainment activities for members or their
You cannot deduct the following items on your
tax return.                                           guests or to provide members or their guests          Passive Activity Limits
                                                      with access to entertainment facilities.
                                                           Boards of trade.                                 A passive activity is generally any activity in­
Loss of growing plants, produce, and
                                                                                                            volving the conduct of any trade or business in
crops. Losses of plants, produce, and crops                Business leagues.
                                                                                                            which you do not materially participate. Gener­
raised for sale are generally not deductible.              Chambers of commerce.                            ally, a rental activity is a passive activity.
However, you may have a deductible loss on
plants with a preproductive period of more than            Civic or public service organizations.
                                                                                                                If you have a passive activity, special rules
2 years. See chapter 11 for more information.              Professional associations.                       limit the loss you can deduct in the tax year.

Page 26      Chapter 4     Farm Business Expenses
You generally can deduct losses from passive            investment activity intended only to produce tax        you first started farming. You must file Form
activities only up to income from passive activi­       losses for the investors also comes under this          5213 within 3 years after the due date of your
ties. Credits are similarly limited.                    limit.                                                  return for the year in which you first carried on
                                                                                                                the activity, or, if earlier, within 60 days after re­
   For more information, see Publication 925.               The limit on not­for­profit losses applies to       ceiving a written notice from the IRS proposing
                                                        individuals, partnerships, estates, trusts, and S       to disallow deductions attributable to the activ­
                                                        corporations. It does not apply to corporations
Excess Farm Loss Limit                                  other than S corporations.
                                                                                                                ity.
                                                                                                                     The benefit gained by making this choice is
For tax years beginning after 2009, excess farm             In determining whether you are carrying on          that the IRS will not immediately question
losses (defined below) are not deductible if you        your farming activity for profit, all the facts are     whether your farming activity is engaged in for
received certain applicable subsidies. This limit       taken into account. No one factor alone is deci­        profit. Accordingly, it will not limit your deduc­
applies to any farming businesses, other than a         sive. Among the factors to consider are                 tions. Rather, you will gain time to earn a profit
C corporation, that received a direct or coun­          whether:                                                in 3 (or 2) out of the first 5 (or 7) years you carry
ter­cyclical payment (or any payment in lieu of               You operate your farm in a businesslike           on the farming activity. If you show 3 (or 2)
such payments) under title I of the Food, Con­                manner;                                           years of profit at the end of this period, your de­
servation, and Energy Act of 2008, or from a                  The time and effort you spend on farming          ductions are not limited under these rules. If you
Commodity Credit Corporation loan. Your farm­                 indicate you intend to make it profitable;        do not have 3 (or 2) years of profit (and cannot
ing losses will be limited to the greater of:                 You depend on income from farming for             otherwise show that you operated your farm for
      $300,000 ($150,000 for a married person                 your livelihood;                                  profit), the limit applies retroactively to any year
      filing a separate return), or                           Your losses are due to circumstances be­          in the 5­year (or 7­year) period with a loss.
      The total net farm income for the prior five            yond your control or are normal in the                 Filing Form 5213 automatically extends the
      tax years.                                              start­up phase of farming;                        period of limitations on any year in the 5­year
                                                              You change your methods of operation in           (or 7­year) period to 2 years after the due date
    Farming losses from casualty losses or los­               an attempt to improve profitability;              of the return for the last year of the period. The
ses by reason of disease or drought are disre­                You, or your advisors, have the knowledge         period is extended only for deductions of the
garded for purposes of figuring this limitation.              needed to carry on the farming activity as a      activity and any related deductions that might
Also, the limitation on farm losses should be ap­             successful business;                              be affected.
plied before the passive activity loss rules are              You were successful in making a profit in
applied.                                                      similar activities in the past;                   Limit on deductions and losses. If your ac­
                                                              You make a profit from farming in some            tivity is not carried on for profit, take deductions
   For more details, see IRC section 461(j).                                                                    only in the following order, only to the extent
                                                              years and the amount of profit you make;
                                                              and                                               stated in the three categories, and, if you are an
Excess farm loss. Generally, an excess farm                                                                     individual, only if you itemize them on Sched­
loss is the amount of your farming loss that ex­              You can expect to make a future profit from
                                                              the appreciation of the assets used in the        ule A (Form 1040).
ceeds the amount of the limitation (as described
above). This loss can be determined by taking                 farming activity.                                     Category 1. Deductions you can take for
the excess of:                                                                                                  personal as well as for business activities are
     The total deductions for the tax year from         Presumption of profit. Your farming or other            allowed in full. For individuals, all nonbusiness
     your farming businesses, over                      activity is presumed carried on for profit if it pro­   deductions, such as those for home mortgage
     The total gross income or gain for the tax         duced a profit in at least 3 of the last 5 tax          interest, taxes, and casualty losses (see chap­
     year from your farming businesses, plus            years, including the current year. Activities that      ter 11), belong in this category. For the limits
     the greater of:                                    consist primarily of breeding, training, showing,       that apply to mortgage interest, see Publication
                                                        or racing horses are presumed carried on for            936.
       1. $300,000 ($150,000 for a married              profit if they produced a profit in at least 2 of the
          person filing a separate return), or          last 7 tax years, including the current year. The            Category 2. Deductions that do not result
       2. The excess (if any) of the total gross        activity must be substantially the same for each        in an adjustment to the basis of property are al­
          income or gain from your farming              year within this period. You have a profit when         lowed next, but only to the extent your gross in­
          businesses for the prior five tax years       the gross income from an activity is more than          come from the activity is more than the deduc­
          over the total deductions from your           the deductions for it.                                  tions you take (or could take) under the first
          farming businesses for the prior five              If a taxpayer dies before the end of the           category. Most business deductions, such as
          tax years.                                    5­year (or 7­year) period, the period ends on           those for fertilizer, feed, insurance premiums,
                                                        the date of the taxpayer's death.                       utilities, wages, etc., belong in this category.
   Excess farm losses that are disallowed can                If your business or investment activity
be carried forward to the next tax year and trea­       passes this 3­ (or 2­) years­of­profit test, pre­           Category 3. Business deductions that de­
ted as a deduction from that year.                      sume it is carried on for profit. This means the        crease the basis of property are allowed last,
                                                        limits discussed here do not apply. You can             but only to the extent the gross income from the
                                                        take all your business deductions from the ac­          activity is more than deductions you take (or
Not-for-Profit Farming                                  tivity on Schedule F, even for the years that you       could take) under the first two categories. The
                                                        have a loss. You can rely on this presumption in        deductions for depreciation, amortization, and
If you operate a farm for profit, you can deduct        every case, unless the IRS shows it is not valid.       the part of a casualty loss an individual could
all the ordinary and necessary expenses of car­              If you fail the 3­ (or 2­) years­of­profit test,   not deduct in category (1) belong in this cate­
rying on the business of farming on Schedule F.         you still may be considered to operate your             gory. Where more than one asset is involved,
However, if you do not carry on your farming ac­        farm for profit by considering the factors listed       divide depreciation and these other deductions
tivity, or other activity you engage or invest in, to   earlier.                                                proportionally among those assets.
make a profit, you report the income from the                                                                               Individuals must claim the amounts in
activity on Form 1040, line 21, and you can de­             Using the presumption later. If you are
                                                        starting out in farming and do not have 3 (or 2)         TIP        categories (2) and (3) above as mis-
duct expenses of carrying on the activity only if                                                                           cellaneous deductions on Schedule A
you itemize your deductions on Schedule A               years showing a profit, you may want to take
                                                        advantage of this presumption later, after you          (Form 1040). They are subject to the 2%-of-ad-
(Form 1040). Also, there is a limit on the deduc­                                                               justed-gross-income limit. See Publication 529,
tions you can take. You cannot use a loss from          have had the 5 (or 7) years of experience al­
                                                        lowed by the test.                                      Miscellaneous Deductions, for information on
that activity to offset income from other activi­                                                               this limit.
ties.                                                       You can choose to do this by filing Form
                                                        5213. Filing this form postpones any determina­
   Activities you do as a hobby, or mainly for          tion that your farming activity is not carried on       Partnerships and S corporations. If a part­
sport or recreation, come under this limit. An          for profit until 5 (or 7) years have passed since       nership or S corporation carries on a

                                                                                                          Chapter 4     Farm Business Expenses              Page 27
not­for­profit activity, these limits apply at the           Conservation expenses                                     quest assistance from NRCS to develop a
partnership or S corporation level. They are re­             Assessment by conservation district                       conservation plan designed specifically for
flected in the individual shareholder's or part­                                                                       their farmland.
                                                             25% limit on deduction                                    NRCS county plans. These plans include a
ner's distributive shares.
                                                             When to deduct or capitalize                              listing of farm conservation practices ap­
More information. For more information on                    Sale of a farm                                            proved for the county where the farmland
not­for­profit activities, see Not-for-Profit Activi-                                                                  is located. You can deduct expenses for
ties Publication 535, chapter 1.                                                                                       conservation practices not included on the
                                                        Business of Farming                                            NRCS county plans only if the practice is a
                                                                                                                       part of an individual site plan.
                                                                                                                       Comparable state agency plans. These
                                                        For purposes of soil and water conservation ex­                plans are approved by state agencies and
                                                        penses, you are in the business of farming if                  can be approved individual site plans or
                                                        you cultivate, operate, or manage a farm for                   county plans.
5.                                                      profit, either as an owner or a tenant. You are
                                                        not in the business of farming if you cultivate or          A list of NRCS conservation programs is
                                                        operate a farm for recreation or pleasure, rather       available at www.nrcs.usda.gov/programs. Indi­
                                                        than for profit. You are not farming if you are en­     vidual site plans can be obtained from NRCS
Soil and Water                                          gaged only in forestry or the growing of timber.        offices and the comparable state agencies.


Conservation                                            Farm defined. A farm includes livestock, dairy,
                                                        poultry, fish, fruit, and truck farms. It also in­      Conservation Expenses
                                                        cludes plantations, ranches, ranges, and or­
Expenses                                                chards. A fish farm is an area where fish and
                                                        other marine animals are grown or raised and
                                                                                                                You can deduct conservation expenses only for
                                                                                                                land you or your tenant are using, or have used
                                                        artificially fed, protected, etc. It does not include   in the past, for farming. These expenses in­
                                                        an area where they are merely caught or har­            clude, but are not limited to, the following.
Introduction                                            vested. A plant nursery is a farm for purposes of
                                                        deducting soil and water conservation expen­
                                                                                                                  1. The treatment or movement of earth, such
If you are in the business of farming, you can                                                                       as:
                                                        ses.
choose to deduct certain expenses for:                                                                                  a. Leveling,
     Soil or water conservation,                        Farm rental. If you own a farm and receive
                                                                                                                        b. Conditioning,
     Prevention of erosion of land used in farm­        farm rental payments based on farm produc­
     ing, or                                            tion, either in cash or crop shares, you are in the             c. Grading,
     Endangered species recovery.                       business of farming. If you get cash rental for a
                                                                                                                        d. Terracing,
                                                        farm you own that is not used in farm produc­
    Otherwise, these are capital expenses that          tion, you cannot deduct soil and water conser­                  e. Contour furrowing, and
must be added to the basis of the land. (See            vation expenses for that farm.
chapter 6 for information on determining basis.)                                                                         f. Restoration of soil fertility.
                                                            If you receive a fixed rental payment that is
Conservation expenses for land in a foreign             not based on farm production, you are in the              2. The construction, control, and protection
country do not qualify for this special treatment.      business of farming only if you materially partici­          of:
    The deduction for conservation expenses             pate in operating or managing the farm.
cannot be more than 25% of your gross income                                                                            a. Diversion channels,
from farming. See 25% Limit on Deduction,                   Example. You own a farm in Iowa and live                    b. Drainage ditches,
later.                                                  in California. You rent the farm for $125 in cash
    Certain ordinary and necessary expenses                                                                             c. Irrigation ditches,
                                                        per acre and do not materially participate in pro­
that are otherwise deductible are not soil and          ducing or managing production of the crops                      d. Earthen dams, and
water conservation expenses. These include in­          grown on the farm. You cannot deduct your soil
terest and taxes, the cost of periodically clear­                                                                       e. Watercourses, outlets, and ponds.
                                                        conservation expenses for this farm. You must
ing brush from productive land, the regular re­         capitalize the expenses and add them to the               3. The eradication of brush.
moval of sediment from a drainage ditch, and            basis of the land.
expenses paid or incurred primarily to produce                                                                    4. The planting of windbreaks.
                                                            For more information, see Material participa-
an agricultural crop that may also conserve soil.       tion for landlords under Landlord Participation in      You cannot deduct expenses to drain or fill wet­
    You must include in income most govern­             Farming in chapter 12.                                  lands, or to prepare land for center pivot irriga­
ment payments for approved conservation                                                                         tion systems, as soil and water conservation ex­
practices. However, you can exclude some                                                                        penses. These expenses are added to the
payments you receive under certain cost­shar­           Plan Certification                                      basis of the land.
ing conservation programs. For more informa­
tion, see Agricultural Program Payments in              You can deduct soil and water conservation ex­                   If you choose to deduct soil and water
chapter 3.                                              penses only if they are consistent with a plan             !     conservation expenses, you cannot
                                                        approved by the Natural Resources Conserva­             CAUTION  exclude from gross income any
         To get the full deduction to which you                                                                 cost-sharing payments you receive for those
         are entitled, you should maintain your         tion Service (NRCS) of the Department of Agri­
                                                        culture. If no such plan exists, the expenses           expenses. See chapter 3 for information about
         records to clearly distinguish between                                                                 payments eligible for the cost-sharing exclu-
                                                        must be consistent with a soil conservation plan
RECORDS

your ordinary and necessary farm business ex­                                                                   sion.
penses and your soil and water conservation             of a comparable state agency. Keep a copy of
expenses.                                               the plan with your books and records to support
                                                        your deductions.                                        New farm or farmland. If you acquire a new
                                                                                                                farm or new farmland from someone who was
Topics                                                  Conservation plan. A conservation plan in­              using it in farming immediately before you ac­
This chapter discusses:                                 cludes the farming conservation practices ap­           quired the land, soil and water conservation ex­
                                                        proved for the area where your farmland is loca­        penses you incur on it will be treated as made
     Business of farming                                ted. There are three types of approved plans.           on land used in farming at the time the expen­
                                                             NRCS individual site plans. These plans            ses were paid or incurred. You can deduct soil
     Plan certification                                      are issued individually to farmers who re­         and water conservation expenses for this land if

Page 28       Chapter 5      Soil and Water Conservation Expenses
your use of it is substantially a continuation of   agricultural purposes as a soil and water con­            Covers expenses for depreciable property
its use in farming. The new farming activity        servation expense. It is a capital expense. You           used in the district's business.
does not have to be the same as the old farm­       recover your cost through depreciation. You
                                                    also must capitalize your cost for drilling a test
ing activity. For example, if you buy land that
was used for grazing cattle and then prepare it     hole. If the test hole produces no water and you
                                                                                                          Assessment for Depreciable
for use as an apple orchard, you can deduct         continue drilling, the cost of the test hole is       Property
your conservation expenses.                         added to the cost of the producing well. You
                                                    can recover the total cost through depreciation       You generally can deduct as a conservation ex­
Land not used for farming. If your conserva­        deductions.                                           pense amounts you pay or incur for the part of a
tion expenses benefit both land that does not           If a test hole, dry hole, or dried­up well (re­   conservation or drainage district assessment
qualify as land used for farming and land that      sulting from prolonged lack of rain, for instance)    that covers expenses for depreciable property.
does qualify, you must allocate the expenses        is abandoned, you can deduct your unrecov­            This includes items such as pumps, locks, con­
between the two types of land. For example, if      ered cost in the year of abandonment. Aban­           crete structures (including dams and weir
the expenses benefit 200 acres of your land,        donment means that all economic benefits from         gates), draglines, and similar equipment. The
but only 120 acres of this land are used for        the well are terminated. For example, filling or      depreciable property must be used in the dis­
farming, then you can deduct 60% (120 ÷ 200)        sealing a well excavation or casing so that all       trict's soil and water conservation activities.
of the expenses. You can use another method         economic benefits from the well are terminated        However, the following limits apply to these as­
to allocate these expenses if you can clearly       constitutes an abandonment.                           sessments.
show that your method is more reasonable.
                                                    Endangered species recovery expenses. If                  The total assessment limit.
Depreciable conservation assets. You gen­           you are in the business of farming and meet
erally cannot deduct your expenses for depreci­     other specific requirements, you can choose to            The yearly assessment limit.
able conservation assets. However, you can          deduct the conservation expenses discussed
deduct certain amounts you pay or incur for an      earlier as endangered species recovery expen­             After you apply these limits, the amount you
assessment for depreciable property that a soil     ses. Otherwise, these are capital expenses that       can deduct is added to your other conservation
and water conservation or drainage district lev­    must be added to the basis of the land.               expenses for the year. The total for these ex­
ies against your farm. See Assessment for De-          The expenses must be paid or incurred for          penses is then subject to the 25% of gross in­
preciable Property, later.                          the purpose of achieving site­specific manage­        come from farming limit on the deduction, dis­
     You must capitalize expenses to buy, build,    ment actions recommended in a recovery plan           cussed later. See Table 5­1 for a brief summary
install, or improve depreciable structures or fa­   approved under section 4(f) of the Endangered         of these limits.
cilities. These expenses include those for mate­    Species Act of 1973. See Internal Revenue                       To ensure your deduction is within the
rials, supplies, wages, fuel, hauling, and moving   Code section 175 for more information.                          deduction limits, keep records to show
dirt when making structures such as tanks, res­                                                           RECORDS   the following.
ervoirs, pipes, culverts, canals, dams, wells, or                                                              The total assessment against all members
pumps composed of masonry, concrete, tile,          Assessment by                                              of the district for the depreciable property.
metal, or wood. You recover your capital invest­
ment through annual allowances for deprecia­
                                                    Conservation District                                      Your deductible share of the cost to the
                                                                                                               district for the depreciable property.
tion.                                                                                                          Your gross income from farming.
     You can deduct soil and water conservation     In some localities, a soil or water conservation
expenses for nondepreciable earthen items.          or drainage district incurs expenses for soil or
                                                    water conservation and levies an assessment              Total assessment limit. You cannot de­
Nondepreciable earthen items include certain
                                                    against the farmers who benefit from the expen­       duct more than 10% of the total amount as­
dams, ponds, and terraces described under
                                                    ses. You can deduct as a conservation expense         sessed to all members of the conservation or
Property Having a Determinable Useful Life in
                                                    amounts you pay or incur for the part of an as­       drainage district for the depreciable property.
chapter 7.
                                                    sessment that:                                        This applies whether you pay the assessment in
     Water well. You cannot deduct the cost of           Covers expenses you could deduct if you          one payment or in installments. If your assess­
drilling a water well for irrigation and other           had paid them directly, or                       ment is more than 10% of the total amount as­
                                                                                                          sessed, both the following rules apply.
                                                                                                               The amount over 10% is a capital expense
Table 5­1. Limits on Deducting an Assessment by a Conservation
                                                                                                               and is added to the basis of your land.
           District for Depreciable Property                                                                   If the assessment is paid in installments,
                                                                                                               each payment must be prorated between
 Total Limit on Deduction          Yearly Limit on Deduction
                                                                                                               the conservation expense and the capital
 for Assessment for                for Assessment for               Yearly Limit for All
                                                                                                               expense.
 Depreciable Property              Depreciable Property             Conservation Expenses
                                                                                                               Yearly assessment limit. The maximum
            10% of:                       $500 + 10% of:                        25% of:
                                                                                                          amount you can deduct in any one year is the
 Total assessment against all      Your deductible share of the     Your gross income from                total of 10% of your deductible share of the cost
 members of the district for the   cost to the district for the     farming.                              as explained earlier, plus $500. If the amount
 property.                         property.                                                              you pay or incur is equal to or less than the
                                                                                                          maximum amount, you can deduct it in the year
      No one taxpayer can              If the amount you pay or          Limit for all conservation       it is paid or incurred. If the amount you pay or
      deduct more than 10%             incur for any year is             expenses, including              incur is more, you can deduct in that year only
      of the total assessment.         more than the limit, you          assessments for                  10% of your deductible share of the cost. You
      Any amount over 10% is           can deduct for that year          depreciable property.            can deduct the remainder in equal amounts
      a capital expense and is         only 10% of your                  Amounts greater than             over the next 9 tax years. Your total conserva­
      added to the basis of            deductible share of the           25% can be carried to            tion expense deduction for each year is also
      your land.                       cost.                             the following year and           subject to the 25% of gross income from farm­
      If an assessment is paid         You can deduct the                added to that year's             ing limit on the deduction, discussed later.
      in installments, each            remainder in equal                expenses. The total is
      payment must be                  amounts over the next 9           then subject to the 25%              Example 1. This year, the soil conservation
      prorated between the             tax years.                        of gross income from             district levies and you pay an assessment of
      conservation expense                                               farming limit in that year.      $2,400 against your farm. Of the assessment,
                                                                                                          $1,500 is for digging drainage ditches. You can
      and the capital expense.

                                                                                    Chapter 5      Soil and Water Conservation Expenses            Page 29
deduct this part as a soil or conservation ex­          business of farming from the production of                  A statement that you will account sepa­
pense as if you had paid it directly. The remain­       crops, fish, fruits, other agricultural products, or        rately in your books for the expenses to
ing $900 is for depreciable equipment to be             livestock. Gains from sales of draft, breeding, or          which this method or change of method re­
used in the district's irrigation activities. The to­   dairy livestock are included. Gains from sales of           lates.
tal amount assessed by the district against all         assets such as farm machinery, or from the dis­
its members for the depreciable equipment is            position of land, are not included.                             Send your request to the following
$7,000.                                                                                                                 address.
    The total amount you can deduct for the de­         Carryover of deduction. If your deductible
preciable equipment is limited to 10% of the to­        conservation expenses in any year are more
                                                        than 25% of your gross income from farming for              Department of the Treasury
tal amount assessed by the district against all
                                                        that year, you can carry the unused deduction               Internal Revenue Service Center
its members for depreciable equipment, or
                                                        over to later years. However, the deduction in              Cincinnati, OH 45999
$700. The $200 excess ($900 − $700) is a capi­
tal expense you must add to the basis of your           any later year is limited to 25% of the gross in­
farm.                                                   come from farming for that year as well.                   For more information, see Change in
    To figure the maximum amount you can de­                                                                   Accounting Method in chapter 2.
duct for the depreciable equipment this year,               Example. In 2011, you have gross income
multiply your deductible share of the total as­         of $32,000 from two farms. During the year, you
sessment ($700) by 10%. Add $500 to the re­             incurred $10,000 of deductible soil and water          Sale of a Farm
sult for a total of $570. Your deductible share,        conservation expenses for one of the farms.
$700, is greater than the maximum amount de­            However, your deduction is limited to 25% of           If you sell your farm, you cannot adjust the ba­
ductible in one year, so you can deduct only            $32,000, or $8,000. The $2,000 excess                  sis of the land at the time of the sale for any un­
$70 of the amount you paid or incurred for de­          ($10,000 − $8,000) is carried over to 2012 and         used carryover of soil and water conservation
preciable property this year (10% of $700). You         added to deductible soil and water conservation        expenses (except for deductions of assess­
can deduct the balance at the rate of $70 a year        expenses made in that year. The total of the           ments for depreciable property, discussed ear­
over the next 9 years.                                  2011 carryover plus 2012 expenses is deducti­          lier). However, if you acquire another farm and
    You add $70 to the $1,500 portion of the as­        ble in 2012, subject to the limit of 25% of your       return to the business of farming, you can start
sessment for drainage ditches. You can deduct           gross income from farming in 2012. Any expen­          taking deductions again for the unused carry­
$1,570 of the $2,400 assessment as a soil and           ses over the limit in that year are carried to 2013    overs.
water conservation expense this year, subject           and later years.
to the 25% of gross income from farming limit                                                                  Gain on sale of farmland. If you held the land
                                                            Net operating loss. The deduction for soil         5 years or less before you sold it, gain on the
on the deduction, discussed later.
                                                        and water conservation expenses, after apply­          sale of the land is treated as ordinary income up
    Example 2. Assume the same facts in Ex-             ing the 25% limit, is included when figuring a net     to the amount you previously deducted for soil
ample 1 except that $1,850 of the $2,400 as­            operating loss (NOL) for the year. If the NOL is       and water conservation expenses. If you held
sessment is for digging drainage ditches and            carried to another year, the soil and water con­       the land less than 10 but more than 5 years, the
$550 is for depreciable equipment. The total            servation deduction included in the NOL is not         gain is treated as ordinary income up to a speci­
amount assessed by the district against all its         subject to the 25% limit in the year to which it is    fied percentage of the previous deductions. See
members for depreciable equipment is $5,500.            carried.                                               Section 1252 property under Other Gains in
The total amount you can deduct for the depre­                                                                 chapter 9.
ciable equipment is limited to 10% of this
amount, or $550.                                        When to Deduct or Capitalize
    The maximum amount you can deduct this
year for the depreciable equipment is $555              If you choose to deduct soil and water conser­
(10% of your deductible share of the total as­          vation expenses, you must deduct the total al­
sessment, $55, plus $500). Since your deducti­          lowable amount on your tax return for the first
ble share is less than the maximum amount de­
ductible in one year, you can deduct the entire
                                                        year you pay or incur these expenses. If you do
                                                        not choose to deduct the expenses, you must
                                                                                                               6.
$550 this year. You can deduct the entire as­           capitalize them.
sessment, $2,400, as a soil and water conser­
vation expense this year, subject to the 25% of         Change of method. If you want to change
                                                        your method for the treatment of soil and water
                                                                                                               Basis of Assets
gross income from farming limit on the deduc­
tion, discussed below.                                  conservation expenses, or you want to treat the
                                                        expenses for a particular project or a single
Sale or other disposal of land during 9-year            farm in a different manner, you must get the ap­       Introduction
period. If you dispose of the land during the           proval of the IRS. To get this approval, submit a
                                                                                                               Your basis is the amount of your investment in
9­year period for deducting conservation ex­            written request by the due date of your return
                                                                                                               property for tax purposes. Use basis to figure
penses subject to the yearly limit, any amounts         for the first tax year you want the new method to
                                                                                                               the gain or loss on the sale, exchange, or other
you have not yet deducted because of this limit         apply. You or your authorized representative
                                                                                                               disposition of property. Also use basis to figure
are added to the basis of the property.                 must sign the request.
                                                                                                               depreciation, amortization, depletion, and casu­
                                                            The request must include the following infor­
                                                                                                               alty losses. If you use property for both busi­
Death of farmer during 9-year period. If a              mation.
                                                                                                               ness or investment purposes and for personal
farmer dies during the 9­year period, any re­                 Your name and address.
                                                                                                               purposes, you must allocate the basis based on
maining amounts not yet deducted are deduc­                  The first tax year the method or change of        the use. Only the basis allocated to the busi­
ted in the year of death.                                    method is to apply.                               ness or investment use of the property can be
                                                             Whether the method or change of method            depreciated.
                                                             applies to all your soil and water conserva­          Your original basis in property is adjusted
25% Limit on Deduction                                       tion expenses or only to those for a particu­     (increased or decreased) by certain events. For
                                                             lar project or farm. If the method or change      example, if you make improvements to the
The total deduction for conservation expenses                of method does not apply to all your ex­          property, increase your basis. If you take de­
in any tax year is limited to 25% of your gross              penses, identify the project or farm to           ductions for depreciation, or casualty losses, or
income from farming for the year.                            which the expenses apply.                         claim certain credits, reduce your basis.
                                                             The total expenses you paid or incurred in
Gross income from farming. Gross income                      the first tax year the method or change of
from farming is the income you derive in the                 method is to apply.

Page 30       Chapter 6      Basis of Assets
         Keep accurate records of all items that       basis between the land and improvements. Al­              In addition, if you use your own employees,
         affect the basis of your assets. For in­      locate the cost basis according to the respec­        farm materials, and equipment to build an as­
RECORDS  formation on keeping records, see             tive fair market values (FMVs) of the land and        set, do not deduct the following expenses. You
chapter 1.                                             improvements at the time of purchase. Figure          must capitalize them (include them in the as­
                                                       the basis of each asset by multiplying the lump       set's basis).
                                                       sum by a fraction. The numerator is the FMV of              Employee wages paid for the construction
Topics                                                 that asset and the denominator is the FMV of                work, reduced by any employment credits
This chapter discusses:                                the whole property at the time of purchase.                 allowed.
                                                                                                                   Depreciation on equipment you own while
     Cost basis                                             Fair market value (FMV). FMV is the price
                                                                                                                   it is used in the construction.
                                                       at which property would change hands between
     Adjusted basis                                                                                                Operating and maintenance costs for
                                                       a willing buyer and a willing seller, neither hav­
                                                                                                                   equipment used in the construction.
     Basis other than cost                             ing to buy or sell, and both having reasonable
                                                                                                                   The cost of business supplies and materi­
                                                       knowledge of all necessary facts. Sales of simi­
                                                                                                                   als used in the construction.
                                                       lar property on or about the same date may help
Useful Items                                           in figuring the FMV of the property.                          Do not include the value of your own
You may want to see:
                                                                                                                !    labor, or any other labor you did not
                                                               If you are not certain of the FMV of the
                                                                                                                     pay for, in the basis of any property
                                                        TIP land and improvements, you can allo-
                                                                                                             CAUTION
  Publication                                                                                                you construct.
                                                               cate the basis according to their as-
     535 Business Expenses                             sessed values for real estate tax purposes.
     544 Sales and Other Dispositions of                                                                     Allocating the Basis
         Assets                                        Real estate taxes. If you pay real estate taxes
                                                       the seller owed on real property you bought,          In some instances, the rules for determining ba­
     551 Basis of Assets
                                                       and the seller did not reimburse you, treat those     sis apply to a group of assets acquired in the
     946 How To Depreciate Property                    taxes as part of your basis.                          same transaction or to property that consists of
                                                           If you reimburse the seller for taxes the
See chapter 16 for information about getting                                                                 separate items. To determine the basis of these
                                                       seller paid for you, you generally can deduct
publications and forms.                                                                                      assets or separate items, there must be an allo­
                                                       that amount as a tax expense. Whether or not
                                                                                                             cation of basis.
                                                       you reimburse the seller, do not include that
                                                       amount in the basis of your property.
Cost Basis                                                                                                   Group of assets acquired. If you buy multiple
                                                                                                             assets for a lump sum, allocate the amount you
                                                       Settlement costs. Your basis includes the set­
The basis of property you buy is usually its cost.                                                           pay among the assets. Use this allocation to fig­
                                                       tlement fees and closing costs for buying the
Cost is the amount you pay in cash, debt obli­                                                               ure your basis for depreciation and gain or loss
                                                       property. See Publication 551 for a detailed list
gations, other property, or services. Your cost                                                              on a later disposition of any of these assets.
                                                       of items you can and cannot include in basis.
includes amounts you pay for sales tax, freight,                                                             You and the seller may agree in the sales con­
                                                            Do not include fees and costs for getting a
installation, and testing. The basis of real estate                                                          tract to a specific allocation of the purchase
                                                       loan on the property. Also, do not include
and business assets will include other items,                                                                price among the assets. If this allocation is
                                                       amounts placed in escrow for the future pay­
discussed later. Basis generally does not in­                                                                based on the value of each asset and you and
                                                       ment of items such as taxes and insurance.
clude interest payments. However, see Carry-                                                                 the seller have adverse tax interests, the alloca­
ing charges and Capitalized interest in chap­          Points. If you pay points to get a loan (includ­      tion generally will be accepted.
ter 4 of Publication 535.                              ing a mortgage, second mortgage, or
                                                                                                             Farming business acquired. If you buy a
                                                       line­of­credit), do not add the points to the basis
    You also may have to capitalize (add to ba­                                                              group of assets that makes up a farming busi­
                                                       of the related property. You may be able to de­
sis) certain other costs related to buying or pro­                                                           ness, there are special rules you must use to al­
                                                       duct the points currently or over the term of the
ducing property. Under the uniform capitaliza­                                                               locate the purchase price among the assets.
                                                       loan. For more information about deducting
tion rules, discussed later, you may have to                                                                 Generally, reduce the purchase price by any
                                                       points, see Points in chapter 4 of Publication
capitalize direct costs and certain indirect costs                                                           cash received. Allocate the remaining purchase
                                                       535.
of producing property.                                                                                       price to the other business assets received in
                                                       Assumption of a mortgage. If you buy prop­            proportion to (but not more than) their FMV and
Loans with low or no interest. If you buy                                                                    in a certain order. See Trade or Business Ac-
                                                       erty and assume (or buy the property subject to)
property on a time­payment plan that charges                                                                 quired under Allocating the Basis in Publication
                                                       an existing mortgage, your basis includes the
little or no interest, the basis of your property is                                                         551 for more information.
                                                       amount you pay for the property plus the
your stated purchase price minus the amount
                                                       amount you owe on the mortgage.
considered to be unstated interest. You gener­                                                               Transplanted embryo. If you buy a cow that is
ally have unstated interest if your interest rate is      Example. If you buy a farm for $100,000            pregnant with a transplanted embryo, allocate
less than the applicable federal rate. See the         cash and assume a mortgage of $400,000, your          to the basis of the cow the part of the purchase
discussion of unstated interest in Publication         basis is $500,000.                                    price equal to the FMV of the cow without the
537, Installment Sales.                                                                                      implant. Allocate the rest of the purchase price
                                                       Constructing assets. If you build property or         to the basis of the calf. Neither the cost alloca­
Real Property                                          have assets built for you, your expenses for this     ted to the cow nor the cost allocated to the calf
                                                       construction are part of your basis. Some of          is deductible as a current business expense.
Real property, also called real estate, is land        these expenses include the following costs:
and generally anything built on, growing on, or            Land,                                             Uniform Capitalization Rules
attached to land.                                           Labor and materials,
   If you buy real property, certain fees and               Architect's fees,                                Under the uniform capitalization rules, you must
other expenses you pay are part of your cost                Building permit charges,                         include certain direct and indirect costs in the
basis in the property. Some of these expenses                                                                basis of property you produce or in your inven­
                                                            Payments to contractors,
are discussed next.                                                                                          tory costs, rather than claim them as a current
                                                            Payments for rental equipment, and               deduction. You recover these costs through de­
Lump sum purchase. If you buy improve­                      Inspection fees.                                 preciation, amortization, or cost of goods sold
ments, such as buildings, and the land on which                                                              when you use, sell, or otherwise dispose of the
they stand for a lump sum, allocate your cost                                                                property.

                                                                                                                    Chapter 6   Basis of Assets       Page 31
    Generally, you are subject to the uniform         planting, cultivation, maintenance, or develop­      Increases to Basis
capitalization rules if you do any of the follow­     ment of any citrus or almond grove (or any part
ing:                                                  thereof) within the first 4 years the trees were     Increase the basis of any property by all items
                                                      planted.                                             properly added to a capital account. These in­
  1. Produce real or tangible personal prop­
     erty, or                                                  If you elect not to use the uniform capi-   clude the cost of any improvements having a
                                                               talization rules, you must use the alter-   useful life of more than 1 year.
  2. Acquire property for resale. However, this          !     native depreciation system for all             The following costs increase the basis of
     rule does not apply to personal property if      CAUTION

     your average annual gross receipts for the       property used in any of your farming businesses      property.
     3­tax­year period ending with the year pre­      and placed in service in any tax year during             The cost of extending utility service lines to
     ceding the current tax year are $10 million      which the election is in effect.                         property.
     or less.                                                                                                  Legal fees, such as the cost of defending
                                                          Example. You grow trees that have a pre­             and perfecting title.
    You produce property if you construct, build,     productive period of more than 2 years. The              Legal fees for seeking a decrease in an as­
install, manufacture, develop, improve, or cre­       trees produce an annual crop. You are an indi­           sessment levied against property to pay for
ate the property.                                     vidual and the uniform capitalization rules apply        local improvements.
                                                      to your farming business. You must capitalize            Assessments for items such as paving
          You are not subject to the uniform
                                                      the direct costs and an allocable part of indirect       roads and building ditches that increase
 TIP      capitalization rules if the property is
                                                      costs incurred due to the production of the              the value of the property assessed. Do not
          produced for personal use.
                                                      trees. You are not required to capitalize the            deduct these expenses as taxes. How­
                                                      costs of producing the annual crop because its           ever, you can deduct as taxes amounts as­
    In a farming business, you produce property
                                                      preproductive period is 2 years or less.                 sessed for maintenance or repairs, or for
if you raise or grow any agricultural or horticul­
                                                                                                               meeting interest charges related to the im­
tural commodity, including plants and animals.
                                                      Preproductive period of more than 2 years.               provements.
Plants. A plant produced in a farming business        The preproductive period of plants grown in
                                                                                                               If you make additions or improvements to
includes the following items:                         commercial quantities in the United States is
                                                                                                           business property, depreciate the basis of each
     A fruit, nut, or other crop­bearing tree;        based on their nationwide weighted average
                                                                                                           addition or improvement as separate deprecia­
                                                      preproductive period. Plants producing the
     An ornamental tree;                                                                                   ble property using the rules that would apply to
                                                      crops or yields shown in Table 6­1 have a na­
     A vine;                                                                                               the original property if you had placed it in serv­
                                                      tionwide weighted average preproductive pe­
                                                                                                           ice at the same time you placed the addition or
     A bush;                                          riod of more than 2 years. Other plants (not
                                                                                                           improvement in service. See chapter 7.
                                                      shown in Table 6­1) may also have a nation­
     Sod; and
                                                      wide weighted average preproductive period of
     The crop or yield of a plant that will have                                                           Deducting vs. capitalizing costs. Do not add
                                                      more than 2 years.
     more than one crop or yield.                                                                          to your basis costs you can deduct as current
                                                                                                           expenses. For example, amounts paid for inci­
                                                      More information. For more information on
Animals. An animal produced in a farming                                                                   dental repairs or maintenance are deductible as
                                                      the uniform capitalization rules that apply to
business includes any stock, poultry or other                                                              business expenses and are not added to basis.
                                                      property produced in a farming business, see
bird, and fish or other sea life.                                                                          However, you can elect either to deduct or to
                                                      Regulations section 1.263A­4.
                                                                                                           capitalize certain other costs. See chapter 7 in
     The direct and indirect costs of producing                                                            Publication 535.
plants or animals include preparatory costs and
preproductive period costs. Preparatory costs
                                                      Adjusted Basis
include the acquisition costs of the seed, seed­
                                                                                                           Decreases to Basis
ling, plant, or animal. For plants, preproductive     Before figuring gain or loss on a sale, ex­
                                                      change, or other disposition of property or figur­   The following are some items that reduce the
period costs include the costs of items such as
                                                      ing allowable depreciation, depletion, or amorti­    basis of property.
irrigation, pruning, frost protection, spraying,
                                                      zation, you must usually make certain                     Section 179 deduction.
and harvesting. For animals, preproductive pe­
riod costs include the costs of items such as         adjustments (increases and decreases) to the              Deductions previously allowed or allowa­
feed, maintaining pasture or pen areas, breed­        cost of the property. The result is the adjusted          ble for amortization, depreciation, and de­
ing, veterinary services, and bedding.                basis of the property.                                    pletion.
                                                                                                                Alternative motor vehicle credit. See Form
Exceptions. In a farming business, the uniform                                                                  8910.
capitalization rules do not apply to:                                                                           Alternative fuel vehicle refueling property
                                                                                                                credit. See Form 8911.
  1. Any animal,
  2. Any plant with a preproductive period of 2
                                                      Table 6­1. Plants With a Preproductive Period of More Than 2 Years
     years or less, or                                 Plants producing the following crops or yields have a nationwide weighted average
  3. Any costs of replanting certain plants lost       preproductive period of more than 2 years.
     or damaged due to casualty.                             Almonds                Currants               Macadamia nuts              Persimmons
   Exceptions (1) and (2) do not apply to a cor­             Apples                 Dates                  Mangoes                     Pistachio nuts
poration, partnership, or tax shelter required to
use an accrual method of accounting. See Ac-                 Apricots               Figs                   Nectarines                  Plums
crual Method Required under Accounting Meth-                 Avocados               Grapefruit             Olives                      Pomegranates
ods in chapter 2.
   In addition, you can elect not to use the uni­            Blackberries           Grapes                 Oranges                     Prunes
form capitalization rules for plants with a prepro­          Blueberries            Guavas                 Papayas                     Raspberries
ductive period of more than 2 years. If you
make this election, special rules apply. This                Cherries               Kiwifruit              Peaches                     Tangelos
election cannot be made by a corporation, part­              Chestnuts              Kumquats               Pears                       Tangerines
nership, or tax shelter required to use an ac­
crual method of accounting. This election also               Coffee beans           Lemons                 Pecans                      Tangors
does not apply to any costs incurred for the                                        Limes                                              Walnuts

Page 32        Chapter 6   Basis of Assets
    Residential energy efficient property cred­     Easements. The amount you receive for grant­         be changing the use of your pickup truck that
    its. See Form 5695.                             ing an easement is usually considered to be          you originally purchased for your personal use
    Investment credit (part or all) taken.          proceeds from the sale of an interest in the real    to use in your farming business.
    Casualty and theft losses and insurance         property. It reduces the basis of the affected           If you later sell or dispose of this property,
    reimbursements.                                 part of the property. If the amount received is      the basis you use will depend on whether you
    Payments you receive for granting an            more than the basis of the part of the property      are figuring a gain or loss. The basis for figuring
    easement.                                       affected by the easement, reduce your basis in       a gain is your adjusted basis in the property
    Exclusion from income of subsidies for en­      that part to zero and treat the excess as a rec­     when you sell the property. Figure the basis for
    ergy conservation measures.                     ognized gain. See Easements and rights-of-way        a loss starting with the smaller of your adjusted
    Certain canceled debt excluded from in­         in chapter 3.                                        basis or the FMV of the property at the time of
    come.                                                                                                the change to business or rental use. Then
    Rebates from a manufacturer or seller.          Exclusion from income of subsidies for en-           make adjustments (increases and decreases)
                                                    ergy conservation measures. You can ex­              for the period after the change in the property's
    Patronage dividends received from a co­         clude from gross income any subsidy you re­          use, as discussed earlier under Adjusted Basis.
    operative association as a result of a pur­     ceived from a public utility company for the             The basis for depreciation is the lesser of:
    chase of property. See Patronage Divi-          purchase or installation of an energy conserva­            The FMV of the property on the date of the
    dends in chapter 3.                             tion measure for a dwelling unit. Reduce the ba­           change, or
    Gas­guzzler tax. See Form 6197.                 sis of the property by the excluded amount.                Your adjusted basis on the date of the
Some of these items are discussed next. For a                                                                  change.
                                                    Canceled debt excluded from income. If a
more detailed list of items that decrease basis,
                                                    debt you owe is canceled or forgiven, other          Property received for services. If you re­
see section 1016 of the Internal Revenue Code
                                                    than as a gift or bequest, you generally must in­    ceive property for services, include the proper­
and Publication 551.
                                                    clude the canceled amount in your gross in­          ty's FMV in income. The amount you include in
Depreciation and section 179 deduction.             come for tax purposes. A debt includes any in­       income becomes your basis. If the services
The adjustments you must make to the basis of       debtedness for which you are liable or which         were performed for a price agreed on before­
property if you take the section 179 deduction      attaches to property you hold.                       hand, it will be accepted as the FMV of the
or depreciate the property are explained next.          You can exclude your canceled debt from          property if there is no evidence to the contrary.
For more information on these deductions, see       income if the debt is any of the following.
chapter 7.                                            1. Debt canceled in a bankruptcy case or               Example. George Smith is an accountant
                                                         when you are insolvent.                         and also operates a farming business. George
    Section 179 deduction. If you take the                                                               agreed to do some accounting work for his
section 179 expense deduction for all or part of      2. Qualified farm debt.                            neighbor in exchange for a dairy cow. The ac­
the cost of qualifying business property, de­                                                            counting work and the cow are each worth
                                                      3. Qualified real property business debt (pro­
crease the basis of the property by the deduc­                                                           $1,500. George must include $1,500 in income
                                                         vided you are not a C corporation).
tion.                                                                                                    for his accounting services. George's basis in
                                                      4. Qualified principal residence indebted­         the cow is $1,500.
    Depreciation. Decrease the basis of prop­            ness.
erty by the depreciation you deducted or could
have deducted on your tax returns under the           5. Discharge of certain indebtedness of a          Taxable Exchanges
method of depreciation you chose. If you took            qualified individual because of Midwestern
less depreciation than you could have under the          disasters.
                                                                                                         A taxable exchange is one in which the gain is
method chosen, decrease the basis by the                                                                 taxable, or the loss is deductible. A taxable gain
                                                    If you exclude canceled debt described in (1) or
amount you could have taken under that                                                                   or deductible loss also is known as a recog­
                                                    (2), you may have to reduce the basis of your
method. If you did not take a depreciation de­                                                           nized gain or loss. A taxable exchange occurs
                                                    depreciable and nondepreciable property. If
duction, reduce the basis by the full amount of                                                          when you receive cash or get property that is
                                                    you exclude canceled debt described in (3),
the depreciation you could have taken.                                                                   not similar or related in use to the property ex­
                                                    you must only reduce the basis of your depreci­
    If you deducted more depreciation than you                                                           changed. If you receive property in exchange
                                                    able property by the excluded amount.
should have, decrease your basis by the                                                                  for other property in a taxable exchange, the
                                                        For more information about canceled debt in
amount you should have deducted plus the part                                                            basis of the property you receive is usually its
                                                    a bankruptcy case, see Publication 908, Bank­
of the excess depreciation you deducted that                                                             FMV at the time of the exchange.
                                                    ruptcy Tax Guide. For more information about
actually reduced your tax liability for any year.
                                                    insolvency and canceled debt that is qualified
    See chapter 7 for information on figuring the                                                            Example. You trade a tract of farmland with
                                                    farm debt or qualified principal residence in­
depreciation you should have claimed.                                                                    an adjusted basis of $3,000 for a tractor that
                                                    debtedness, see chapter 3. For more informa­
    In decreasing your basis for depreciation,                                                           has an FMV of $6,000. You must report a taxa­
                                                    tion about qualified real property business debt,
take into account the amount deducted on your                                                            ble gain of $3,000 for the land. The tractor has a
                                                    see Publication 334, Tax Guide for Small Busi­
tax returns as depreciation and any deprecia­                                                            basis of $6,000.
                                                    ness. For more information about canceled
tion you must capitalize under the uniform capi­
                                                    debt in Midwestern disaster areas, see Publica­
talization rules.
                                                    tion 4492­B, Information for Affected Taxpayers
                                                    in the Midwestern Disaster Areas.
                                                                                                         Involuntary Conversions
Casualty and theft losses. If you have a
casualty or theft loss, decrease the basis of the                                                        If you receive property as a result of an involun­
property by any insurance or other reimburse­
ment. Also, decrease it by any deductible loss
                                                    Basis Other Than Cost                                tary conversion, such as a casualty, theft, or
                                                                                                         condemnation, figure the basis of the replace­
not covered by insurance. See chapter 11 for                                                             ment property you receive using the basis of the
information about figuring your casualty or theft   There are times when you cannot use cost as
                                                                                                         converted property.
loss.                                               basis. In these situations, the fair market value
    You must increase your basis in the property    or the adjusted basis of property may be used.       Similar or related property. If the replace­
by the amount you spend on clean­up costs           Examples are discussed next.                         ment property is similar or related in service or
(such as debris removal) and repairs that re­                                                            use to the converted property, the replacement
store the property to its pre­casualty condition.   Property changed from personal to busi-
                                                                                                         property's basis is the same as the old proper­
To make this determination, compare the re­         ness or rental use. When you hold property
                                                                                                         ty's basis on the date of the conversion. How­
paired property to the property before the casu­    for personal use and then change it to business
                                                                                                         ever, make the following adjustments.
alty.                                               use or use it to produce rent, you must figure its
                                                    basis for depreciation. An example of changing         1. Decrease the basis by the following
                                                    property from personal to business use would              amounts.

                                                                                                              Chapter 6     Basis of Assets        Page 33
      a. Any loss you recognize on the invol­        same as the adjusted basis of the truck you             2. Increase the basis by the following
         untary conversion.                          traded.                                                    amounts.
      b. Any money you receive that you do                                                                        a. Any additional costs you incur.
                                                         Example 2. You trade a field cultivator (ad­
         not spend on similar property.
                                                     justed basis of $8,000) for a planter (FMV of                b. Any gain you recognize on the ex­
  2. Increase the basis by the following             $9,000). You use both the field cultivator and                  change.
     amounts.                                        the planter in your farming business. The basis
                                                     of the planter you receive is $8,000, the same        If the other party to the exchange assumes your
      a. Any gain you recognize on the invol­                                                              liabilities, treat the debt assumption as money
                                                     as the field cultivator traded
         untary conversion.                                                                                you received in the exchange.
      b. Any cost of acquiring the replacement       Exchange expenses. Exchange expenses
                                                     generally are the closing costs that you pay.             Example 1. You trade farmland (basis of
         property.
                                                     They include such items as brokerage commis­          $100,000) for another tract of farmland (FMV of
                                                                                                           $110,000) and $30,000 cash. You realize a gain
Money or property not similar or related. If         sions, attorney fees, and deed preparation fees.
                                                                                                           of $40,000. This is the FMV of the land received
you receive money or property not similar or re­     Add them to the basis of the like­kind property
                                                                                                           plus the cash minus the basis of the land you
lated in service or use to the converted property    you receive.
                                                                                                           traded ($110,000 + $30,000 − $100,000). In­
and you buy replacement property similar or re­
                                                     Property plus cash. If you trade property in a        clude your gain in income (recognize gain) only
lated in service or use to the converted prop­
                                                     like­kind exchange and also pay money, the ba­        to the extent of the cash received. Your basis in
erty, the basis of the replacement property is its
                                                                                                           the land you received is figured as follows.
cost decreased by the gain not recognized on         sis of the property you receive is the adjusted
the involuntary conversion.                          basis of the property you gave up plus the
                                                     money you paid.                                           Basis of land traded . . . . . . . . . . . .$100,000
Allocating the basis. If you buy more than                                                                     Minus: Cash received (adjustment
one piece of replacement property, allocate              Example. You trade in a truck (adjusted ba­           1(a)) . . . . . . . . . . . . . . . . . . . . . . . . . − 30,000
your basis among the properties based on their       sis of $3,000) for another truck (FMV of $7,500)                                                                  $70,000
respective costs.                                    and pay $4,000. Your basis in the new truck is            Plus: Gain recognized (adjustment
                                                     $7,000 (the $3,000 adjusted basis of the old              2(b)) . . . . . . . . . . . . . . . . . . . . . . . . . + 30,000
Basis for depreciation. Special rules apply in       truck plus the $4,000 cash).                              Basis of land received             . . . . . . . . .$100,000
determining and depreciating the basis of
MACRS property acquired in an involuntary            Special rules for related persons. If a
                                                                                                               Example 2. You trade a truck (adjusted ba­
conversion. For information, see Figuring the        like­kind exchange takes place directly or indi­
                                                                                                           sis of $22,750) for another truck (FMV of
Deduction for Property Acquired in a Nontaxa-        rectly between related persons and either party
                                                                                                           $20,000) and $10,000 cash. You realize a gain
ble Exchange under Figuring Depreciation Un-         disposes of the property within 2 years after the
                                                                                                           of $7,250. This is the FMV of the truck received
der MACRS in chapter 7.                              exchange, the exchange no longer qualifies for
                                                                                                           plus the cash minus the adjusted basis of the
                                                     like­kind exchange treatment. Each person
   For more information about involuntary con­                                                             truck you traded ($20,000 + $10,000 −
                                                     must report any gain or loss not recognized on
versions, see chapter 11.                                                                                  $22,750). You include all the gain in your in­
                                                     the original exchange unless the loss is not de­
                                                                                                           come (recognize gain) because the gain is less
                                                     ductible under the related party rules. Each per­
                                                                                                           than the cash you received. Your basis in the
Nontaxable Exchanges                                 son reports it on the tax return filed for the year
                                                                                                           truck you received is figured as follows.
                                                     in which the later disposition occurred. If this
A nontaxable exchange is an exchange in              rule applies, the basis of the property received
                                                     in the original exchange will be its FMV. For             Adjusted basis of truck traded . . . . $22,750
which you are not taxed on any gain and you                                                                    Minus: Cash received (adjustment
cannot deduct any loss. A nontaxable gain or         more information, see chapter 8.
                                                                                                               1(a)) . . . . . . . . . . . . . . . . . . . . . . . . . −10,000
loss also is known as an unrecognized gain or                                                                                                                          $12,750
                                                     Exchange of business property. Exchanging
loss. If you receive property in a nontaxable ex­                                                              Plus: Gain recognized (adjustment
                                                     the property of one business for the property of
change, its basis is usually the same as the ba­                                                               2(b)) . . . . . . . . . . . . . . . . . . . . . . . . . + 7,250
                                                     another business generally is a multiple prop­
sis of the property you transferred.                                                                           Basis of truck received . . . . . . . . $20,000
                                                     erty exchange. For information on figuring ba­
                                                     sis, see Multiple Property Exchanges in chap­
Like-Kind Exchanges                                  ter 1 of Publication 544.                             Allocation of basis. If you receive like­kind
The exchange of property for the same kind of                                                              and unlike properties in the exchange, allocate
                                                     Basis for depreciation. Special rules apply in        the basis first to the unlike property, other than
property is the most common type of nontaxa­         determining and depreciating the basis of
ble exchange.                                                                                              money, up to its FMV on the date of the ex­
                                                     MACRS property acquired in a like­kind trans­         change. The rest is the basis of the like­kind
                                                     action. For information, see Figuring the Deduc-      property.
    For an exchange to qualify as a like­kind ex­    tion for Property Acquired in a Nontaxable Ex-
change, you must hold for business or invest­        change under Figuring Depreciation Under                  Example. You traded a tractor with an ad­
ment purposes both the property you transfer         MACRS in chapter 7.                                   justed basis of $15,000 for another tractor that
and the property you receive. There must also
                                                                                                           had an FMV of $12,500. You also received
be an exchange of like­kind property. For more
information, see Like-Kind Exchanges in
                                                     Partially Nontaxable Exchanges                        $1,000 cash and a truck that had an FMV of
                                                                                                           $3,000. The truck is unlike property. You real­
chapter 8.
                                                     A partially nontaxable exchange is an exchange        ized a gain of $1,500. This is the FMV of the
                                                     in which you receive unlike property or money         tractor received plus the FMV of the truck re­
    The basis of the property you receive gener­     in addition to like­kind property. The basis of the   ceived plus the cash minus the adjusted basis
ally is the same as the adjusted basis of the        property you receive is the same as the adjus­        of the tractor you traded ($12,500 + $3,000 +
property you gave up.                                ted basis of the property you gave up with the        $1,000 − $15,000). You include in income (rec­
                                                     following adjustments.                                ognize) all $1,500 of the gain because it is less
    Example 1. You traded a truck you used in                                                              than the FMV of the unlike property plus the
your farming business for a new smaller truck to       1. Decrease the basis by the following
                                                                                                           cash received. Your basis in the properties you
use in farming. The adjusted basis of the old             amounts.                                         received is figured as follows.
truck was $10,000. The FMV of the new truck is
                                                           a. Any money you receive.
$30,000. Because this is a nontaxable ex­
change, you do not recognize any gain, and                 b. Any loss you recognize on the ex­
your basis in the new truck is $10,000, the                   change.

Page 34      Chapter 6     Basis of Assets
    Adjusted basis of old tractor . . . . .                 .   $15,000                    Net increase in value of the gift                       basis ($100,000), you would get a $10,000 loss.
    Minus: Cash received (adjustment                                                              Amount of the gift                               If you then tried to figure a loss using the FMV
    1(a)) . . . . . . . . . . . . . . . . . . . . . . . .   .   − 1,000                                                                            ($80,000), you would get a $10,000 gain.
                                                                $14,000       The net increase in value of the gift is the
                                                                                                                                                       Business property. If you hold the gift as
    Plus: Gain recognized (adjustment                                     FMV of the gift minus the donor's adjusted ba­
                                                                                                                                                   business property, your basis for figuring any
    2(b)) . . . . . . . . . . . . . . . . . . . . . . . .   .   + 1,500   sis. The amount of the gift is its value for gift tax
                                                                                                                                                   depreciation, depletion, or amortization deduc­
    Total basis of properties                                             purposes after reduction by any annual exclu­
                                                                                                                                                   tions is the same as the donor's adjusted basis
    received . . . . . . . . . . . . . . . . . . . .        .   $15,500   sion and marital or charitable deduction that ap­
                                                                                                                                                   plus or minus any required adjustments to basis
                                                                          plies to the gift. For information on the gift tax,
                                                                                                                                                   while you hold the property.
Allocate the total basis of $15,500 first to the                          see Publication 950, Introduction to Estate and
unlike property—the truck ($3,000). This is the                           Gift Taxes.
truck's FMV. The rest ($12,500) is the basis of                                                                                                    Property Transferred
the tractor.                                                                 Example. In 2012, you received a gift of                              From a Spouse
                                                                          property from your mother that had an FMV of
                                                                          $50,000. Her adjusted basis was $20,000. The                             The basis of property transferred to you or
Sale and Purchase                                                         amount of the gift for gift tax purposes was                             transferred in trust for your benefit by your
If you sell property and buy similar property in                          $37,000 ($50,000 minus the $13,000 annual                                spouse is the same as your spouse's adjusted
two mutually dependent transactions, you may                              exclusion). She paid a gift tax of $7,540. Your                          basis. The same rule applies to a transfer by
have to treat the sale and purchase as a single                           basis, $26,107, is figured as follows.                                   your former spouse if the transfer is incident to
nontaxable exchange.                                                                                                                               divorce. However, for property transferred in
                                                                           Fair market value   . .      . . . . . . . . . . . . . . .   $50,000    trust, adjust your basis for any gain recognized
    Example. You used a tractor on your farm                               Minus: Adjusted basis         . . . . . . . . . . . . . .    −20,000    by your spouse or former spouse if the liabilities
for 3 years. Its adjusted basis is $22,000 and its                         Net increase in value       . . . . . . . . . . . . . . .    $30,000    assumed plus the liabilities to which the prop­
FMV is $40,000. You are interested in a new                                Gift tax paid . . . . . . . . . . . . . .   . . . . . . .     $7,540    erty is subject are more than the adjusted basis
tractor, which sells for $60,000. Ordinarily, you                          Multiplied by ($30,000 ÷ $37,000)             . . . . . .       × .81   of the property transferred.
would trade your old tractor for the new one and                           Gift tax due to net increase in value . . . . .               $6,107
                                                                                                                                                      The transferor must give you the records
pay the dealer $20,000. Your basis for depreci­                            Adjusted basis of property to your
                                                                                                                                                   needed to determine the adjusted basis and
                                                                             mother . . . . . . . . . . . . . . . . . . . . . . .       +20,000
ating the new tractor would then be $42,000                                                                                                        holding period of the property as of the date of
                                                                           Your basis in the property . . . . . . . . . .               $26,107
($20,000 + $22,000, the adjusted basis of your                                                                                                     the transfer.
old tractor). However, you want a higher basis
for depreciating the new tractor, so you agree to                                                                                                     For more information, see Property Settle-
                                                                              Note. If you received a gift before 1977,
pay the dealer $60,000 for the new tractor if he                                                                                                   ments in Publication 504, Divorced or Separa­
                                                                          your basis in the gift (the donor's adjusted ba­
will pay you $40,000 for your old tractor. Be­                                                                                                     ted Individuals.
                                                                          sis) includes any gift tax paid on it. However,
cause the two transactions are dependent on                               your basis cannot exceed the FMV of the gift
each other, you are treated as having ex­                                 when it was given to you.                                                Inherited Property
changed your old tractor for the new one and
paid $20,000 ($60,000 − $40,000). Your basis                              FMV less than donor's adjusted basis. If the                             If you inherited property from a decedent who
for depreciating the new tractor is $42,000, the                          FMV of the property at the time of the gift is less                      died before January 1, 2010, your basis in prop­
same as if you traded the old tractor.                                    than the donor's adjusted basis, your basis de­                          erty you inherit from a decedent is generally
                                                                          pends on whether you have a gain or a loss                               one of the following:
Property Received                                                         when you dispose of the property. Your basis                                  The FMV of the property at the date of the
                                                                          for figuring gain is the donor's adjusted basis                               decedent's death. If a federal estate return
as a Gift                                                                 plus or minus any required adjustments to basis                               is filed, you can use its appraised value.
                                                                          while you held the property. Your basis for figur­                            The FMV on the alternate valuation date, if
To figure the basis of property you receive as a
                                                                          ing loss is its FMV when you received the gift                                the personal representative for the estate
gift, you must know its adjusted basis (defined
                                                                          plus or minus any required adjustments to basis                               elects to use alternate valuation. For infor­
earlier) to the donor just before it was given to
                                                                          while you held the property. (See Adjusted Ba-                                mation on the alternate valuation, see the
you. You also must know its FMV at the time it
                                                                          sis, earlier.)                                                                Instructions for Form 706.
was given to you and any gift tax paid on it.
                                                                               If you use the donor's adjusted basis for fig­                           The decedent's adjusted basis in land to
                                                                          uring a gain and get a loss, and then use the                                 the extent of the value that is excluded
FMV equal to or greater than donor's adjus-
                                                                          FMV for figuring a loss and get a gain, you have                              from the decedent's taxable estate as a
ted basis. If the FMV of the property is equal
                                                                          neither gain nor loss on the sale or other dispo­                             qualified conservation easement.
to or greater than the donor's adjusted basis,
your basis is the donor's adjusted basis when                             sition of the property.                                                      If a federal estate tax return does not have
you received the gift. Increase your basis by all                                                                                                  to be filed, your basis in the inherited property is
or part of any gift tax paid, depending on the                                Example. You received farmland as a gift                             its appraised value at the date of death for state
date of the gift.                                                         from your parents when they retired from farm­                           inheritance or transmission taxes.
    Also, for figuring gain or loss from a sale or                        ing. At the time of the gift, the land had an FMV
other disposition of the property, or for figuring                        of $80,000. Your parents' adjusted basis was                             Special-use valuation method. Under certain
depreciation, depletion, or amortization deduc­                           $100,000. After you received the land, no                                conditions, when a person dies, the executor or
tions on business property, you must increase                             events occurred that would increase or de­                               personal representative of that person's estate
or decrease your basis (the donor's adjusted                              crease your basis.                                                       may elect to value qualified real property at
basis) by any required adjustments to basis                                   If you sell the land for $120,000, you will                          other than its FMV. If so, the executor or per­
while you held the property. See Adjusted Ba-                             have a $20,000 gain because you must use the                             sonal representative values the qualified real
sis, earlier.                                                             donor's adjusted basis at the time of the gift                           property based on its use as a farm or other
    If you received a gift during the tax year, in­                       ($100,000) as your basis to figure a gain. If you                        closely held business. If the executor or per­
crease your basis in the gift (the donor's adjus­                         sell the land for $70,000, you will have a                               sonal representative elects this method of valu­
ted basis) by the part of the gift tax paid on it                         $10,000 loss because you must use the FMV at                             ation for estate tax purposes, this value is the
due to the net increase in value of the gift. Fig­                        the time of the gift ($80,000) as your basis to                          basis of the property for the qualified heirs. The
ure the increase by multiplying the gift tax paid                         figure a loss.                                                           qualified heirs should be able to get the neces­
by the following fraction.                                                    If the sales price is between $80,000 and                            sary value from the executor or personal repre­
                                                                          $100,000, you have neither gain nor loss. For                            sentative of the estate.
                                                                          instance, if the sales price was $90,000 and you                             If you are a qualified heir who received spe­
                                                                          tried to figure a gain using the donor's adjusted                        cial­use valuation property, increase your basis

                                                                                                                                                        Chapter 6     Basis of Assets        Page 35
by any gain recognized by the estate or trust         partner cannot be more than the adjusted basis      534, Depreciating Property Placed in Service
because of post­death appreciation. Post­death        of his or her interest in the partnership reduced   Before 1987.
appreciation is the property's FMV on the date        by any money received in the same transaction.
of distribution minus the property's FMV either       For more information, see Partner's Basis for       Topics
on the date of the individual's death or on the al­   Distributed Property in Publication 541, Partner­   This chapter discusses:
ternate valuation date. Figure all FMVs without       ships.
regard to the special­use valuation.
    You may be liable for an additional estate        Shareholder's basis. The basis of property               Overview of depreciation
tax if, within 10 years after the death of the de­    distributed by a corporation to a shareholder is         Section 179 expense deduction
cedent, you transfer the property or the property     its fair market value. For more information about        Special depreciation allowance
stops being used as a farm. This tax does not         corporate distributions, see Distributions to
                                                                                                               Modified Accelerated Cost Recovery
apply if you dispose of the property in a             Shareholders in Publication 542, Corporations.
                                                                                                               System (MACRS)
like­kind exchange or in an involuntary conver­
                                                                                                               Listed property
sion in which all of the proceeds are reinvested
in qualified replacement property. The tax also                                                                Basic information on cost depletion
does not apply if you transfer the property to a                                                               (including timber depletion) and
member of your family and certain requirements                                                                 percentage depletion
are met.                                                                                                       Amortization of the costs of going into
    You can elect to increase your basis in spe­
cial­use valuation property if it becomes subject
                                                      7.                                                       business, reforestation costs, the costs of
                                                                                                               pollution control facilities, and the costs of
to the additional estate tax. To increase your                                                                 section 197 intangibles
basis, you must make an irrevocable election
and pay interest on the additional estate tax fig­    Depreciation,                                       Useful Items
ured from the date 9 months after the dece­                                                               You may want to see:
dent's death until the date of payment of the ad­
ditional estate tax. If you meet these
                                                      Depletion, and                                        Publication
requirements, increase your basis in the prop­
erty to its FMV on the date of the decedent's
death or the alternate valuation date. The in­
                                                      Amortization                                             463 Travel, Entertainment, Gift, and Car
                                                                                                                   Expenses
crease in your basis is considered to have oc­
                                                                                                               534 Depreciating Property Placed in
curred immediately before the event that resul­
ted in the additional estate tax.                     What's New for 2012                                          Service Before 1987
    You make the election by filing, with Form                                                                 535 Business Expenses
706­A, United States Additional Estate Tax Re­        Decreased section 179 expense deduction
turn, a statement that:                                                                                        544 Sales and Other Dispositions of
                                                      dollar limits. The maximum amount you can
      Contains your (and the estate's) name, ad­                                                                   Assets
                                                      elect to deduct for most section 179 property
      dress, and taxpayer identification number;      you placed in service in 2012 is $139,000. This          551 Basis of Assets
      Identifies the election as an election under    limit is reduced by the amount by which the cost
      section 1016(c) of the Internal Revenue         of the property placed in service during the tax         946 How To Depreciate Property
      Code;                                           year exceeds $560,000. See Dollar Limits un­
      Specifies the property for which you are        der Section 179 Expense Deduction, later.             Form (and Instructions)
      making the election; and
                                                      Expiration of special depreciation allow-                T    (Timber), Forest Activities Schedule
      Provides any additional information re­
                                                      ance for certain qualified property acquired
      quired by the Form 706­A instructions.                                                                   3115 Application for Change in
                                                      after September 8, 2010. The 100% special
    For more information, see Form 706, United        depreciation allowance will only apply to certain            Accounting Method
States Estate (and Generation­Skipping Trans­         property with a long production period and cer­          4562 Depreciation and Amortization
fer) Tax Return, Form 706­A, and the related in­      tain aircraft placed in service before January 1,
structions.                                           2013. See Claiming the Special Depreciation              4797 Sales of Business Property
                                                      Allowance, later.
Property inherited from a decedent who                                                                    See chapter 16 for information about getting
                                                      Expiration of special depreciation allow-           publications and forms.
died in 2010. If you inherited property from a
                                                      ance for certain qualified property acquired
decedent who died in 2010, different rules may                                                                      It is important to keep good records for
                                                      after December 31, 2007. The 50% special
apply. See Publication 4895, Tax Treatment of                                                                       property you depreciate. Do not file
                                                      depreciation allowance for certain qualified
Property Acquired From a Decendent Dying in                                                                         these records with your return. In­
                                                      property acquired after December 31, 2007, will     RECORDS
2010, for details.                                                                                        stead, you should keep them as part of the per­
                                                      expire for most property placed in service after
                                                      December 31, 2012. See Claiming the Special         manent records of the depreciated property.
Property Distributed From a                           Depreciation Allowance, later.                      They will help you verify the accuracy of the de­
Partnership or Corporation                                                                                preciation of assets placed in service in the cur­
                                                                                                          rent and previous tax years. For general infor­
                                                                                                          mation on recordkeeping, see Publication 583,
The following rules apply to determine a part­
ner's basis and a shareholder's basis in prop­
                                                      Introduction                                        Starting a Business and Keeping Records. For
                                                      If you buy or make improvements to farm prop­       specific information on keeping records for sec­
erty distributed respectively from a partnership
                                                      erty such as machinery, equipment, livestock,       tion 179 property and listed property, see Publi­
to the partner with respect to the partner's inter­
                                                      or a structure with a useful life of more than a    cation 946, How To Depreciate Property.
est in the partnership and from a corporation to
the shareholder with respect to the sharehold­        year, you generally cannot deduct its entire cost
er's ownership of stock in the corporation.           in one year. Instead, you must spread the cost
                                                      over the time you use the property and deduct       Overview of Depreciation
Partner's basis. Unless there is a complete           part of it each year. For most types of property,
liquidation of a partner's interest, the basis of     this is called depreciation.                        This overview discusses basic information on
property (other than money) distributed by a              This chapter gives information on deprecia­     the following.
partnership to the partner is its adjusted basis to   tion methods that generally apply to property            What property can be depreciated.
the partnership immediately before the distribu­      placed in service after 1986. For information on
tion. However, the basis of the property to the       depreciating pre­1987 property, see Publication          What property cannot be depreciated.

Page 36      Chapter 7     Depreciation, Depletion, and Amortization
    When depreciation begins and ends.              (investment use), the income must be taxable.              land generally includes the cost of clear­
    Whether MACRS can be used to figure de­         You cannot depreciate property that you use                ing, grading, planting, and landscaping. Al­
    preciation.                                     solely for personal activities. However, if you            though you cannot depreciate land, you
    What is the basis of your depreciable prop­     use property for business or investment purpo­             can depreciate certain costs incurred in
    erty.                                           ses and for personal purposes, you can deduct              preparing land for business use. See chap­
    How to treat repairs and improvements.          depreciation based only on the percentage of               ter 1 of Publication 946.
                                                    business or investment use.                                Property placed in service and disposed of
    When you must file Form 4562.                                                                              in the same year. Determining when prop­
    How you can correct depreciation claimed            Example 1. If you use your car for farm                erty is placed in service is explained later.
    incorrectly.                                    business, you can deduct depreciation based                Equipment used to build capital improve­
                                                    on its percentage of use in farming. If you also           ments. You must add otherwise allowable
                                                    use it for investment purposes, you can depre­
What Property Can Be                                ciate it based on its percentage of investment
                                                                                                               depreciation on the equipment during the
                                                                                                               period of construction to the basis of your
Depreciated?                                        use.                                                       improvements.
                                                        Example 2. If you use part of your home for            Intangible property such as section 197 in­
You can depreciate most types of tangible prop­                                                                tangibles. This property does not have a
                                                    business, you may be able to deduct deprecia­
erty (except land), such as buildings, machi­                                                                  determinable useful life and generally can­
                                                    tion on that part based on its business use. For
nery, equipment, vehicles, certain livestock,                                                                  not be depreciated. However, see Amorti-
                                                    more information, see Business Use of Your
and furniture. You can also depreciate certain                                                                 zation, later. Special rules apply to com­
                                                    Home in chapter 4.
intangible property, such as copyrights, patents,                                                              puter software (discussed below).
and computer software. To be depreciable, the       Inventory. You can never depreciate inventory              Certain term interests (discussed below).
property must meet all the following require­       because it is not held for use in your business.
ments.                                              Inventory is any property you hold primarily for      Computer software. Computer software is
     It must be property you own.                   sale to customers in the ordinary course of your      generally not a section 197 intangible even if
    It must be used in your business or in­         business.                                             acquired in connection with the acquisition of a
    come­producing activity.                                                                              business, if it meets all of the following tests.
    It must have a determinable useful life.            Livestock. Livestock purchased for draft,              It is readily available for purchase by the
                                                    breeding, or dairy purposes can be depreciated             general public.
    It must have a useful life that extends sub­    only if they are not kept in an inventory account.
    stantially beyond the year you place it in                                                                 It is subject to a nonexclusive license.
                                                    Livestock you raise usually has no depreciable
    service.                                        basis because the costs of raising them are de­            It has not been substantially modified.
                                                    ducted and not added to their basis. However,
                                                                                                              If the software meets the tests above, it can
Property You Own                                    see Immature livestock under When Does De-
                                                                                                          be depreciated and may qualify for the section
                                                    preciation Begin and End, later, for a special
                                                                                                          179 expense deduction and the special depre­
To claim depreciation, you usually must be the      rule.
                                                                                                          ciation allowance (if applicable), discussed
owner of the property. You are considered as
                                                                                                          later.
owning property even if it is subject to a debt.
                                                    Property Having a Determinable
Leased property. You can depreciate leased
                                                    Useful Life                                           Certain term interests in property. You can­
                                                                                                          not depreciate a term interest in property cre­
property only if you retain the incidents of own­
                                                    To be depreciable, your property must have a          ated or acquired after July 27, 1989, for any pe­
ership in the property. This means you bear the
                                                    determinable useful life. This means it must be       riod during which the remainder interest is held,
burden of exhaustion of the capital investment
                                                    something that wears out, decays, gets used           directly or indirectly, by a person related to you.
in the property. Therefore, if you lease property
                                                    up, becomes obsolete, or loses its value from         This rule does not apply to the holder of a term
from someone to use in your trade or business
                                                    natural causes.                                       interest in property acquired by gift, bequest, or
or for the production of income, you generally
                                                                                                          inheritance. For more information, see chap­
cannot depreciate its cost because you do not       Irrigation systems and water wells. Irriga­           ter 1 of Publication 946.
retain the incidents of ownership. You can,         tion systems and wells used in a trade or busi­
however, depreciate any capital improvements        ness can be depreciated if their useful life can
you make to the leased property. See Additions      be determined. You can depreciate irrigation          When Does Depreciation
and Improvements under Which Recovery Pe-           systems and wells composed of masonry, con­           Begin and End?
riod Applies in chapter 4 of Publication 946.       crete, tile, metal, or wood. In addition, you can
    If you lease property to someone, you gen­      depreciate costs for moving dirt to construct irri­   You begin to depreciate your property when
erally can depreciate its cost even if the lessee   gation systems and water wells composed of            you place it in service for use in your trade or
(the person leasing from you) has agreed to         these materials. However, land preparation            business or for the production of income. You
preserve, replace, renew, and maintain the          costs for center pivot irrigation systems are not     stop depreciating property either when you
property. However, you cannot depreciate the        depreciable.                                          have fully recovered your cost or other basis or
cost of the property if the lease provides that                                                           when you retire it from service, whichever hap­
the lessee is to maintain the property and return   Dams, ponds, and terraces. In general, you            pens first.
to you the same property or its equivalent in       cannot depreciate earthen dams, ponds, and
value at the expiration of the lease in as good     terraces unless the structures have a determi­
condition and value as when leased.
                                                                                                          Placed in Service
                                                    nable useful life.
                                                                                                          Property is placed in service when it is ready
Life tenant. Generally, if you hold business or
investment property as a life tenant, you can       What Property Cannot Be                               and available for a specific use, whether in a
                                                                                                          business activity, an income­producing activity,
depreciate it as if you were the absolute owner     Depreciated?                                          a tax­exempt activity, or a personal activity.
of the property. See Certain term interests in
                                                                                                          Even if you are not using the property, it is in
property, later, for an exception.                  Certain property cannot be depreciated, even if
                                                                                                          service when it is ready and available for its
                                                    the requirements explained earlier are met. This
                                                                                                          specific use.
Property Used in Your Business or                   includes the following.
Income-Producing Activity                                Land. You can never depreciate the cost of           Example. You bought a planter for use in
                                                         land because land does not wear out, be­         your farm business. The planter was delivered
To claim depreciation on property, you must              come obsolete, or get used up. The cost of       in December 2011 after harvest was over. You
use it in your business or income­producing ac­
tivity. If you use property to produce income

                                                                                 Chapter 7     Depreciation, Depletion, and Amortization            Page 37
begin to depreciate the planter for 2011 be­               You transfer the property to a supplies or         If you deduct more depreciation than you
cause it was ready and available for its specific          scrap account.                                  should, you must reduce your basis by any
use in 2011, even though it will not be used until         The property is destroyed.                      amount deducted from which you received a tax
the spring of 2012.                                                                                        benefit (the depreciation allowed).
    If your planter comes unassembled in De­              For information on abandonment of prop­             For more information, see chapter 6.
cember 2011 and is put together in February           erty, see chapter 8. For information on de­
2012, it is not placed in service until 2012. You
begin to depreciate it in 2012.
                                                      stroyed property, see chapter 11 and Publica­        How Do You Treat Repairs
                                                      tion 547, Casualties, Disasters, and Thefts.
    If your planter was delivered and assembled                                                            and Improvements?
in February 2012 but not used until April 2012, it
is placed in service in February 2012, because        Can You Use MACRS To                                 You generally deduct the cost of repairing busi­
this is when the planter was ready for its speci­     Depreciate Your Property?                            ness property in the same way as any other
fied use. You begin to depreciate it in 2012.                                                              business expense. However, if a repair or re­
                                                      You must use the Modified Accelerated Cost           placement increases the value of your property,
Fruit or nut trees and vines. If you acquire an       Recovery System (MACRS) to depreciate most           makes it more useful, or lengthens its life, you
orchard, grove, or vineyard before the trees or       business and investment property placed in           must treat it as an improvement and depreciate
vines have reached the income­producing               service after 1986. MACRS is explained later         it. Treat improvements as separate depreciable
stage, and they have a preproductive period of        under Figuring Depreciation Under MACRS.             property. See chapter 1 of Publication 946 for
more than 2 years, you must capitalize the pre­           You cannot use MACRS to depreciate the           more information.
productive­period costs under the uniform capi­       following property.
talization rules (unless you elect not to use                                                                  Example. You repair a small section on a
                                                           Property you placed in service before
these rules). See chapter 6 for information                1987. Use the methods discussed in Publi­       corner of the roof of a barn that you rent to oth­
about the uniform capitalization rules. Your de­           cation 534.                                     ers. You deduct the cost of the repair as a busi­
preciation begins when the trees and vines                 Certain property owned or used in 1986.         ness expense. However, if you replace the en­
reach the income­producing stage (that is,                 See chapter 1 of Publication 946.               tire roof, the new roof is considered to be an
when they bear fruit, nuts, or grapes in quanti­           Intangible property.                            improvement because it increases the value
ties sufficient to commercially warrant harvest­                                                           and lengthens the life for the property. You de­
ing).                                                      Films, video tapes, and recordings.             preciate the cost of the new roof.
                                                           Certain corporate or partnership property
Immature livestock. Depreciation for live­                 acquired in a nontaxable transfer.              Improvements to rented property. You can
stock begins when the livestock reaches the                Property you elected to exclude from            depreciate permanent improvements you make
age of maturity. If you bought immature live­              MACRS.                                          to business property you rent from someone
stock for drafting purposes, depreciation begins                                                           else.
                                                          For more information, see chapter 1 of Pub­
when they can be worked. If you bought imma­          lication 946.
ture livestock for dairy purposes, depreciation
begins when they can be milked. If you bought
                                                                                                           Do You Have To File
immature livestock for breeding purposes, de­         What Is the Basis of Your                            Form 4562?
preciation begins when they can be bred. Your         Depreciable Property?
basis for depreciation is your initial cost for the                                                        Use Form 4562 to claim your deduction for de­
immature livestock.                                   To figure your depreciation deduction, you must      preciation and amortization. You must complete
                                                      determine the basis of your property. To deter­      and attach Form 4562 to your tax return if you
                                                      mine basis, you need to know the cost or other       are claiming any of the following.
Idle Property
                                                      basis of your property.                                   A section 179 expense deduction for the
Continue to claim a deduction for depreciation                                                                  current year or a section 179 carryover
on property used in your business or for the pro­     Cost or other basis. The basis of property                from a prior year.
duction of income even if it is temporarily idle.     you buy is usually its cost plus amounts you              Depreciation for property placed in service
For example, if you stop using a machine be­          paid for items such as sales tax, freight                 during the current year.
cause there is a temporary lack of a market for       charges, and installation and testing fees. The           Depreciation on any vehicle or other listed
a product made with that machine, continue to         cost includes the amount you pay in cash, debt            property, regardless of when it was placed
deduct depreciation on the machine.                   obligations, other property, or services.                 in service.
                                                          There are times when you cannot use cost              Amortization of costs that began in the cur­
                                                      as basis. In these situations, the fair market            rent year.
Cost or Other Basis Fully                             value (FMV) or the adjusted basis of the prop­
Recovered                                             erty may be used.                                        For more information, see the Instructions
                                                                                                           for Form 4562.
You stop depreciating property when you have          Adjusted basis. To find your property's basis
fully recovered your cost or other basis. This
happens when your section 179 and allowed or
                                                      for depreciation, you may have to make certain       How Do You Correct
                                                      adjustments (increases and decreases) to the
allowable depreciation deductions equal your          basis of the property for events occurring be­       Depreciation Deductions?
cost or investment in the property.                   tween the time you acquired the property and
                                                      the time you placed it in service.                   If you deducted an incorrect amount of depreci­
Retired From Service                                                                                       ation in any year, you may be able to make a
                                                      Basis adjustment for depreciation allowed            correction by filing an amended return for that
You stop depreciating property when you retire        or allowable. After you place your property in       year. You can file an amended return to correct
it from service, even if you have not fully recov­    service, you must reduce the basis of the prop­      the amount of depreciation claimed for any
ered its cost or other basis. You retire property     erty by the depreciation allowed or allowable,       property in any of the following situations.
from service when you permanently withdraw it         whichever is greater. Depreciation allowed is             You claimed the incorrect amount because
from use in a trade or business or from use in        depreciation you actually deducted (from which            of a mathematical error made in any year.
the production of income because of any of the        you received a tax benefit). Depreciation allow­          You claimed the incorrect amount because
following events.                                     able is depreciation you are entitled to deduct.          of a posting error made in any year, for ex­
      You sell or exchange the property.                  If you do not claim depreciation you are enti­        ample, omitting an asset from the depreci­
     You convert the property to personal use.        tled to deduct, you must still reduce the basis of        ation schedule.
                                                      the property by the full amount of depreciation           You have not adopted a method of ac­
     You abandon the property.                        allowable.                                                counting for the property placed in service

Page 38      Chapter 7     Depreciation, Depletion, and Amortization
     by you in tax years ending after December           4. Storage facilities (except buildings and              Use of structure. A structure must be used
     29, 2003.                                              their structural components) used in con­         only for the purpose that qualified it. For exam­
     You claimed the incorrect amount on prop­              nection with distributing petroleum or any        ple, a hog barn will not be qualifying property if
     erty placed in service by you in tax years             primary product of petroleum.                     you use it to house poultry. Similarly, using part
     ending before December 30, 2003.                                                                         of your greenhouse to sell plants will make the
                                                         5. Off­the­shelf computer software that is
                                                                                                              greenhouse nonqualifying property.
    Note. You have adopted a method of ac­                  readily available for purchase by the gen­
                                                                                                                  If a structure includes work space, the work
counting if you used the same incorrect method              eral public, is subject to a nonexclusive
                                                                                                              space can be used only for the following activi­
of depreciation for two or more consecutively               lease, and has not been substantially
                                                                                                              ties.
filed returns.                                              modified.
                                                                                                                    Stocking, caring for, or collecting livestock
                                                                                                                    or plants or their produce.
    If you are not allowed to make the correction      Tangible personal property. Tangible per­
                                                                                                                    Maintaining the enclosure or structure.
on an amended return, you may be able to               sonal property is any tangible property that is
change your accounting method to claim the             not real property. It includes the following prop­          Maintaining or replacing the equipment or
correct amount of depreciation. See the Instruc­       erty.                                                       stock enclosed or housed in the structure.
tions for Form 3115.                                         Machinery and equipment.
                                                            Property contained in or attached to a            Property Acquired by Purchase
                                                            building (other than structural compo­
Section 179 Expense                                         nents), such as milk tanks, automatic feed­       To qualify for the section 179 expense deduc­
                                                                                                              tion, your property must have been acquired by
Deduction                                                   ers, barn cleaners, and office equipment.
                                                                                                              purchase. For example, property acquired by
                                                            Gasoline storage tanks and pumps at retail
                                                            service stations.                                 gift or inheritance does not qualify. Property ac­
You can elect to recover all or part of the cost of                                                           quired from a related person (that is, your
certain qualifying property, up to a limit, by de­          Livestock, including horses, cattle, hogs,
                                                            sheep, goats, and mink and other fur­bear­        spouse, ancestors, or lineal descendants) is not
ducting it in the year you place the property in                                                              considered acquired by purchase.
service. This is the section 179 expense deduc­             ing animals.
tion. You can elect the section 179 expense de­                                                                   Example. Ken is a farmer. He purchased
duction instead of recovering the cost by taking       Facility used for the bulk storage of fungi-
                                                       ble commodities. A facility used for the bulk          two tractors, one from his brother and one from
depreciation deductions.                                                                                      his father. He placed both tractors in service in
                                                       storage of fungible commodities is qualifying
    This part of the chapter explains the rules for    property for purposes of the section 179 ex­           the same year he bought them. The tractor pur­
the section 179 expense deduction. It explains         pense deduction if it is used in connection with       chased from his father does not qualify for the
what property qualifies for the deduction, what        any of the activities listed earlier in item (3)(a).   section 179 expense deduction because he is a
property does not qualify for the deduction, the       Bulk storage means the storage of a commodity          related person (as defined above). The tractor
limits that may apply, how to elect the deduc­         in a large mass before it is used.                     purchased from his brother does qualify for the
tion, and when you may have to recapture the                                                                  deduction because Ken is not a related person
deduction.                                                 Grain bins. A grain bin is an example of a         (as defined above).
                                                       storage facility that is qualifying section 179
    For more information, see chapter 2 of Pub­
lication 946.
                                                       property. It is a facility used in connection with
                                                       the production of grain or livestock for the bulk
                                                                                                              What Property Does Not
                                                       storage of fungible commodities.                       Qualify?
What Property Qualifies?                                                                                      Land and improvements. Land and land im­
                                                       Single purpose agricultural or horticultural
                                                       structures. A single purpose agricultural (live­       provements, do not qualify as section 179 prop­
To qualify for the section 179 expense deduc­
                                                       stock) or horticultural structure is qualifying        erty. Land improvements include nonagricul­
tion, your property must meet all the following
                                                       property for purposes of the section 179 ex­           tural fences, swimming pools, paved parking
requirements.
                                                       pense deduction.                                       areas, wharves, docks, bridges, and fences.
      It must be eligible property.
                                                                                                              However, agricultural fences do qualify as sec­
     It must be acquired for business use.                 Agricultural structure. A single purpose           tion 179 property. Similarly, field drainage tile
     It must have been acquired by purchase.           agricultural (livestock) structure is any building     also qualifies as section 179 property.
                                                       or enclosure specifically designed, constructed,
                                                       and used for both the following reasons.               Excepted property. Even if the requirements
Eligible Property                                           To house, raise, and feed a particular type       explained in the preceding discussions are met,
                                                            of livestock and its produce.                     farmers cannot elect the section 179 expense
To qualify for the section 179 expense deduc­               To house the equipment, including any re­         deduction for the following property.
tion, your property must be one of the following            placements, needed to house, raise, or                 Certain property you lease to others (if you
types of depreciable property.                              feed the livestock.                                    are a noncorporate lessor).
  1. Tangible personal property.                                                                                   Certain property used predominantly to fur­
                                                       For this purpose, livestock includes poultry.
                                                                                                                   nish lodging or in connection with the fur­
  2. Other tangible property (except buildings            Single purpose structures are qualifying
                                                                                                                   nishing of lodging.
     and their structural components) used as:         property if used, for example, to breed chickens
                                                                                                                   Property used by a tax­exempt organiza­
                                                       or hogs, produce milk from dairy cattle, or pro­
      a. An integral part of manufacturing, pro­                                                                   tion (other than a tax­exempt farmers' co­
                                                       duce feeder cattle or pigs, broiler chickens, or
         duction, or extraction or of furnishing                                                                   operative) unless the property is used
                                                       eggs. The facility must include, as an integral
         transportation, communications, elec­                                                                     mainly in a taxable unrelated trade or busi­
                                                       part of the structure or enclosure, equipment
         tricity, gas, water, or sewage disposal                                                                   ness.
                                                       necessary to house, raise, and feed the live­
         services;                                                                                                 Property used by governmental units or
                                                       stock.
                                                                                                                   foreign persons or entities (except property
      b. A research facility used in connection                                                                    used under a lease with a term of less than
                                                          Horticultural structure. A single purpose
         with any of the activities in (a) above;                                                                  6 months).
                                                       horticultural structure is either of the following.
         or
                                                            A greenhouse specifically designed, con­
      c. A facility used in connection with any             structed, and used for the commercial pro­        How Much Can You Deduct?
         of the activities in (a) for the bulk stor­        duction of plants.
         age of fungible commodities.                       A structure specifically designed, construc­
                                                                                                              Your section 179 expense deduction is gener­
                                                            ted, and used for the commercial produc­
  3. Single purpose agricultural (livestock) or                                                               ally the cost of the qualifying property. How­
                                                            tion of mushrooms.
     horticultural structures.                                                                                ever, the total amount you can elect to deduct

                                                                                    Chapter 7      Depreciation, Depletion, and Amortization            Page 39
under section 179 is subject to a dollar limit and        Example. This year, James Smith placed in           net income or loss derived from a trade or busi­
a business income limit. These limits apply to        service machinery costing $610,000. Because             ness also includes the following items.
each taxpayer, not to each business. However,         this cost is $50,000 more than $560,000, he                  Section 1231 gains (or losses) as dis­
see Married individuals under Dollar Limits,          must reduce his dollar limit to $89,000                      cussed in chapter 9.
later. See also the special rules for applying the    ($139,000 − $50,000).                                        Interest from working capital of your trade
limits for partnerships and S corporations under                                                                   or business.
Partnerships and S Corporations, later.               Limits for sport utility vehicles. The total                 Wages, salaries, tips, or other pay earned
                                                      amount you can elect to deduct for certain sport             by you (or your spouse if you file a joint re­
    If you deduct only part of the cost of qualify­   utility vehicles and certain other vehicles placed           turn) as an employee of any employer.
ing property as a section 179 expense deduc­          in service in 2012 is $25,000. This rule applies
                                                                                                                 In addition, figure taxable income without re­
tion, you can generally depreciate the cost you       to any 4­wheeled vehicle primarily designed or
                                                                                                              gard to any of the following.
do not deduct.                                        used to carry passengers over public streets,
                                                                                                                   The section 179 expense deduction.
                                                      roads, and highways that is rated at more than
    Use Part I of Form 4562 to figure your sec­       6,000 pounds gross vehicle weight and not                    The self­employment tax deduction.
tion 179 expense deduction.                           more than 14,000 pounds gross vehicle weight.                Any net operating loss carryback or carry­
                                                           For more information, see chapter 2 of Pub­             forward.
Partial business use. When you use property           lication 946.                                                Any unreimbursed employee business ex­
for business and nonbusiness purposes, you                                                                         penses.
can elect the section 179 expense deduction           Limits for passenger automobiles. For a
only if you use it more than 50% for business in      passenger automobile that is placed in service          Two different taxable income limits. In addi­
the year you place it in service. If you used the     in 2012, the total section 179 and depreciation         tion to the business income limit for your section
property more than 50% for business, multiply         deduction is limited. See Do the Passenger Au-          179 expense deduction, you may have a taxa­
the cost of the property by the percentage of         tomobile Limits Apply, later.                           ble income limit for some other deduction (for
business use. Use the resulting business cost                                                                 example, charitable contributions). You may
to figure your section 179 expense deduction.         Married individuals. If you are married, how            have to figure the limit for this other deduction
                                                      you figure your section 179 expense deduction           taking into account the section 179 expense de­
Trade-in of other property. If you buy qualify­       depends on whether you file jointly or sepa­            duction. If so, complete the following steps.
ing property with cash and a trade­in, its cost for   rately. If you file a joint return, you and your
purposes of the section 179 expense deduction         spouse are treated as one taxpayer in determin­               Step                   Action
includes only the cash you paid. For example, if      ing any reduction to the dollar limit, regardless
you buy (for cash and a trade­in) a new tractor                                                                      1        Figure taxable income without
                                                      of which of you purchased the property or
for use in your business, your cost for the sec­                                                                              the section 179 expense
                                                      placed it in service. If you and your spouse file
tion 179 expense deduction is the cash you                                                                                    deduction or the other
                                                      separate returns, you are treated as one tax­
                                                                                                                              deduction.
paid. It does not include the adjusted basis of       payer for the dollar limit, including the reduction
the old tractor you trade for the new tractor.        for costs over $560,000. You must allocate the                 2        Figure a hypothetical section
                                                      dollar limit (after any reduction) equally between                      179 expense deduction using
    Example. J­Bar Farms traded two cultiva­          you, unless you both elect a different allocation.                      the taxable income figured in
tors having a total adjusted basis of $6,800 for a    If the percentages elected by each of you do                            Step 1.
new cultivator costing $13,200. They received         not total 100%, 50% will be allocated to each of               3        Subtract the hypothetical
an $8,000 trade­in allowance for the old cultiva­     you.                                                                    section 179 expense deduction
tors and paid $5,200 cash for the new cultivator.                                                                             figured in Step 2 from the
J­Bar also traded a used pickup truck with an             Joint return after separate returns. If you
                                                                                                                              taxable income figured in Step 1.
adjusted basis of $8,000 for a new pickup truck       and your spouse elect to amend your separate
costing $15,000. They received a $5,000               returns by filing a joint return after the due date            4        Figure a hypothetical amount for
trade­in allowance and paid $10,000 cash for          for filing your return, the dollar limit on the joint                   the other deduction using the
the new pickup truck.                                 return is the lesser of the following amounts.                          amount figured in Step 3 as
    Only the cash paid by J­Bar qualifies for the            The dollar limit (after reduction for any cost                   taxable income.
section 179 expense deduction. J­Bar's busi­                 of section 179 property over $560,000).                 5        Subtract the hypothetical other
ness costs that qualify for a section 179 ex­                The total cost of section 179 property you                       deduction figured in Step 4 from
pense deduction are $15,200 ($5,200 +                        and your spouse elected to expense on                            the taxable income figured in
$10,000).                                                    your separate returns.                                           Step 1.
                                                                                                                     6        Figure your actual section 179
Dollar Limits                                         Business Income Limit                                                   expense deduction using the
                                                                                                                              taxable income figured in Step 5.
The total amount you can elect to deduct under        The total cost you can deduct each year after
                                                      you apply the dollar limit is limited to the taxable           7        Subtract your actual section 179
section 179 for most property placed in service                                                                               expense deduction figured in
in 2012 is $139,000. If you acquire and place in      income from the active conduct of any trade or
                                                      business during the year. Generally, you are                            Step 6 from the taxable income
service more than one item of qualifying prop­                                                                                figured in Step 1.
erty during the year, you can allocate the sec­       considered to actively conduct a trade or busi­
tion 179 expense deduction among the items in         ness if you meaningfully participate in the man­               8        Figure your actual other
any way, as long as the total deduction is not        agement or operations of the trade or business.                         deduction using the taxable
more than $139,000.                                                                                                           income figured in Step 7.
                                                          Any cost not deductible in one year under
Reduced dollar limit for cost exceeding               section 179 because of this limit can be carried            Example. On February 1, 2012, the XYZ
$560,000. If the cost of your qualifying section      to the next year. See Carryover of disallowed           farm corporation purchased and placed in serv­
179 property placed in service in 2012 is over        deduction, later.                                       ice qualifying section 179 property that cost
$560,000, you must reduce the dollar limit (but                                                               $139,000. It elects to expense the entire
not below zero) by the amount of cost over            Taxable income. In general, figure taxable in­          $139,000 cost under section 179. In June, the
$560,000. If the cost of your section 179 prop­       come for this purpose by totaling the net in­           corporation gave a charitable contribution of
erty placed in service during 2012 is $560,000        come and losses from all trades and busi­               $10,000. A corporation's limit on charitable con­
or more, you cannot take a section 179 ex­            nesses you actively conducted during the year.          tributions is figured after subtracting any section
pense deduction and you cannot carry over the         In addition to net income or loss from a sole           179 expense deduction. The business income
cost that is more than $560,000.                      proprietorship, partnership, or S corporation,          limit for the section 179 expense deduction is

Page 40      Chapter 7     Depreciation, Depletion, and Amortization
figured after subtracting any allowable charita­        expense deduction subject to the limits. It then       return must also include any resulting adjust­
ble contributions. XYZ's taxable income figured         allocates the deduction among its partners or          ments to taxable income (for example, allowa­
without the section 179 expense deduction or            shareholders.                                          ble depreciation in that tax year for the item of
the deduction for charitable contributions is                                                                  section 179 property for which the election per­
$159,000. XYZ figures its section 179 expense                If you are a partner in a partnership or share­   tains.) Once made, the revocation is irrevoca­
deduction and its deduction for charitable con­         holder of an S corporation, you add the amount         ble.
tributions as follows.                                  allocated from the partnership or S corporation
     Step 1. Taxable income figured without ei­         to any section 179 costs not related to the part­      When Must You Recapture
                                                        nership or S corporation and then apply the dol­
     ther deduction is $159,000.
                                                        lar limit to this total. To determine any reduction
                                                                                                               the Deduction?
     Step 2. Using $159,000 as taxable in­
     come, XYZ's hypothetical section 179 ex­           in the dollar limit for costs over $560,000, you
                                                                                                               You may have to recapture the section 179 ex­
     pense deduction is $139,000.                       do not include any of the cost of section 179
                                                                                                               pense deduction if, in any year during the prop­
     Step 3. $20,000 ($159,000 − $139,000).             property placed in service by the partnership or
                                                                                                               erty's recovery period, the percentage of busi­
     Step 4. Using $20,000 (from Step 3) as             S corporation. After you apply the dollar limit,
                                                                                                               ness use drops to 50% or less. In the year the
     taxable income, XYZ's hypothetical charita­        you apply the business income limit to any re­
                                                                                                               business use drops to 50% or less, you include
     ble contribution (limited to 10% of taxable        maining section 179 costs. For more informa­
                                                                                                               the recapture amount as ordinary income. You
     income) is $2,000.                                 tion, see chapter 2 of Publication 946.
                                                                                                               also increase the basis of the property by the
     Step 5. $157,000 ($159,000 − $2,000).                                                                     recapture amount. Recovery periods for prop­
     Step 6. Using $157,000 (from Step 5) as                Example. In 2012, Partnership P placed in
                                                                                                               erty are discussed later.
     taxable income, XYZ figures the actual             service section 179 property with a total cost of
     section 179 expense deduction. Because             $580,000. P must reduce its dollar limit by                      If you sell, exchange, or otherwise dis-
     the taxable income is at least $139,000,           $20,000 ($580,000 − $560,000). Its maximum                       pose of the property, do not figure the
     XYZ can take a $139,000 section 179 ex­            section 179 expense deduction is $119,000
                                                                                                                  !
                                                                                                                CAUTION  recapture amount under the rules ex-
     pense deduction.                                   ($139,000 − $20,000), and it elects to expense         plained in this discussion. Instead, use the rules
     Step 7. $20,000 ($159,000 − $139,000).             that amount. Because P's taxable income from           for recapturing depreciation explained in
     Step 8. Using $20,000 (from Step 7) as             the active conduct of all its trades or businesses     chapter 9 under Section 1245 Property.
     taxable income, XYZ's actual charitable            for the year was $400,000, it can deduct the full
     contribution (limited to 10% of taxable in­        $119,000. P allocates $100,000 of its section
     come) is $2,000.                                   179 expense deduction and $110,000 of its tax­                  If the property is listed property, do not
                                                        able income to John, one of its partners.                       figure the recapture amount under the
Carryover of disallowed deduction. You can                  John also conducts a business as a sole
                                                                                                                  !
                                                                                                                CAUTION rules explained in this discussion
carry over for an unlimited number of years the         proprietor and in 2012, placed in service in that      when the percentage of business use drops to
cost of any section 179 property you elected to         business, section 179 property costing                 50% or less. Instead, use the rules for recaptur-
expense but were unable to because of the               $28,000. John's taxable income from that busi­         ing depreciation explained in chapter 5 of Publi-
business income limit.                                  ness was $10,000. In addition to the $100,000          cation 946 under Recapture of Excess Depreci­
    The amount you carry over is used in deter­         allocated from P, he elects to expense the             ation.
mining your section 179 expense deduction in            $28,000 of his sole proprietorship's section 179
the next year. However, it is subject to the limits     costs. However, John's deduction is limited to
                                                                                                               Figuring the recapture amount. To figure the
in that year. If you place more than one property       his business taxable income of $120,000
                                                                                                               amount to recapture, take the following steps.
in service in a year, you can select the proper­        ($110,000 from P plus $10,000 from his sole
ties for which all or a part of the cost will be car­   proprietorship). He carries over $8,000                  1. Figure the allowable depreciation for the
ried forward. Your selections must be shown in          ($128,000 − $120,000) of the elected section                section 179 expense deduction you
your books and records.                                 179 costs to 2013.                                          claimed. Begin with the year you placed
                                                                                                                    the property in service and include the
                                                                                                                    year of recapture.
    Example. Last year, Joyce Jones placed in           How Do You Elect the
service a machine that cost $8,000 and elected
to deduct all $8,000 under section 179. The tax­
                                                        Deduction?                                               2. Subtract the depreciation figured in (1)
                                                                                                                    from the section 179 expense deduction
able income from her business (determined                                                                           you actually claimed. The result is the
without regard to both a section 179 expense            You elect to take the section 179 expense de­
                                                                                                                    amount you must recapture.
deduction for the cost of the machine and the           duction by completing Part I of Form 4562.
self­employment tax deduction) was $6,000.                        If you elect the deduction for listed            Example. In January 2010, Paul Lamb, a
Her section 179 expense deduction was limited                     property, complete Part V of                 calendar year taxpayer, bought and placed in
to $6,000. The $2,000 cost that was not allowed            !
                                                        CAUTION   Form 4562 before completing Part I.          service section 179 property costing $10,000.
as a section 179 expense deduction (because                                                                    The property is not listed property. He elected a
of the business income limit) is carried to this                                                               $5,000 section 179 expense deduction for the
year.                                                      File Form 4562 with either of the following:        property and also elected not to claim a special
    This year, Joyce placed another machine in              Your original tax return (whether or not you       depreciation allowance. He used the property
service that cost $9,000. Her taxable income                filed it timely), or                               only for business in 2010 and 2011. During
from business (determined without regard to                 An amended return filed within the time            2012, he used the property 40% for business
both a section 179 expense deduction for the                prescribed by law. An election made on an          and 60% for personal use. He figures his recap­
cost of the machine and the self­employment                 amended return must specify the item of            ture amount as follows.
tax deduction) is $10,000. Joyce can deduct                 section 179 property to which the election
the full cost of the machine ($9,000) but only              applies and the part of the cost of each            Section 179 expense deduction claimed
$1,000 of the carryover from last year because              such item to be taken into account. The             (2010) . . . . . . . . . . . . . . . . . . . . . . .   . . . .    $5,000
of the business income limit. She can carry over            amended return must also include any re­            Minus: Allowable depreciation
the balance of $1,000 to next year.                         sulting adjustments to taxable income.              (instead of section 179 expense deduction):
                                                                                                                2010 . . . . . . . . . . . . . . . . . . . . . . $1,250
Partnerships and S Corporations                         Revoking an election. An election (or any               2011 . . . . . . . . . . . . . . . . . . . . . . 1,875
                                                                                                                2012 ($1,250 × 40% (business)) . . .                500            3,625
                                                        specification made in the election) to take a
The section 179 expense deduction limits apply          section 179 expense deduction for 2012 can be           2012 — Recapture amount                 . . . . . . . . . . .     $1,375
both to the partnership or S corporation and to         revoked without IRS approval by filing an amen­
each partner or shareholder. The partnership or         ded return. The amended return must be filed
S corporation determines its section 179                within the time prescribed by law. The amended

                                                                                     Chapter 7      Depreciation, Depletion, and Amortization                                    Page 41
   Paul must include $1,375 in income for                  System (MACRS) with a recovery period of      System (GDS) and the Alternative Depreciation
2012.                                                      20 years or less.                             System (ADS). Generally, these systems pro­
                                                           Water utility property.                       vide different methods and recovery periods to
Where to report recapture. Report any re­                  Off­the­shelf computer software.              use in figuring depreciation deductions.
capture of the section 179 expense deduction
as ordinary income in Part IV of Form 4797 and             Qualified leasehold improvement property.             To be sure you can use MACRS to fig-
include it in income on Schedule F (Form 1040).                                                             !    ure depreciation for your property, see
                                                        Qualified property must also meet all of the     CAUTION Can You Use MACRS To Depreciate
                                                    following tests:                                     Your Property, earlier.
Recapture for qualified section 179 GO                   You must have acquired qualified property
Zone property. If any qualified section 179              by purchase after December 31, 2007. If a
GO Zone property ceases to be used in the GO                                                                 This part explains how to determine which
                                                         binding contract to acquire the property ex­
Zone in a later year, you must recapture the                                                             MACRS depreciation system applies to your
                                                         isted before January 1, 2008, the property
benefit of the increased section 179 expense                                                             property. It also discusses the following infor­
                                                         does not qualify.
deduction as “other income.”                                                                             mation that you need to know before you can
                                                         Qualified property must be placed in serv­
                                                                                                         figure depreciation under MACRS.
                                                         ice after December 31, 2007 and placed in
                                                                                                              Property's recovery class.
                                                         service before January 1, 2013 (before
Claiming the Special                                     January 1, 2014 for certain property with a            Placed­in­service date.
Depreciation Allowance                                   long production period and for certain air­            Basis for depreciation.
                                                         craft).                                                Recovery period.
For qualified property (defined below) placed in         The original use of the property must begin
                                                         with you after December 31, 2007.                      Convention.
service in 2012, you can take an additional 50%
(or 100%, if applicable) special depreciation al­                                                               Depreciation method.
lowance. The allowance is an additional deduc­      How Can You Elect Not To                             Finally, this part explains how to use this infor­
tion you can take after any section 179 expense     Claim the Allowance?                                 mation to figure your depreciation deduction.
deduction and before you figure regular depre­
ciation under MACRS. Figure the special de­
preciation allowance by multiplying the depreci­
                                                    You can elect, for any class of property, not to
                                                    deduct the special depreciation allowance for
                                                                                                         Which Depreciation System
able basis of the qualified property by 50% (or     all property in such class placed in service dur­    (GDS or ADS) Applies?
100%, if applicable).                               ing the tax year. To make the election, attach a
                                                    statement to your return indicating the class of     Your use of either the General Depreciation
What is Qualified Property?                         property for which you are making the election.      System (GDS) or the Alternative Depreciation
                                                                                                         System (ADS) to depreciate property under
                                                        Generally, you must make the election on a       MACRS determines what depreciation method
For farmers, qualified property generally is cer­   timely filed tax return (including extensions) for   and recovery period you use. You generally
tain qualified property acquired after September    the year in which you place the property in serv­    must use GDS unless you are specifically re­
8, 2010, and certain qualified property acquired    ice. However, if you timely filed your return for    quired by law to use ADS or you elect to use
after December 31, 2007, and placed in service      the year without making the election, you still      ADS.
before January 1, 2013.                             can make the election by filing an amended re­
                                                    turn within 6 months of the due date of the origi­   Required use of ADS. You must use ADS for
Certain qualified property acquired after           nal return (not including extensions). Attach the    the following property.
September 8, 2010. Certain qualified property       election statement to the amended return. On              All property used predominantly in a farm­
acquired after September 8, 2010, is eligible for   the amended return, write “Filed pursuant to              ing business and placed in service in any
a 100% special depreciation allowance.              section 301.9100­2.”                                      tax year during which an election not to ap­
   Qualified property includes the following:
                                                       Once made, the election may not be re­                 ply the uniform capitalization rules to cer­
    Certain property with a long production pe­
                                                    voked without IRS consent.                                tain farming costs is in effect.
    riod.
                                                                                                              Listed property used 50% or less in a
    Certain aircraft.                                       If you elect not to have the special de-          qualified business use. See Additional
   Qualified property must also meet the fol­          !    preciation allowance apply, the prop-             Rules for Listed Property, later.
lowing requirements.                                CAUTION erty may be subject to an alternative             Any tax­exempt use property.
     The property must be acquired by pur­          minimum tax adjustment for depreciation.
                                                                                                                Any tax­exempt bond­financed property.
     chase after September 8, 2010. If a bind­                                                                  Any property imported from a foreign coun­
     ing contract to acquire the property existed
     before September 9, 2010, the property
                                                    When Must You Recapture                                     try for which an Executive Order is in effect
     does not qualify.                              an Allowance                                                because the country maintains trade re­
                                                                                                                strictions or engages in other discrimina­
     The property must be placed in service be­                                                                 tory acts.
     fore January 1, 2013.                          When you dispose of property for which you
                                                    claimed a special depreciation allowance, any               Any tangible property used predominantly
     The original use of the property must begin                                                                outside the United States during the year.
     with you after September 8, 2010.              gain on the disposition is generally recaptured
                                                    (included in income) as ordinary income up to                   If you are required to use ADS to de-
For more information, see chapter 3 of Publica­     the amount of the special depreciation allow­
tion 946 and Revenue Procedure 2011­26,                                                                     !       preciate your property, you cannot
                                                    ance previously allowed or allowable. For more                  claim the special depreciation allow-
2011­16 I.R.B. 664, available at                    information, see chapter 3 of Publication 946.
                                                                                                         CAUTION

www.irs.gov/irb/2011-16_IRB/ar10.html.                                                                   ance.

Certain qualified property acquired after
December 31, 2007, and placed in service
                                                    Figuring Depreciation Under                          Electing ADS. Although your property may
                                                                                                         qualify for GDS, you can elect to use ADS. The
before January 1, 2013. Certain qualified           MACRS                                                election generally must cover all property in the
property (defined below) acquired after Decem­                                                           same property class you placed in service dur­
ber 31, 2007, and before January 1, 2013, is eli­   The Modified Accelerated Cost Recovery Sys­          ing the year. However, the election for residen­
gible for a 50% special depreciation allowance.     tem (MACRS) is used to recover the basis of          tial rental property and nonresidential real prop­
    Qualified property includes the following:      most business and investment property placed         erty can be made on a property­by­property
     Tangible property depreciated under the        in service after 1986. MACRS consists of two         basis. Once you make this election, you can
     Modified Accelerated Cost Recovery             depreciation systems, the General Depreciation       never revoke it.

Page 42      Chapter 7    Depreciation, Depletion, and Amortization
    You make the election by completing line 20                                        What Is the                                                            Any deduction for removal of barriers to
in Part III of Form 4562.                                                                                                                                     the disabled and the elderly.
                                                                                       Placed-in-Service Date?                                                Any disabled access credit, enhanced oil
                                                                                                                                                              recovery credit, and credit for em­
Which Property Class                                                                   You begin to claim depreciation when your
                                                                                                                                                              ployer­provided childcare facilities and
Applies Under GDS?                                                                     property is placed in service for use either in a
                                                                                                                                                              services.
                                                                                       trade or business or for the production of in­
                                                                                                                                                              Any special depreciation allowance.
The following is a list of the nine property                                           come. The placed­in­service date for your prop­
                                                                                       erty is the date the property is ready and availa­                     Basis adjustment for investment credit
classes under GDS.
                                                                                       ble for a specific use. It is therefore not                            property under section 50(c) of the Internal
     1. 3­year property.                                                               necessarily the date it is first used. If you con­                     Revenue Code.
     2. 5­year property.                                                               verted property held for personal use to use in a                 For information about how to determine the cost
                                                                                       trade or business or for the production of in­                    or other basis of property, see What Is the Basis
     3. 7­year property.                                                               come, treat the property as being placed in                       of Your Depreciable Property, earlier. Also, see
     4. 10­year property.                                                              service on the conversion date. See Placed in                     chapter 6.
                                                                                       Service under When Does Depreciation Begin
     5. 15­year property.                                                              and End, earlier, for examples illustrating when                      For additional credits and deductions that
     6. 20­year property.                                                              property is placed in service.                                    affect basis, see section 1016 of the Internal
                                                                                                                                                         Revenue Code.
     7. 25­year property.
                                                                                       What Is the Basis for
     8. Residential rental property.
                                                                                       Depreciation?                                                     Which Recovery Period
     9. Nonresidential real property.                                                                                                                    Applies?
                                                                                       The basis for depreciation of MACRS property
See Which Property Class Applies Under GDS                                             is the property's cost or other basis multiplied                  The recovery period of property is the number
in chapter 4 of Publication 946 for examples of                                        by the percentage of business/investment use.                     of years over which you recover its cost or other
the types of property included in each class.                                          Reduce that amount by any credits and deduc­                      basis. It is determined based on the deprecia­
                                                                                       tions allocable to the property. The following are                tion system (GDS or ADS) used. See Table 7­1
                                                                                       examples of some of the credits and deductions                    for recovery periods under both GDS and ADS
                                                                                       that reduce basis.                                                for some commonly used assets. For a com­
                                                                                             Any deduction for section 179 property.                     plete list of recovery periods, see the Table of
                                                                                                                                                         Class Lives and Recovery Periods in Appendix
                                                                                                                                                         B of Publication 946.
Table 7­1. Farm Property Recovery Periods                                                                                                                    House trailers for farm laborers. To de­
                                                                                                                       Recovery Period in Years          preciate a house trailer you supply as housing
 Assets                                                                                                                    GDS                ADS        for those who work on your farm, use one of the
                                                                                                                                                         following recovery periods if the house trailer is
                                                                                                                                  ..
                                                                                                                                                    .
 Agricultural structures (single purpose)                . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         10                15
                                                                                                                                                         mobile (it has wheels and a history of move­
 Automobiles . . . . . . . . . . . . . . . . . .       . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5                 5
                                                                                                                                                         ment).
 Calculators and copiers . . . . . . . .           . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5                 6              A 7­year recovery period under GDS.
 Cattle (dairy or breeding) . . . . . . .          . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5                 7
 Communication equipment1 . . . . .                . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          7                10             A 10­year recovery period under ADS.
 Computer and peripheral equipment                   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5                 5
                                                                                                                                                              However, if the house trailer is not mobile
 Drainage facilities . . . . . . . . .       . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         15                20        (its wheels have been removed and permanent
 Farm buildings2 . . . . . . . . . . .       . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         20                25        utilities and pipes attached to it), use one of the
 Farm machinery and equipment                  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          7                10        following recovery periods.
 Fences (agricultural) . . . . . . .         . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          7                10
                                                                                                                                                                A 20­year recovery period under GDS.
 Goats and sheep (breeding)              . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5                 5             A 25­year recovery period under ADS.
 Grain bin . . . . . . . . . . . . .     . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          7                10

 Hogs (breeding) . . . . . . . . . . . . . . . . . . . . . .         . . . . . . . . . . . . . . . . . . . . . . . .          3                 3            Water wells. Water wells used to provide
 Horses (age when placed in service)                                                                                                                     water for raising poultry and livestock are land
     Breeding and working (12 years or less) . .                     . . . . . . . . . . . . . . . . . . . . . . . .          7                10        improvements. If they are depreciable, use one
     Breeding and working (more than 12 years)                       . . . . . . . . . . . . . . . . . . . . . . . .          3                10        of the following recovery periods.
     Racing horses . . . . . . . . . . . . . . . . . . . .           . . . . . . . . . . . . . . . . . . . . . . . .          3                12             A 15­year recovery period under GDS.
 Horticultural structures (single purpose) . . . . . .               . . . . . . . . . . . . . . . . . . . . . . . .         10                15
                                                                                                                                                              A 20­year recovery period under ADS.
 Logging machinery and equipment3                  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5                 6

 Nonresidential real property            . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        394                40            The types of water wells that can be depre­
                                                                                                                                                         ciated were discussed earlier in Irrigation sys-
 Office furniture, fixtures, and equipment (not calculators, copiers, or
                                                                                                                                                         tems and water wells under Property Having a
 typewriters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      . . . . . . . . . . .          7                10
                                                                                                                                                         Determinable Useful Life.
 Paved lots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      . . . . . . . . . . .         15                20

 Residential rental property                                                                                                 27.5              40
                                                                                                                                                         Which Convention Applies?
                                       . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

 Tractor units (over­the­road) . . . . . . . . . . . . . . . . . . . .           . . . . . . . . . . . . . . . . . .          3                 4
 Trees or vines bearing fruit or nuts . . . . . . . . . . . . . . . .            . . . . . . . . . . . . . . . . . .         10                20
                                                                                                                                                         Under MACRS, averaging conventions estab­
 Truck (heavy duty, unloaded weight 13,000 lbs. or more)                         . . . . . . . . . . . . . . . . . .          5                 6
                                                                                                                                                         lish when the recovery period begins and ends.
 Truck (actual weight less than 13,000 lbs) . . . . . . . . . .                  . . . . . . . . . . . . . . . . . .          5                 5
                                                                                                                                                         The convention you use determines the number
 Water wells       . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         15                20        of months for which you can claim depreciation
                                                                                                                                                         in the year you place property in service and in
 1
   Not including communication equipment listed in other classes.                                                                                        the year you dispose of the property. Use one
 2
   Not including single purpose agricultural or horticultural structures.                                                                                of the following conventions.
 3
   Used by logging and sawmill operators for cutting of timber.                                                                                               The half­year convention.
 4
   For property placed in service after May 12, 1993; for property placed in service before May 13, 1993,                                                     The mid­month convention.
   the recovery period is 31.5 years.

                                                                                                                                  Chapter 7     Depreciation, Depletion, and Amortization          Page 43
      The mid­quarter convention.                                   For property placed in service before     ADS recovery periods, which are generally lon­
                                                            !       1999, you could have elected to use       ger than the GDS recovery periods. The ADS
    For a detailed explanation of each conven­            CAUTION   the 150% declining balance method         recovery periods for many assets used in the
tion, see Which Convention Applies in chapter 4          using the ADS recovery periods for certain           business of farming are listed in Table 7–1. Ad­
of Publication 946. Also, see the Instructions for       property classes. If you made this election, con-    ditional ADS recovery periods for other classes
Form 4562.                                               tinue to use the same method and recovery pe-        of property may be found in the Table of Class
                                                         riod for that property.                              Lives and Recovery Periods in Appendix B of
                                                                                                              Publication 946.
Which Depreciation Method
                                                         Real property. You can depreciate real prop­
Applies?                                                 erty using the straight line method under either     How Is the Depreciation
MACRS provides three depreciation methods
                                                         GDS or ADS.                                          Deduction Figured?
under GDS and one depreciation method under              Switching to straight line. If you use a declin­
ADS.                                                     ing balance method, you switch to the straight       To figure your depreciation deduction under
    The 200% declining balance method over               line method in the year it provides an equal or      MACRS, you first determine the depreciation
    a GDS recovery period.                               greater deduction. If you use the MACRS per­         system, property class, placed­in­service date,
    The 150% declining balance method over               centage tables, discussed later under How Is         basis amount, recovery period, convention, and
    a GDS recovery period.                               the Depreciation Deduction Figured, you do not       depreciation method that applies to your prop­
    The straight line method over a GDS re­              need to determine in which year your deduction       erty. Then you are ready to figure your depreci­
    covery period.                                       is greater using the straight line method. The ta­   ation deduction. You can figure it in one of two
    The straight line method over an ADS re­             bles have the switch to the straight line method     ways.
    covery period.                                       built into their rates.                                    You can use the percentage tables provi­
                                                                                                                    ded by the IRS.
Depreciation Table. The following table lists            Fruit or nut trees and vines. Depreciate                   You can figure your own deduction without
the types of property you can depreciate under           trees and vines bearing fruit or nuts under GDS            using the tables.
each method. The declining balance method is             using the straight line method over a 10­year re­
                                                                                                                        Figuring your own MACRS deduction
abbreviated as DB and the straight line method           covery period.
                                                                                                                !       will generally result in a slightly differ-
is abbreviated as SL.
                                                                                                                        ent amount than using the tables.
                                                         ADS required for some farmers. If you elect
                                                                                                              CAUTION


             Depreciation Table                          not to apply the uniform capitalization rules to
                                                         any plant shown in Table 6­1 of chapter 6 and        Using the MACRS Percentage
     System/Method            Type of Property           produced in your farming business, you must          Tables
 GDS using           • All property used in a farming    use ADS for all property you place in service in
 150% DB               business (except real property)   any year the election is in effect. See chapter 6    To help you figure your deduction under
                     • All 15­ and 20­year property      for a discussion of the application of the uniform   MACRS, the IRS has established percentage
                     • Nonfarm 3­, 5­, 7­, and 10­year   capitalization rules to farm property.               tables that incorporate the applicable conven­
                       property1                                                                              tion and depreciation method. These percent­
 GDS using SL        • Nonresidential real property
                                                         Electing a different method. As shown in the         age tables are in Appendix A of Publication 946.
                                                         Depreciation Table, you can elect a different
                     • Residential rental property
                                                         method for depreciation for certain types of         Rules for using the tables. The following
                     • Trees or vines bearing fruit or
                       nuts                              property. You must make the election by the          rules cover the use of the percentage tables.
                     • All 3­, 5­, 7­, 10­, 15­, and     due date of the return (including extensions) for
                       20­year property1                 the year you placed the property in service.          1. You must apply the rates in the percent­
                                                         However, if you timely filed your return for the         age tables to your property's unadjusted
 ADS using SL        • Property used predomi­
                                                         year without making the election, you can still          basis. Unadjusted basis is the same basis
                       nantly outside the United
                       States                            make the election by filing an amended return            amount you would use to figure gain on a
                                                         within 6 months of the due date of your return           sale but figured without reducing your orig­
                     • Farm property used when an
                                                         (excluding extensions). Attach the election to           inal basis by any MACRS depreciation
                       election not to apply the
                       uniform capitalization rules is   the amended return and write “Filed pursuant to          taken in earlier years.
                       in effect                         section 301.9100­2” on the election statement.        2. You cannot use the percentage tables for
                     • Tax­exempt property               File the amended return at the same address              a short tax year. See chapter 4 of Publica­
                     • Tax­exempt bond­financed
                                                         you filed the original return. Once you make the         tion 946 for information on how to figure
                       property
                     • Imported property2
                                                         election, you cannot change it.                          the deduction for a short tax year.
                     • Any property for which you
                                                                   If you elect to use a different method      3. You generally must continue to use them
                       elect to use this method1
                                                            !      for one item in a property class, you          for the entire recovery period of the prop­
 GDS using           • Nonfarm 3­, 5­, 7­, and                     must apply the same method to all
                                                          CAUTION                                                 erty.
 200% DB               10­year property
                                                         property in that class placed in service during
                                                                                                               4. You must stop using the tables if you ad­
                                                         the year of the election. However, you can
   Elective method                                                                                                just the basis of the property for any rea­
 1
                                                         make the election on a property-by-property ba-
   See section 168(g)(6) of the Internal Revenue                                                                  son other than—
 2
                                                         sis for residential rental and nonresidential real
   Code                                                  property.                                                  a. Depreciation allowed or allowable, or
                                                                                                                    b. An addition or improvement to the
Property used in farming business. For per­                 Straight line election. Instead of using the
                                                                                                                       property, which is depreciated as a
sonal property placed in service after 1988 in a         declining balance method, you can elect to use
                                                                                                                       separate property.
farming business, you must use the 150% de­              the straight line method over the GDS recovery
clining balance method over a GDS recovery               period. Make the election by entering “S/L” un­          Basis adjustment due to casualty loss.
period or you can elect one of the following             der column (f) in Part III of Form 4562.             If you reduce the basis of your property be­
methods.                                                                                                      cause of a casualty, you cannot continue to use
                                                             ADS election. As explained earlier under
      The straight line method over a GDS re­                                                                 the percentage tables. For the year of the ad­
                                                         Which Depreciation System (GDS or ADS) Ap-
      covery period.                                                                                          justment and the remaining recovery period,
                                                         plies, you can elect to use ADS even though
      The straight line method over an ADS re­                                                                you must figure the depreciation yourself using
                                                         your property may come under GDS. ADS uses
      covery period.                                                                                          the property's adjusted basis at the end of the
                                                         the straight line method of depreciation over the

Page 44         Chapter 7    Depreciation, Depletion, and Amortization
year. See Figuring the Deduction Without Using      Table 7­3. Straight Line Method                        was disposed of at the time of the exchange or
the Tables in chapter 4 of Publication 946.         (Half-Year Convention)                                 conversion.

Figuring depreciation using the 150% DB             Year    3-Year     5-Year     7-Year 20-Year               When to make the election. You must
method and half-year convention. Table 7­2                                                                 make the election on a timely filed return (in­
                                                      1     16.67%        10%     7.14%        2.5%
has the percentages for 3­, 5­, 7­, and 20­year                                                            cluding extensions) for the year of replacement.
                                                      2     33.33         20     14.29         5.0
property. The percentages are based on the                                                                 Once made, the election may not be revoked
                                                      3     33.33         20     14.29         5.0
150% declining balance method with a change                                                                without IRS consent.
                                                      4     16.67         20     14.28         5.0             For more information and special rules, see
to the straight line method. This table covers        5                   20     14.29         5.0
only the half­year convention and the first 8                                                              chapter 4 of Publication 946.
                                                      6                   10     14.28         5.0
years for 20­year property. See Appendix A in
                                                      7                          14.29         5.0         Property acquired in a nontaxable transfer.
Publication 946 for complete MACRS tables, in­
                                                      8                           7.14         5.0         You must depreciate MACRS property acquired
cluding tables for the mid­quarter and
mid­month convention.                                                                                      by a corporation or partnership in certain non­
                                                        The following example shows how to figure          taxable transfers over the property's remaining
    The following examples show how to figure
                                                    depreciation under MACRS using the straight            recovery period in the transferor's hands, as if
depreciation under MACRS using the percen­
                                                    line percentages in Table 7­3.                         the transfer had not occurred. You must con­
tages in Table 7­2.
                                                                                                           tinue to use the same depreciation method and
                                                       Example. If in Example 2, earlier, you had          convention as the transferor. You can depreci­
     Example 1. During the year, you bought an
                                                    elected the straight line method, you figure this      ate the part of the property's basis in excess of
item of 7­year property for $10,000 and placed
                                                    year's depreciation by multiplying $20,000 (un­        its carried­over basis (the transferor's adjusted
it in service. You do not elect a section 179 ex­
                                                    adjusted basis) by 2.5% to get $500. For next          basis in the property) as newly purchased
pense deduction for this property. In addition,
                                                    year, your depreciation will be $1,000                 MACRS property. For information on the kinds
the property is not qualified property for purpo­
                                                    ($20,000 × 5%).                                        of nontaxable transfers covered by this rule, see
ses of the special depreciation allowance. The
unadjusted basis of the property is $10,000.                                                               chapter 4 of Publication 946.
You use the percentages in Table 7­2 to figure      Figuring Depreciation Without the
your deduction.                                     Tables                                                 How Do You Use General
     Since this is 7­year property, you multiply
$10,000 by 10.71% to get this year's deprecia­      If you are required to or would prefer to figure       Asset Accounts?
tion of $1,071. For next year, your depreciation    your own depreciation without using the tables,
                                                                                                           To make it easier to figure MACRS deprecia­
will be $1,913 ($10,000 × 19.13%).                  see Figuring the Deduction Without Using the
                                                                                                           tion, you can group separate assets into one or
                                                    Tables in chapter 4 of Publication 946.
                                                                                                           more general asset accounts (GAAs). You can
   Example 2. You had a barn constructed on
                                                                                                           then depreciate all the assets in each account
your farm at a cost of $20,000. You placed the      Figuring the Deduction for                             as a single asset. Each account must include
barn in service this year. You elect not to claim   Property Acquired in a Nontaxable                      only assets with the same asset class (if any),
the special depreciation allowance. The barn is     Exchange                                               recovery period, depreciation method, and con­
20­year property and you use the table percen­
                                                                                                           vention. You cannot include an asset if you use
tages to figure your deduction. You figure this     If your property has a carryover basis because         it in both a personal activity and a trade or busi­
year's depreciation by multiplying $20,000 (un­     you acquired it in an exchange or involuntary          ness (or for the production of income) in the
adjusted basis) by 3.75% to get $750. For next      conversion of other property or in a nontaxable        year in which you first placed it in service.
year, your depreciation will be $1,443.80           transfer, you generally figure depreciation for
($20,000 × 7.219%).                                 the property as if the exchange, conversion, or            After you have set up a GAA, you generally
                                                    transfer had not occurred.                             figure the depreciation for it by using the appli­
Table 7­2. 150% Declining Balance                                                                          cable depreciation method, recovery period,
Method (Half-Year Convention)                       Property acquired in a like-kind exchange              and convention for the assets in the GAA. For
                                                    or involuntary conversion. You generally               each GAA, record the depreciation allowance in
Year    3-Year    5-Year    7-Year 20-Year          must depreciate the carryover basis of MACRS           a separate depreciation reserve account.
  1      25.0%     15.0%    10.71%    3.750%        property acquired in a like­kind exchange or in­
                                                                                                               There are additional rules for grouping as­
                      0                             voluntary conversion over the remaining recov­
                                                                                                           sets in a GAA, figuring depreciation for a GAA,
  2      37.5      25.5     19.13     7.219         ery period of the property exchanged or invol­
                                                                                                           disposing of GAA assets, and terminating GAA
                      0                             untarily converted. You also generally continue
                                                                                                           treatment. Special rules apply in determining
  3      25.0      17.8     15.03     6.677         to use the same depreciation method and con­
                                                                                                           the basis and figuring the depreciation deduc­
                      5                             vention used for the exchanged or involuntarily
                                                                                                           tion for MACRS property in a GAA acquired in a
  4      12.5      16.6     12.25     6.177         converted property. This applies only to ac­
                                                                                                           like­kind exchange or involuntary conversion.
                      6                             quired property with the same or a shorter re­
                                                                                                           See chapter 4 in Publication 946.
                                                    covery period and the same or more acceler­
  5                16.6     12.25     5.713
                                                    ated depreciation method than the property
  6
                      6
                   8.33     12.25     5.285
                                                    exchanged or involuntarily converted. The ex­          When Do You Recapture
  7                         12.25     4.888
                                                    cess basis, if any, of the acquired MACRS              MACRS Depreciation?
                                                    property is treated as newly placed in service
  8                          6.13     4.522         MACRS property.                                        When you dispose of property you depreciated
                                                                                                           using MACRS, any gain on the disposition is
Figuring depreciation using the straight            Election out. You can elect not to use the             generally recaptured (included in income) as or­
line method and half-year convention. The           above rules. The election, if made, applies to         dinary income up to the amount of the deprecia­
following table has the straight line percentages   both the acquired property and the exchanged           tion previously allowed or allowable for the
for 3­, 5­, 7­, and 20­year property using the      or involuntarily converted property. If you make       property. For more information on depreciation
half­year convention. The table covers only the     the election, figure depreciation by treating the      recapture, see chapter 9. Also, see chapter 4 of
first 8 years for 20­year property. See Appendix    carryover basis and excess basis, if any, for the      Publication 946.
A in Publication 946 for complete MACRS ta­         acquired property as if placed in service the
bles, including tables for the mid­quarter and      later of on the date you acquired it, or the time
mid­month convention.                               of the disposition of the exchanged or involun­
                                                    tarily converted property. For depreciation pur­
                                                    poses, the adjusted basis of the exchanged or
                                                    involuntarily converted property is treated as if it

                                                                                 Chapter 7      Depreciation, Depletion, and Amortization            Page 45
                                                    What Is the Business-Use                              not, in itself, an economic interest. A production
Additional Rules for Listed                         Requirement?                                          payment carved out of, or retained on the sale
                                                                                                          of, mineral property is not an economic interest.
Property                                            You can claim the section 179 expense deduc­              Mineral property is each separate interest
                                                    tion for listed property and depreciate listed        you own in each mineral deposit in each sepa­
Listed property includes cars and other property    property using GDS and a declining balance            rate tract or parcel of land. You can treat two or
used for transportation, property used for enter­   method, if the property meets the business­use        more separate interests as one property or as
tainment, and certain computers.                    requirement. To meet this requirement, listed         separate properties. See section 614 of the In­
                                                    property must be used predominantly (more             ternal Revenue Code and the related regula­
   Deductions for listed property (other than
                                                    than 50% of its total use) for qualified business     tions for rules on how to treat separate mineral
certain leased property) are subject to the fol­
                                                    use. To determine whether the business­use re­        interests.
lowing special rules and limits.
                                                    quirement is met, you must allocate the use of
     Deduction for employees.                                                                                 Timber property is your economic interest in
                                                    any item of listed property used for more than
    Business­use requirement.                       one purpose during the year among its various         standing timber in each tract or block represent­
    Passenger automobile limits and rules.          uses.                                                 ing a separate timber account.


What Is Listed Property?                            Do the Passenger                                      Figuring Depletion
                                                    Automobile Limits Apply?
                                                                                                          There are two ways of figuring depletion.
Listed property is any of the following.
                                                    The depreciation deduction (including the sec­            Cost depletion.
     Passenger automobiles weighing 6,000
     pounds or less.                                tion 179 expense deduction) you can claim for a            Percentage depletion.
     Any other property used for transportation,    passenger automobile each year is limited. The
                                                    passenger automobile limits are the maximum           For mineral property, you generally must use
     unless it is an excepted vehicle.
                                                    depreciation amounts you can deduct for a pas­        the method that gives you the larger deduction.
     Property generally used for entertainment,
                                                    senger automobile. They are based on the date         For standing timber, you must use cost deple­
     recreation, or amusement.
                                                    you placed the vehicle in service. See chapter 5      tion.
     Computers and related peripheral equip­
     ment unless used only at a regular busi­       of Publication 946 for tables that show the maxi­
     ness establishment and owned or leased         mum depreciation deduction for passenger au­          Cost Depletion
     by the person operating the establishment.     tomobiles. Also, see the Instructions for Form
                                                    4562.                                                 To figure cost depletion you must first deter­
Passenger automobiles. A passenger auto­                                                                  mine the following.
mobile is any 4­wheeled vehicle made primarily          For information about deducting expenses               The property's basis for depletion.
for use on public streets, roads, and highways      for the business use of your passenger automo­
                                                                                                               The total recoverable units of mineral in the
and rated at 6,000 pounds or less of unloaded       bile, see chapter 4 in Publication 463.
                                                                                                               property's natural deposit.
gross vehicle weight (6,000 pounds or less of                                                                  The number of units of mineral sold during
                                                    Deductions for passenger automobiles ac-
gross vehicle weight for trucks and vans). It in­                                                              the tax year.
                                                    quired in a trade-in. Special rules apply in fig­
cludes any part, component, or other item phys­
                                                    uring the depreciation for a passenger automo­
ically attached to the automobile or usually in­                                                              You must estimate or determine recoverable
                                                    bile received in a like­kind exchange or
cluded in the purchase price of an automobile.                                                            units (tons, barrels, board feet, thousands of cu­
                                                    involuntary conversion. See chapter 5 of Publi­
Electric passenger automobiles are vehicles                                                               bic feet, or other measure) using the current in­
                                                    cation    946     and    Regulations    section
produced by an original equipment manufac­                                                                dustry method and the most accurate and relia­
                                                    1.168(i)­6(d)(3).
turer and designed to run primarily on electric­                                                          ble information you can obtain.
ity.
          A truck or van that is a qualified non-   Depletion                                                 Basis for depletion and total recoverable
                                                                                                          units are explained in chapter 9 of Publication
  TIP personal use vehicle is not considered                                                              535.
          a passenger automobile. See Quali­        Depletion is the using up of natural resources
fied nonpersonal use vehicles under Passenger       by mining, quarrying, drilling, or felling. The de­   Number of units sold. You determine the
Automobiles in chapter 5 of Publication 946 for     pletion deduction allows an owner or operator         number of units sold during the tax year based
the definition of qualified nonpersonal use vehi-   to account for the reduction of a product's re­       on your method of accounting. Use the follow­
cles.                                               serves.                                               ing table to make this determination.

Other property used for transportation.             Who Can Claim Depletion?                               IF you use...           THEN the units sold
This includes trucks, buses, boats, airplanes,                                                                                     during the year are...
motorcycles, and other vehicles used for trans­     If you have an economic interest in mineral
porting persons or goods.                                                                                  The cash method of      The units sold for which
                                                    property or standing timber (defined below),           accounting              you receive payment during
    Excepted vehicles. Other property used          you can take a deduction for depletion. More                                   the tax year (regardless of
for transportation does not include the following   than one person can have an economic interest                                  the year of sale).
vehicles.                                           in the same mineral deposit or timber.
                                                                                                           An accrual method of    The units sold based on
      Tractors and other special purpose farm           You have an economic interest if both the          accounting              your inventories.
      vehicles.                                     following apply.
      Bucket trucks (cherry pickers), dump                                                                   The number of units sold during the tax year
                                                         You have acquired by investment any in­
      trucks, flatbed trucks, and refrigerated                                                            does not include any units for which depletion
                                                         terest in mineral deposits or standing tim­
      trucks.                                                                                             deductions were allowed or allowable in earlier
                                                         ber.
      Combines, cranes and derricks, and fork­                                                            years.
                                                         You have a legal right to income from the
      lifts.                                             extraction of the mineral or the cutting of
      Any vehicle designed to carry cargo with a                                                          Figuring the cost depletion deduction.
                                                         the timber, to which you must look for a re­
      loaded gross vehicle weight of over 14,000                                                          Once you have figured your property's basis for
                                                         turn of your capital investment.
      pounds.                                                                                             depletion, the total recoverable units, and the
                                                    A contractual relationship that allows you an         number of units sold during the tax year, you
    For more information, see chapter 5 of Pub­     economic or monetary advantage from prod­             can figure your cost depletion deduction by tak­
lication 946.                                       ucts of the mineral deposit or standing timber is     ing the following steps.

Page 46      Chapter 7    Depreciation, Depletion, and Amortization
  Step              Action                   Result       or loss in the tax year you sell the timber prod­
                                                          ucts.
    1    Divide your property's basis    Rate per unit.                                                            Amortization
         for depletion by total                           Form T (Timber). Complete and attach Form
         recoverable units.                               T (Timber) to your income tax return if you are          Amortization is a method of recovering (deduct­
    2    Multiply the rate per unit by   Cost depletion   claiming a deduction for timber depletion, elect­        ing) certain capital costs over a fixed period of
         units sold during the tax       deduction.       ing to treat the cutting of timber as a sale or ex­      time. It is similar to the straight line method of
         year.                                            change, or making an outright sale of timber.            depreciation. The amortizable costs discussed
                                                          See the Instructions for Form T (Timber).                in this section include the start­up costs of go­
    Cost depletion for ground water in Ogal-                                                                       ing into business, reforestation costs, the costs
lala Formation. Farmers who extract ground                    Example. Sam Brown bought a farm that                of pollution control facilities, and the costs of
water from the Ogallala Formation for irrigation          included standing timber. This year Sam deter­           section 197 intangibles. See chapter 8 in Publi­
are allowed cost depletion. Cost depletion is al­         mined that the standing timber could produce             cation 535 for more information on these topics.
lowed when it can be demonstrated the ground              300,000 units when cut. At that time, the adjus­
water is being depleted and the rate of recharge
is so low that, once extracted, the water would
                                                          ted basis of the standing timber was $24,000.            Business Start-Up Costs
                                                          Sam then cut and sold 27,000 units. (Sam did
be lost to the taxpayer and immediately suc­              not elect to treat the cutting of the timber as a
ceeding generations. To figure your cost deple­           sale or exchange.) Sam's depletion for each                 When you go into business, treat all costs
tion deduction, use the guidance provided in              unit for the year is $.08 ($24,000 ÷ 300,000).           you incur to get your business started as capital
Revenue Procedure 66­11 in Cumulative Bulle­              His deduction for depletion is $2,160 (27,000 ×          expenses. Capital expenses are a part of your
tin 1966­1.                                               $.08). If Sam had cut 27,000 units but sold only         basis in the business. Generally, you recover
                                                          20,000 units during the year, his depletion for          costs for particular assets through depreciation
Timber Depletion                                          each unit would have remained at $.08. How­              deductions. However, you generally cannot re­
                                                          ever, his depletion deduction would have been            cover other costs until you sell the business or
Depletion takes place when you cut standing               $1,600 (20,000 × $.08) for this year and he              otherwise go out of business.
timber (including Christmas trees). You can fig­          would have included the balance of $560                      Start­up costs are costs for creating an ac­
ure your depletion deduction when the quantity            (7,000 × $.08) in the closing inventory for the          tive trade or business or investigating the crea­
of cut timber is first accurately measured in the         year.                                                    tion or acquisition of an active trade or busi­
process of exploitation.                                                                                           ness. Start­up costs include any amounts paid
                                                          Percentage Depletion                                     or incurred in connection with any activity en­
Figuring the timber depletion deduction. To                                                                        gaged in for profit and for the production of in­
figure your cost depletion allowance, multiply            You can use percentage depletion on certain              come before the trade or business begins, in
the number of units of standing timber cut by             mines, wells, and other natural deposits. You            anticipation of the activity becoming an active
your depletion unit.                                      cannot use the percentage method to figure de­           trade or business.
   Timber units. When you acquire timber                  pletion for standing timber, soil, sod, dirt, or turf.
                                                                                                                      You can elect to currently deduct a limited
property, you must make an estimate of the                                                                         amount of business start­up costs paid or incur­
quantity of marketable timber that exists on the              To figure percentage depletion, you multiply         red after October 22, 2004. See Capital Expen-
property. You measure the timber using board              a certain percentage, specified for each min­            ses in chapter 4. If this election is made, any
feet, log scale, cords, or other units. If you later      eral, by your gross income from the property             costs that are not currently deducted can be
determine that you have more or less units of             during the year. See Mines and other natural             amortized.
timber, you must adjust the original estimate.            deposits in chapter 9 of Publication 535 for a list
                                                          of the percentages. You can find a complete list         Amortization period. The amortization period
    Depletion units. You figure your depletion            in section 613(b) of the Internal Revenue Code.          for business start­up costs paid or incurred be­
unit each year by taking the following steps.
                                                                                                                   fore October 23, 2004, is 60 months or more.
  1. Determine your cost or the adjusted basis            Taxable income limit. The percentage deple­              For start­up costs paid or incurred after October
     of the timber on hand at the beginning of            tion deduction cannot be more than 50% (100%             22, 2004, the amortization period is 180
     the year.                                            for oil and gas property) of your taxable income         months. The period starts with the month your
                                                          from the property figured without the depletion          active trade or business begins.
  2. Add to the amount determined in (1) the              deduction and the domestic production activi­
     cost of any timber units acquired during             ties deduction.                                          Reporting requirements. To amortize your
     the year and any additions to capital.                   The following rules apply when figuring your         start­up costs that are not currently deductible
  3. Figure the number of timber units to take            taxable income from the property for purposes            under the election to deduct, complete Part VI
     into account by adding the number of tim­            of the taxable income limit.                             of Form 4562 and attach a statement containing
     ber units acquired during the year to the                  Do not deduct any net operating loss de­           any required information. See the Instructions
     number of timber units on hand in the ac­                  duction from the gross income from the             for Form 4562.
     count at the beginning of the year and                     property.
                                                                Corporations do not deduct charitable con­            For more information, see Starting a Busi-
     then adding (or subtracting) any correction
                                                                tributions from the gross income from the          ness in chapter 8 of Publication 535.
     to the estimate of the number of timber
     units remaining in the account.                            property.

  4. Divide the result of (2) by the result of (3).
                                                                If, during the year, you disposed of an item       Reforestation Costs
                                                                of section 1245 property used in connec­
     This is your depletion unit.                               tion with the mineral property, reduce any         You can elect to currently deduct a limited
                                                                allowable deduction for mining expenses            amount of qualifying reforestation costs for
When to claim timber depletion. Claim your                      by the part of any gain you must report as         each qualified timber property. See Capital Ex-
depletion allowance as a deduction in the year                  ordinary income that is allocable to the           penses in chapter 4. You can elect to amortize
of sale or other disposition of the products cut                mineral property. See Regulations section          over 84 months any amount not deducted.
from the timber, unless you elect to treat the                  1.613­5(b)(1) for information on how to fig­       There is no annual limit on the amount you can
cutting of timber as a sale or exchange as ex­                  ure the ordinary gain allocable to the prop­       elect to amortize. Reforestation costs are the di­
plained in chapter 8. Include allowable deple­                  erty.                                              rect costs of planting or seeding for forestation
tion for timber products not sold during the tax                                                                   or reforestation.
year the timber is cut, as a cost item in the clos­
                                                             For more information on depletion, see
ing inventory of timber products for the year.                                                                     Qualifying costs. Qualifying costs include
                                                          chapter 9 in Publication 535.
The inventory is your basis for determining gain                                                                   only those costs you must otherwise capitalize

                                                                                        Chapter 7      Depreciation, Depletion, and Amortization            Page 47
and include in the adjusted basis of the prop­          intangible's adjusted basis (for purposes of de­          908 Bankruptcy Tax Guide
erty. They include costs for the following items.       termining gain), figured by amortizing it ratably
      Site preparation.                                 over 15 years (180 months). You are not al­            Form (and Instructions)
     Seeds or seedlings.                                lowed any other depreciation or amortization
                                                                                                                  982 Reduction of Tax Attributes Due to
                                                        deduction for an amortizable section 197 intan­
     Labor.                                                                                                           Discharge of Indebtedness (and
                                                        gible.
                                                                                                                      Section 1082 Basis Adjustment)
     Tools.
                                                           Section 197 intangibles include the following          Sch D (Form 1040) Capital Gains and
     Depreciation on equipment used in plant­
                                                        assets.                                                       Losses
     ing and seeding.
                                                            Goodwill.
   If the government reimburses you for refor­                                                                    Sch F (Form 1040) Profit or Loss From
                                                             Patents.
estation costs under a cost­sharing program,                                                                          Farming
you can amortize these costs only if you include             Copyrights.
                                                                                                                  1099-A Acquisition or Abandonment of
the reimbursement in your income.                            Designs.                                                 Secured Property
                                                             Formulas.
Qualified timber property. Qualified timber                                                                       1099-C Cancellation of Debt
                                                             Licenses.
property is property that contains trees in signif­                                                               4797 Sales of Business Property
icant commercial quantities. It can be a woodlot             Permits.
or other site that you own or lease. The property            Covenants not to compete.                            8949 Sales and Other Dispositions of
qualifies only if it meets all the following require­                                                                 Capital Assets
                                                             Franchises.
ments.                                                                                                       See chapter 16 for information about getting
     It is located in the United States.                     Trademarks.
                                                                                                             publications and forms.
     It is held for the growing and cutting of tim­     See chapter 8 in Publication 535 for more infor­
     ber you will either use in, or sell for use in,    mation, including a complete list of assets that
     the commercial production of timber prod­          are section 197 intangibles and special rules.       Sales and Exchanges
     ucts.
     It consists of at least one acre planted with                                                           If you sell, exchange, or otherwise dispose of
     tree seedlings in the manner normally used                                                              your property, you usually have a gain or a loss.
     in forestation or reforestation.                                                                        This section explains certain rules for determin­
    Qualified timber property does not include                                                               ing whether any gain you have is taxable, and
                                                                                                             whether any loss you have is deductible.
property on which you have planted shelter
belts or ornamental trees, such as Christmas            8.                                                       A sale is a transfer of property for money or
trees.                                                                                                       a mortgage, note, or other promise to pay
                                                                                                             money. An exchange is a transfer of property
Amortization period. The 84­month amortiza­
tion period starts on the first day of the first        Gains and                                            for other property or services.
month of the second half of the tax year you in­
cur the costs (July 1 for a calendar year tax­          Losses                                               Determining Gain or Loss
payer), regardless of the month you actually in­
cur the costs. You can claim amortization                                                                    You usually realize a gain or loss when you sell
deductions for no more than 6 months of the                                                                  or exchange property. If the amount you realize
first and last (eighth) tax years of the period.        Introduction                                         from a sale or exchange of property is more
                                                                                                             than its adjusted basis, you will have a gain. If
How to make the election. To elect to amor­             This chapter explains how to figure, and report      the adjusted basis of the property is more than
tize qualifying reforestation costs, enter your         on your tax return, your gain or loss on the dis­    the amount you realize, you will have a loss.
deduction in Part VI of Form 4562. Attach a             position of your property or debt and whether
statement containing any required information.          such gain or loss is ordinary or capital. Ordinary   Basis and adjusted basis. The basis of prop­
See the Instructions for Form 4562.                     gain is taxed at the same rates as wages and         erty you buy is usually its cost. The adjusted ba­
    Generally, you must make the election on a          interest income while capital gain is generally      sis of property is basis plus certain additions
timely filed return (including extensions) for the      taxed at lower rates. Dispositions discussed in      and minus certain deductions. See chapter 6 for
year in which you incurred the costs. However,          this chapter include sales, exchanges, foreclo­      more information about basis and adjusted ba­
if you timely filed your return for the year without    sures, repossessions, canceled debts, hedging        sis.
making the election, you can still make the elec­       transactions, and elections to treat cutting of
tion by filing an amended return within 6 months        timber as a sale or exchange.                        Amount realized. The amount you realize
of the due date of your return (excluding exten­                                                             from a sale or exchange is the total of all money
sions). Attach Form 4562 and the statement to           Topics                                               you receive plus the fair market value (FMV)
the amended return and write “Filed pursuant to         This chapter discusses:                              (defined in chapter 6) of all property or services
section 301.9100­2” on Form 4562. File the                                                                   you receive. The amount you realize also in­
amended return at the same address you filed                                                                 cludes any of your liabilities assumed by the
                                                             Sales and exchanges
the original return.                                                                                         buyer and any liabilities to which the property
                                                             Ordinary or capital gain or loss                you transferred is subject, such as real estate
    For additional information on reforestation
costs, see chapter 8 of Publication 535.                                                                     taxes or a mortgage.
                                                                                                                 If the liabilities relate to an exchange of mul­
                                                        Useful Items
                                                                                                             tiple properties, see Multiple Property Ex-
Section 197 Intangibles                                 You may want to see:
                                                                                                             changes in chapter 1 of Publication 544.

You must generally amortize over 15 years the             Publication                                        Amount recognized. Your gain or loss real­
capitalized costs of section 197 intangibles you             334 Tax Guide for Small Business                ized from a sale or exchange of certain property
acquired after August 10, 1993. You must am­                                                                 is usually a recognized gain or loss for tax pur­
ortize these costs if you hold the section 197 in­           523 Selling Your Home                           poses. A recognized gain is a gain you must in­
tangible in connection with your farming busi­                                                               clude in gross income and report on your in­
                                                             544 Sales and Other Dispositions of
ness or in an activity engaged in for the                                                                    come tax return. A recognized loss is a loss you
                                                                 Assets
production of income. Your amortization deduc­                                                               deduct from gross income. However, your gain
tion each year is the applicable part of the                 550 Investment Income and Expenses              or loss realized from the exchange of certain

Page 48       Chapter 8      Gains and Losses
property may not be recognized for tax purpo­          8824 explain how to report the details of the ex­        General Asset Classes. General Asset
ses. See Like-Kind Exchanges next. Also, a             change.                                               Classes describe the types of property fre­
loss from the disposition of property held for            If you have any recognized gain because            quently used in many businesses. They include,
personal use is not deductible.                        you received money or unlike property, report it      but are not limited to, the following property.
                                                       on Schedule D (Form 1040) or Form 4797,
                                                                                                               1. Office furniture, fixtures, and equipment
                                                       whichever applies. You may also have to report
Like-Kind Exchanges                                    the recognized gain as ordinary income be­
                                                                                                                  (asset class 00.11).
                                                       cause of depreciation recapture on Form 4797.           2. Information systems, such as computers
Certain exchanges of property are not taxable.         See chapter 9 for more information.                        and peripheral equipment (asset class
This means any gain from the exchange is not                                                                      00.12).
recognized, and any loss cannot be deducted.           Qualifying property. In a like­kind exchange,
Your gain or loss will not be recognized until                                                                 3. Data handling equipment except comput­
                                                       both the property you give up and the property
you sell or otherwise dispose of the property                                                                     ers (asset class 00.13).
                                                       you receive must be held by you for investment
you receive.                                           or for productive use in your trade or business.        4. Automobiles and taxis (asset class 00.22).
                                                       Machinery, buildings, land, trucks, breeding
    The exchange of property for the same kind                                                                 5. Light general purpose trucks (asset class
                                                       livestock, rental houses, and certain mutual
of property is the most common type of nontax­                                                                    00.241).
                                                       ditch, reservoir, or irrigation company stock are
able exchange. To qualify for treatment as a
                                                       examples of property that may qualify.                  6. Heavy general purpose trucks (asset class
like­kind exchange, the property traded and the
                                                                                                                  00.242).
property received must be both of the following.
                                                       Nonqualifying property. The rules for
      Qualifying property.                             like­kind exchanges do not apply to exchanges           7. Tractor units for use over­the­road (asset
     Like­kind property.                               of the following property.                                 class 00.26).
                                                             Property you use for personal purposes,           8. Trailers and trailer­mounted containers
These two requirements are discussed later.                  such as your home and family car.                    (asset class 00.27).
                                                             Stock in trade or other property held pri­
Multiple-party transactions. The like­kind ex­                                                                 9. Industrial steam and electric generation
                                                             marily for sale, such as crops and produce.
change rules also apply to property exchanges                                                                     and/or distribution systems (asset class
                                                             Stocks, bonds, or notes. However, see
that involve three­ and four­party transactions.             Qualifying property above.                           00.4).
Any part of these multiple­party transactions                Other securities or evidences of indebted­
can qualify as a like­kind exchange if it meets all                                                              Product Classes. Product Classes include
                                                             ness, such as accounts receivable.              property listed in a 6­digit product class (except
the requirements described in this section.                  Partnership interests.                          any ending in 9) in sectors 31 through 33 of the
    Receipt of title from third party. If you re­                                                            North American Industry Classification System
                                                       However, you may have a nontaxable ex­
ceive property in a like­kind exchange and the                                                               (NAICS) of the Executive Office of the Presi­
                                                       change under other rules. See Other Nontaxa-
other party who transfers the property to you                                                                dent, Office of Management and Budget, United
                                                       ble Exchanges in chapter 1 of Publication 544.
does not give you the title, but a third party                                                               States, 2012 (NAICS Manual). It can be ac­
does, you can still treat this transaction as a        Like-kind property. To qualify as a nontaxa­          cessed at www.census.gov/eos/www/naics/.
like­kind exchange if it meets all the require­        ble exchange, the properties exchanged must           Copies of the hard cover manual may be pur­
ments.                                                 be of like kind. Like­kind properties are proper­     chased from the National Technical Information
                                                       ties of the same nature or character, even if         Service (NTIS) at
Basis of property received. If you receive                                                                   www.ntis.gov/products/naics.aspx or by calling
                                                       they differ in grade or quality. Generally, real
property in a like­kind exchange, the basis of                                                               1­800­553­NTIS (1­800­553­6847) or (703)
                                                       property exchanged for real property qualifies
the property will be the same as the basis of the                                                            605­6000. A CD­ROM version with search and
                                                       as an exchange of like­kind property. For exam­
property you gave up. See chapter 6 for more                                                                 retrieval software is also available from NTIS.
                                                       ple, an exchange of city property for farm prop­
information.
                                                       erty or improved property for unimproved prop­                NAICS class 333111, Farm Machinery
                                                       erty is a like­kind exchange.                                 and Equipment Manufacturing, in-
Money paid. If, in addition to giving up                                                                      TIP
                                                           An exchange of a tractor for a new tractor is             cludes most machinery and equip-
like­kind property, you pay money in a like­kind
                                                       an exchange of like­kind property, and so is an       ment used in a farming business.
exchange, you still have no recognized gain or
                                                       exchange of timber land for crop acreage. An
loss. The basis of the property received is the
                                                       exchange of a tractor for acreage, however, is
basis of the property given up, increased by the                                                             Partially nontaxable exchange. If, in addition
                                                       not an exchange of like­kind property. The ex­
money paid.                                                                                                  to like­kind property, you receive money or un­
                                                       change of livestock of one sex for livestock of
                                                       the other sex is not a like­kind exchange. For        like property in an exchange on which you real­
    Example. You traded an old tractor with an                                                               ize gain, you have a partially nontaxable ex­
                                                       example, the exchange of a bull for a cow is not
adjusted basis of $1,500 for a new one. The                                                                  change. You are taxed on the gain you realize,
                                                       a like­kind exchange. An exchange of the as­
new tractor costs $30,000. You were allowed                                                                  but only to the extent of the money and the FMV
                                                       sets of a business for the assets of a similar
$8,000 for the old tractor and paid $22,000                                                                  of the unlike property you receive. A loss is not
                                                       business cannot be treated as an exchange of
cash. You have no recognized gain or loss on                                                                 deductible.
                                                       one property for another property.
the transaction regardless of the adjusted basis
                                                           Note. Whether you engaged in a like­kind
of your old tractor and the basis of the new trac­                                                               Example 1. You trade farmland that cost
                                                       exchange depends on an analysis of each as­
tor is $23,500, the adjusted basis of the old                                                                $30,000 for $10,000 cash and other land to be
                                                       set involved in the exchange.
tractor plus the cash paid.                                                                                  used in farming with a FMV of $50,000. You
    If you had sold the old tractor to a third party       Personal property. Depreciable tangible           have a realized gain of $30,000 ($50,000 FMV
for $8,000 and bought a new one, you would             personal property can be either like kind or like     of new land + $10,000 cash − $30,000 basis of
have a recognized gain or loss on the sale of          class to qualify for nontaxable exchange treat­       old farmland = $30,000 realized gain). How­
your old tractor equal to the difference between       ment. Like­class properties are depreciable tan­      ever, only $10,000, the cash received, is recog­
the amount realized and the adjusted basis of          gible personal properties within the same Gen­        nized (included in income).
the old tractor. In this case, the taxable gain        eral Asset Class or Product Class. Property
would be $6,500 ($8,000 − $1,500) and the ba­          classified in any General Asset Class may not            Example 2. Assume the same facts as in
sis of the new tractor would be $30,000.               be classified within a Product Class. Assets that     Example 1, except that, instead of money, you
                                                       are not in the same class will qualify as like­kind   received a tractor with a FMV of $10,000. Your
Reporting the exchange. Report the ex­                 property if they are of the same nature or char­      recognized gain is still limited to $10,000, the
change of like­kind property, even though no           acter.                                                value of the tractor (the unlike property).
gain or loss is recognized, on Form 8824,
Like­Kind Exchanges. The Instructions for Form

                                                                                                               Chapter 8     Gains and Losses         Page 49
   Example 3. Assume in Example 1 that the               In addition, your sister must report on her tax   gain recognized on a transfer in trust increases
FMV of the land you received was only                return for 2012 the $6,000 balance of her gain        the basis.
$15,000. Your $5,000 loss is not recognized.         on the 2011 exchange. Her adjusted basis in
                                                     the grey pickup truck is increased to $7,000 (its         For more information on transfers of prop­
    Unlike property given up. If, in addition to     $1,000 basis plus the $6,000 gain recognized).        erty incident to divorce, see Property Settle-
like­kind property, you give up unlike property,                                                           ments in Publication 504, Divorced or Separa­
you must recognize gain or loss on the unlike           Exceptions to the rules for related per-           ted Individuals.
property you give up. The gain or loss is the dif­   sons. The following property dispositions are
ference between the FMV of the unlike property       excluded from these rules.
and the adjusted basis of the unlike property.            Dispositions due to the death of either rela­    Ordinary or Capital
                                                          ted person.
Like-kind exchanges between related per-                  Involuntary conversions.                         Gain or Loss
sons. Special rules apply to like­kind ex­                Dispositions where it is established to the
changes between related persons. These rules                                                               Generally, you will have a capital gain or loss if
                                                          satisfaction of the IRS that neither the ex­
affect both direct and indirect exchanges. Un­                                                             you sell or exchange a capital asset (defined
                                                          change nor the disposition has, as a main
der these rules, if either person disposes of the                                                          below). You may also have a capital gain if your
                                                          purpose, the avoidance of federal income
property within 2 years after the exchange, the                                                            section 1231 transactions result in a net gain.
                                                          tax.
exchange is disqualified from nonrecognition                                                               See Section 1231 Gains and Losses in
treatment. The gain or loss on the original ex­                                                            chapter 9.
                                                     Multiple property exchanges. Under the
change must be recognized as of the date of          like­kind exchange rules, you must generally             To figure your net capital gain or loss, you
the later disposition. The 2­year holding period     make a property­by­property comparison to fig­        must classify your gains and losses as either or­
begins on the date of the last transfer of prop­     ure your recognized gain and the basis of the         dinary or capital (and your capital gains or los­
erty that was part of the like­kind exchange.        property you receive in the exchange. However,        ses as either short­term or long­term).
                                                     for exchanges of multiple properties, you do not
    Related persons. Under these rules, rela­
                                                     make a property­by­property comparison if you             Your net capital gains may be taxed at a
ted persons include, for example, you and a
                                                     do either of the following.                           lower tax rate than ordinary income. See Capi-
member of your family (spouse, brother, sister,
                                                           Transfer and receive properties in two or       tal Gains Tax Rates, later. Your deduction for a
parent, child, etc.), you and a corporation in
                                                           more exchange groups.                           net capital loss may be limited. See Treatment
which you have more than 50% ownership, you
                                                           Transfer or receive more than one property      of Capital Losses, later.
and a partnership in which you directly or indi­
                                                           within a single exchange group.
rectly own more than a 50% interest of the capi­
tal or profits, and two partnerships in which you       For more information, see Multiple Property        Capital Assets
directly or indirectly own more than 50% of the      Exchanges in chapter 1 of Publication 544.
capital interests or profits.                                                                              Almost everything you own and use for per­
    For the complete list of related persons, see    Deferred exchange. A deferred exchange for            sonal purposes or investment is a capital asset.
Related persons in chapter 2 of Publication          like­kind property may qualify for nonrecogni­
544.                                                 tion of gain or loss. A deferred exchange is an          The following items are examples of capital
                                                     exchange in which you transfer property you           assets.
    Example. You used a grey pickup truck in         use in business or hold for investment and later          A home owned and occupied by you and
your farming business. Your sister used a red        receive like­kind property you will use in busi­          your family.
pickup truck in her landscaping business. In De­     ness or hold for investment. The property you             Household furnishings.
cember 2011, you exchanged your grey pickup          receive is replacement property. The transac­              A car used for pleasure. If your car is used
truck, plus $200, for your sister's red pickup       tion must be an exchange of property for prop­             both for pleasure and for farm business, it
truck. At that time, the FMV of the grey pickup      erty rather than a transfer of property for money          is partly a capital asset and partly a nonca­
truck was $7,000 and its adjusted basis was          used to buy replacement property. In addition,             pital asset, defined later.
$6,000. The FMV of the red pickup truck was          the replacement property will not be treated as            Stocks and bonds. However, there are
$7,200 and its adjusted basis was $1,000. You        like­kind property unless certain identification           special rules for gains on qualified small
realized a gain of $1,000 (the $7,200 FMV of         and receipt requirements are met.                          business stock. For more information on
the red pickup truck, minus the grey pickup              For more information see Deferred Ex-                  this subject, see Gains on Qualified Small
truck's $6,000 adjusted basis, minus the $200        changes in chapter 1 of Publication 544.                   Business Stock and Losses on Section
you paid). Your sister realized a gain of $6,200                                                                1244 (Small Business) Stock in chapter 4
(the $7,000 FMV of the grey pickup truck plus        Transfer to Spouse                                         of Publication 550.
the $200 you paid, minus the $1,000 adjusted
basis of the red pickup truck).                                                                            Personal-use property. Gain from a sale or
                                                     No gain or loss is recognized on a transfer of
    However, because this was a like­kind ex­                                                              exchange of personal­use property is a capital
                                                     property from an individual to (or in trust for the
change, you recognized no gain. Your basis in                                                              gain and is taxable. Loss from the sale or ex­
                                                     benefit of) a spouse, or a former spouse if inci­
the red pickup truck was $6,200 (the $6,000 ad­                                                            change of personal­use property is not deducti­
                                                     dent to divorce. This rule does not apply if the
justed basis of the grey pickup truck plus the                                                             ble. You can deduct a loss relating to per­
                                                     recipient is a nonresident alien. Nor does this
$200 you paid). She recognized gain only to the                                                            sonal­use property only if it results from a
                                                     rule apply to a transfer in trust to the extent the
extent of the money she received, $200. Her                                                                casualty or theft. For information on casualties
                                                     liabilities assumed and the liabilities on the
basis in the grey pickup truck was $1,000 (the                                                             and thefts, see chapter 11.
                                                     property are more than the property's adjusted
$1,000 adjusted basis of the red pickup truck
                                                     basis.
minus the $200 received, plus the $200 gain                                                                Long and Short Term
recognized).                                             Any transfer of property to a spouse or for­
    In 2012, you sold the red pickup truck to a      mer spouse on which gain or loss is not recog­        Where you report a capital gain or loss depends
third party for $7,000. Because you sold it within   nized is not considered a sale or exchange. The       on how long you own the asset before you sell
2 years after the exchange, the exchange is dis­     recipient's basis in the property will be the same    or exchange it. The time you own an asset be­
qualified from nonrecognition treatment. On          as the adjusted basis of the giver immediately        fore disposing of it is the holding period.
your tax return for 2012, you must report your       before the transfer. This carryover basis rule
$1,000 gain on the 2011 exchange. You also           applies whether the adjusted basis of the trans­         If you hold a capital asset 1 year or less, the
report a loss on the sale as $200 (the adjusted      ferred property is less than, equal to, or greater    gain or loss resulting from its disposition is short
basis of the red pickup truck, $7,200 (its $6,200    than either its FMV at the time of transfer or any    term. Report it in Part I of Schedule D (Form
basis plus the $1,000 gain recognized), minus        consideration paid by the recipient. This rule        1040). If you hold a capital asset longer than 1
the $7,000 realized from the sale).                  applies for determining loss as well as gain. Any     year, the gain or loss resulting from its

Page 50      Chapter 8     Gains and Losses
disposition is long term. Report it in Part II of       difference is taxable. However, part of your gain     a noncapital asset. Gain or loss from sales or
Schedule D (Form 1040).                                 (but not more than your net capital gain) may be      other dispositions of this property is reported on
                                                        taxed at a lower rate than the rate of tax on your    Schedule F (Form 1040) (not on Schedule D
Holding period. To figure if you held property          ordinary income. See Capital Gains Tax Rates,         (Form 1040) or Form 4797). The treatment of
longer than 1 year, start counting on the day af­       later.                                                this property is discussed in chapter 3.
ter the day you acquired the property. The day
you disposed of the property is part of your            Net loss. If the total of your capital losses is      Land and depreciable properties. Land and
holding period.                                         more than the total of your capital gains, the dif­   depreciable property you use in farming are not
                                                        ference is deductible. But there are limits on        capital assets. Noncapital assets also include
   Example. If you bought an asset on June              how much loss you can deduct and when you             livestock held for draft, breeding, dairy, or sport­
19, 2011, you should start counting on June 20,         can deduct it. See Treatment of Capital Los-          ing purposes. However, your gains and losses
2011. If you sold the asset on June 19, 2012,           sesnext.                                              from sales and exchanges of your farmland and
your holding period is not longer than 1 year,                                                                depreciable properties must be considered to­
but if you sold it on June 20, 2012, your holding       Treatment of Capital Losses                           gether with certain other transactions to deter­
period is longer than 1 year.                                                                                 mine whether the gains and losses are treated
                                                        If your capital losses are more than your capital     as capital or ordinary gains and losses. The
    Inherited property. If you inherit property,                                                              sales of these business assets are reported on
you are considered to have held the property            gains, you must claim the difference even if you
                                                        do not have ordinary income to offset it. For tax­    Form 4797. See chapter 9 for more information.
longer than 1 year, regardless of how long you
actually held it. This rule does not apply to live­     payers other than corporations, the yearly limit
stock used in a farm business. See Holding pe-          on the capital loss you can deduct is $3,000          Hedging
riod under Livestock, later.                            ($1,500 if you are married and file a separate
                                                        return). If your other income is low, you may not
                                                                                                              (Commodity Futures)
    Nonbusiness bad debt. A nonbusiness                 be able to use the full $3,000. The part of the       Hedging transactions are transactions that you
bad debt is a short­term capital loss, deductible       $3,000 you cannot use becomes part of your            enter into in the normal course of business pri­
in the year the debt becomes worthless. See             capital loss carryover (discussed next).              marily to manage the risk of interest rate or
chapter 4 of Publication 550.                                                                                 price changes, or currency fluctuations, with re­
                                                        Capital loss carryover. Generally, you have a         spect to borrowings, ordinary property, or ordi­
   Nontaxable exchange. If you acquire an               capital loss carryover if either of the following
asset in exchange for another asset and your                                                                  nary obligations. Ordinary property or obliga­
                                                        situations applies to you.                            tions are those that cannot produce capital gain
basis for the new asset is figured, in whole or in           Your net loss on Schedule D (Form 1040),
part, by using your basis in the old property, the                                                            or loss if sold or exchanged.
                                                             is more than the yearly limit.
holding period of the new property includes the              Your taxable income without your deduc­              A commodity futures contract is a standar­
holding period of the old property. That is, it be­          tion for exemptions is less than zero.           dized, exchange­traded contract for the sale or
gins on the same day as your holding period for                                                               purchase of a fixed amount of a commodity at a
the old property.                                       If either of these situations applies to you for
                                                                                                              future date for a fixed price. The holder of an
                                                        2012, see Capital Losses under Reporting Cap-
                                                                                                              option on a futures contract has the right (but
    Gift. If you receive a gift of property and         ital Gains and Losses in chapter 4 of Publica­
                                                                                                              not the obligation) for a specified period of time
your basis in it is figured using the donor's ba­       tion 550 to figure the amount you can carry over
                                                                                                              to enter into a futures contract to buy or sell at a
sis, your holding period includes the donor's           to 2013.
                                                                                                              particular price. A forward contract is generally
holding period.
                                                                To figure your capital loss carryover         similar to a futures contract except that the
    Real property. To figure how long you held           TIP    from 2012 to 2013, you will need a            terms are not standardized and the contract is
real property, start counting on the day after you              copy of your 2012 Form 1040 and               not exchange traded.
received title to it or, if earlier, on the day after   Schedule D (Form 1040).
                                                                                                                  Businesses may enter into commodity fu­
you took possession of it and assumed the bur­
                                                                                                              tures contracts or forward contracts and may
dens and privileges of ownership.
                                                        Capital Gains Tax Rates                               acquire options on commodity futures contracts
    However, taking possession of real property
                                                                                                              as either of the following.
under an option agreement is not enough to
                                                        The tax rates that apply to a net capital gain are         Hedging transactions.
start the holding period. The holding period
cannot start until there is an actual contract of       generally lower than the tax rates that apply to           Transactions that are not hedging transac­
sale. The holding period of the seller cannot           other income. These lower rates are called the             tions.
end before that time.                                   maximum capital gains rates.
                                                                                                                  Futures transactions with exchange­traded
                                                            The term “net capital gain” means the             commodity futures contracts that are not hedg­
Figuring Net Gain or Loss                               amount by which your net long­term capital gain
                                                                                                              ing transactions, generally, result in capital gain
                                                                                                              or loss and are subject to the mark­to­market
                                                        for the year is more than your net short­term
The totals for short­term capital gains and los­                                                              rules discussed in Publication 550. There is a
                                                        capital loss.
ses and the totals for long­term capital gains                                                                limit on the amount of capital losses you can
and losses must be figured separately.                                                                        deduct each year. Hedging transactions are not
                                                            See Schedule D (Form 1040) and the In­
                                                                                                              subject to the mark­to­market rules.
Net short-term capital gain or loss. Com­               structions for Schedule D (Form 1040). Also
bine your short­term capital gains and losses.          see Publication 550.                                      If, as a farmer­producer, to protect yourself
Do this by totalling all of your short­term capital                                                           from the risk of unfavorable price fluctuations,
gains. Then total all of your short­term capital        Noncapital Assets                                     you enter into commodity forward contracts, fu­
                                                                                                              tures contracts, or options on futures contracts
losses. Subtract the lesser total from the
greater. The difference is your net short­term                                                                and the contracts cover an amount of the com­
                                                        Noncapital assets include property such as in­        modity within your range of production, the
capital gain or loss, whichever is greater.             ventory and depreciable property used in a            transactions are generally considered hedging
                                                        trade or business. A list of properties that are      transactions. They can take place at any time
Net long-term capital gain or loss. Follow              not capital assets is provided in the Instructions
the same steps to combine your long­term capi­                                                                you have the commodity under production,
                                                        for Schedule D (Form 1040).                           have it on hand for sale, or reasonably expect to
tal gains and losses. The result is your net
long­term capital gain or loss.                                                                               have it on hand.
                                                        Property held for sale in the ordinary
                                                        course of your farm business. Property you               The gain or loss on the termination of these
Net gain. If the total of your capital gains is         hold mainly for sale to customers, such as live­      hedges is generally ordinary gain or loss. Farm­
more than the total of your capital losses, the         stock, poultry, livestock products, and crops, is     ers who file their income tax returns on the cash

                                                                                                                Chapter 8     Gains and Losses          Page 51
method report any profit or loss on the hedging       ter into the following hedging transaction. You                                     The rules discussed here do not apply
transaction on Schedule F, line 10.                   sell 10 December futures contracts of 5,000                                  !      to the sale of livestock held primarily
                                                      bushels each for a total of 50,000 bushels of                              CAUTION  for sale to customers. The sale of this
   Gains or losses from hedging transactions          corn at $5.75 a bushel.                                                   livestock is reported on Schedule F. See chap-
that hedge supplies of a type regularly used or           The price did not drop as anticipated but                             ter 3.
consumed in the ordinary course of your trade         rose to $6 a bushel. In November, you sell your
or business may be ordinary gains or losses.          crop at a local elevator for $6 a bushel. You also
Examples include fuel and feed.                                                                                                 Also, special rules apply to sales or exchanges
                                                      close out your futures position by buying 10 De­                          caused by weather-related conditions. See
          If you have numerous transactions in        cember contracts for $6 a bushel. You paid a                              chapter 3.
          the commodity futures market during         broker's commission of $1,400 ($70 per con­
RECORDS   the year, you must be able to show          tract) for the complete in and out position in the                        Holding period. The sale or exchange of live­
which transactions are hedging transactions.          futures market.                                                           stock used in your farm business (defined be­
Clearly identify a hedging transaction on your            The result is that the price of corn rose 25                          low) qualifies as a section 1231 transaction if
books and records before the end of the day           cents a bushel and the actual selling price is $6                         you held the livestock for 12 months or more
you entered into the transaction. It may be help­     a bushel. Your loss on the hedge is 25 cents a                            (24 months or more for horses and cattle).
ful to have separate brokerage accounts for           bushel. In effect, the net selling price of your
your hedging and speculation transactions.            corn is $5.75 a bushel.                                                   Livestock. For section 1231 transactions, live­
                                                          Report the results of your futures transac­                           stock includes cattle, hogs, horses, mules, don­
    Retain the identification of each hedging         tions and your sale of corn separately on                                 keys, sheep, goats, fur­bearing animals, and
transaction with your books and records. Also,        Schedule F. See the instructions for the 2012                             other mammals. Also, for section 1231 transac­
identify the item(s) or aggregate risk that is be­    Schedule F (Form 1040).                                                   tions, livestock does not include chickens, tur­
ing hedged in your records. Although the identi­          The loss on your futures transactions is                              keys, pigeons, geese, emus, ostriches, rheas,
fication of the hedging transaction must be           $13,900, figured as follows.                                              or other birds, fish, frogs, reptiles, etc.
made before the end of the day it was entered
into, you have 35 days after entering into the         July 2 ­ Sold December corn futures                                          Livestock used in farm business. If live­
transaction to identify the hedged item(s) or          (50,000 bu. @$5.75) . . . . . . . . . . .        . . . .     $287,500    stock is held primarily for draft, breeding, dairy,
risk.                                                  November 6 ­ Bought December corn                                        or sporting purposes, it is used in your farm
                                                       futures (50,000 bu. @$6 plus $1,400                                      business. The purpose for which an animal is
                                                       broker's commission) . . . . . . . . . .                      301,400
    For more information on the tax treatment of                                                        . . . .                 held ordinarily is determined by a farmer's ac­
                                                       Futures loss . . . . . . . . . . . . . . . .     . . . .     ($13,900)
futures and options contracts, see Commodity                                                                                    tual use of the animal. An animal is not held for
Futures and Section 1256 Contracts Marked to                                                                                    draft, breeding, dairy, or sporting purposes
Market in Publication 550.                            This loss is reported as a negative figure on                             merely because it is suitable for that purpose, or
                                                      Schedule F, Part I, as other income.                                      because it is held for sale to other persons for
Accounting methods for hedging transac-                    The proceeds from your corn sale at the lo­                          use by them for that purpose. However, a draft,
tions. The accounting method you use for a            cal elevator are $300,000 (50,000 bu. × $6).                              breeding, or sporting purpose may be present if
hedging transaction must clearly reflect income.      Report it on Schedule F, Part I, as income from                           an animal is disposed of within a reasonable
This means that your accounting method must           sales of products you raised.                                             time after it is prevented from its intended use
reasonably match the timing of income, deduc­              Assume you were right and the price went                             or made undesirable as a result of an accident,
tion, gain, or loss from a hedging transaction        down 25 cents a bushel. In effect, you would                              disease, drought, or unfitness of the animal.
with the timing of income, deduction, gain, or        still net $5.75 a bushel, figured as follows.
loss from the item or items being hedged. There                                                                                      Example 1. You discover an animal that
are requirements and limits on the method you          Sold cash corn, per bushel         . . . . . . . . . . . .      $5.50    you intend to use for breeding purposes is ster­
can use for certain hedging transactions. See          Gain on hedge, per bushel          . . . . . . . . . . . .        .25    ile. You dispose of it within a reasonable time.
Regulations section 1.446­4(e) for those re­           Net price, per bushel        . . . . . . . . . . . . . . .      $5.75    This animal was held for breeding purposes.
quirements and limits.
    Hedging transactions must be accounted for           The gain on your futures transactions would                               Example 2. You retire and sell your entire
under the rules stated above unless the trans­        have been $11,100, figured as follows.                                    herd, including young animals that you would
action is subject to mark­to­market accounting                                                                                  have used for breeding or dairy purposes had
under section 475 or you use an accounting             July 2 ­ Sold December corn futures (50,000                              you remained in business. These young ani­
method other than the following methods.               bu. @$5.75) . . . . . . . . . . . . . . . . . . . . . .      $287,500    mals were held for breeding or dairy purposes.
                                                       November 6 ­ Bought December corn                                        Also, if you sell young animals to reduce your
  1. Cash method.                                      futures (50,000 bu. @$5.50 plus $1,400
                                                                                                                     276,400
                                                                                                                                breeding or dairy herd because of drought,
  2. Farm­price method.                                broker's commission) . . . . . . . . . . . . . . .
                                                                                                                                these animals are treated as having been held
                                                       Futures gain . . . . . . . . . . . . . . . . . . . . .        $11,100
                                                                                                                                for breeding or dairy purposes. See Sales
  3. Unit­livestock­price method.
                                                                                                                                Caused by Weather-Related Conditions in
                                                      The $11,100 is reported on Schedule F, Part I,
    Once you adopt a method, you must apply it                                                                                  chapter 3.
                                                      as other income.
consistently and must have IRS approval before
                                                         The proceeds from the sale of your corn at                                 Example 3. You are in the business of rais­
changing it.
                                                      the local elevator, $275,000, are reported on
    Your books and records must describe the                                                                                    ing hogs for slaughter. Customarily, before sell­
                                                      Schedule F, Part I, as income from sales of
accounting method used for each type of hedg­                                                                                   ing your sows, you obtain a single litter of pigs
                                                      products you raised.
ing transaction. They must also contain any ad­                                                                                 that you will raise for sale. You sell the brood
ditional identification necessary to verify the ap­                                                                             sows after obtaining the litter. Even though you
plication of the accounting method you used for       Livestock                                                                 hold these brood sows for ultimate sale to cus­
the transaction. You must make the additional                                                                                   tomers in the ordinary course of your business,
identification no more than 35 days after enter­      This part discusses the sale or exchange of                               they are considered to be held for breeding pur­
ing into the hedging transaction.                     livestock used in your farm business. Gain or                             poses.
                                                      loss from the sale or exchange of this livestock
Example of a hedging transaction. You file            may qualify as a section 1231 gain or loss.                                   Example 4. You are in the business of rais­
your income tax returns on the cash method.           However, any part of the gain that is ordinary in­                        ing registered cattle for sale to others for use as
On July 2 you anticipate a yield of 50,000 bush­      come from the recapture of depreciation is not                            breeding cattle. The business practice is to
els of corn this year. The December futures           included as section 1231 gain. See chapter 9                              breed the cattle before sale to establish their fit­
price is $5.75 a bushel, but there are indications    for more information on section 1231 gains and                            ness as registered breeding cattle. Your use of
that by harvest time the price will drop. To pro­     losses and the recapture of depreciation under                            the young cattle for breeding purposes is ordi­
tect yourself against a drop in the price, you en­    section 1245.                                                             nary and necessary for selling them as

Page 52      Chapter 8     Gains and Losses
registered breeding cattle. Such use does not                               A wetland (before conversion) is land that             timber results in no gain or loss. It is not until a
demonstrate that you are holding the cattle for                           meets all the following conditions.                      sale or exchange occurs that gain or loss is re­
breeding purposes. However, those cattle you                                  It is mostly soil that, in its undrained condi­      alized. But if you owned or had a contractual
held as additions or replacements to your own                                 tion, is saturated, flooded, or ponded long          right to cut timber, you can elect to treat the cut­
breeding herd to produce calves are consid­                                   enough during a growing season to de­                ting of timber as a section 1231 transaction in
ered to be held for breeding purposes, even                                   velop an oxygen­deficient state that sup­            the year it is cut. Even though the cut timber is
though they may not actually have produced                                    ports the growth and regeneration of plants          not actually sold or exchanged, you report your
calves. The same applies to hog and sheep                                     growing in water.                                    gain or loss on the cutting for the year the tim­
breeders.                                                                     It is saturated by surface or groundwater at         ber is cut. Any later sale results in ordinary busi­
                                                                              a frequency and duration sufficient to sup­          ness income or loss.
     Example 5. You breed, raise, and train                                   port mostly plants that are adapted for life             To elect this treatment, you must:
horses for racing purposes. Every year you cull                               in saturated soil.
horses from your racing stable. In 2012, you de­                              It supports, under normal circumstances,               1. Own or hold a contractual right to cut the
cided that to prevent your racing stable from                                 mostly plants that grow in saturated soil.                timber for a period of more than 1 year be­
getting too large to be effectively operated, you                                                                                       fore it is cut, and
must cull six horses that had been raced at pub­                          Highly erodible cropland. This is cropland                 2. Cut the timber for sale or use in your trade
lic tracks in 2011. These horses are all consid­                          subject to erosion that you used at any time for              or business.
ered held for sporting purposes.                                          farming purposes other than grazing animals.
                                                                          Generally, highly erodible cropland is land cur­             Making the election. You make the elec­
Figuring gain or loss on the cash method.                                 rently classified by the Department of Agricul­          tion on your return for the year the cutting takes
Farmers or ranchers who use the cash method                               ture as Class IV, VI, VII, or VIII under its classifi­   place by including in income the gain or loss on
of accounting figure their gain or loss on the                            cation system. Highly erodible cropland also             the cutting and including a computation of your
sale of livestock used in their farming business                          includes land that would have an excessive               gain or loss. You do not have to make the elec­
as follows.                                                               average annual erosion rate in relation to the           tion in the first year you cut the timber. You can
                                                                          soil loss tolerance level, as determined by the          make it in any year to which the election would
    Raised livestock. Gain on the sale of                                                                                          apply. If the timber is partnership property, the
                                                                          Department of Agriculture.
raised livestock is generally the gross sales                                                                                      election is made on the partnership return. This
price reduced by any expenses of the sale. Ex­                            Successor. Converted wetland or highly erodi­            election cannot be made on an amended re­
penses of sale include sales commissions,                                 ble cropland is also land held by any person             turn.
freight or hauling from farm to commission com­                           whose basis in the land is figured by reference              Once you have made the election, it re­
pany, and other similar expenses. The basis of                            to the adjusted basis of a person in whose               mains in effect for all later years unless you re­
the animal sold is zero if the costs of raising it                        hands the property was converted wetland or              voke it.
were deducted during the years the animal was                             highly erodible cropland.
being raised. However, see Uniform Capitaliza-                                                                                         Election under section 631(a) may be re-
tion Rules in chapter 6.                                                                                                           voked. If you previously elected for any tax
                                                                          Timber                                                   year ending before October 23, 2004, to treat
    Purchased livestock. The gross sales                                                                                           the cutting of timber as a sale or exchange un­
price minus your adjusted basis and any expen­                            Standing timber you held as investment prop­             der section 631(a), you may revoke this election
ses of sale is the gain or loss.                                          erty is a capital asset. Gain or loss from its sale      without the consent of the IRS for any tax year
                                                                          is capital gain or loss reported on Schedule D           ending after October 22, 2004. The prior elec­
   Example. A farmer sold a breeding cow on                               (Form 1040). If you held the timber primarily for        tion (and revocation) is disregarded for purpo­
January 8, 2012, for $1,250. Expenses of the                              sale to customers, it is not a capital asset. Gain       ses of making a subsequent election. See Form
sale were $125. The cow was bought July 2,                                or loss on its sale is ordinary business income          T (Timber), Forest Activities Schedule, for more
2008, for $1,300. Depreciation (not less than                             or loss. It is reported on Schedule F, line 1 (pur­      information.
the amount allowable) was $867.                                           chased timber) or line 2 (raised timber). See the
                                                                          Instructions for Schedule F (Form 1040).                     Gain or loss. Your gain or loss on the cut­
 Gross sales price . . . . . . . .       . . . . . . . . . . .   $1,250                                                            ting of standing timber is the difference between
                                                                              Farmers who cut timber on their land and
 Cost (basis) . . . . . . . . . . . .    . . . . .   $1,300                                                                        its adjusted basis for depletion and its FMV on
                                                                          sell it as logs, firewood, or pulpwood usually
 Minus: Depreciation deduction             . . . .      867                                                                        the first day of your tax year in which it is cut.
                                                                          have no cost or other basis for that timber.
 Unrecovered cost                                                                                                                      Your adjusted basis for depletion of cut tim­
 (adjusted basis)                                      $ 433              Amounts realized from these sales, and the ex­
                       . . . . . . . . . . . . . .                                                                                 ber is based on the number of units (board feet,
 Expense of sale                                         125       558    penses incurred in cutting, hauling, etc., are or­
                       . . . . . . . . . . . . . .
                                                                                                                                   log scale, or other units) of timber cut during the
 Gain realized                                                   $ 692    dinary farm income and expenses reported on
                     . . . . . . . . . . . . . . . . . . . . .                                                                     tax year and considered to be sold or ex­
                                                                          Schedule F.
                                                                                                                                   changed. Your adjusted basis for depletion is
                                                                              Different rules apply if you owned the timber        also based on the depletion unit of timber in the
Converted Wetland and                                                     longer than 1 year and elect to treat timber cut­        account used for the cut timber, and should be
Highly Erodible Cropland                                                  ting as a sale or exchange or you enter into a           figured in the same manner as shown in section
                                                                          cutting contract, discussed below.                       611 and Regulations section 1.611­3.
Special rules apply to dispositions of land con­                                                                                       Depletion of timber is discussed in chap­
verted to farming use after March 1, 1986. Any                            Timber considered cut. Timber is considered              ter 7.
gain realized on the disposition of converted                             cut on the date when, in the ordinary course of
wetland or highly erodible cropland is treated as                         business, the quantity of felled timber is first             Example. In April 2012, you owned 4,000
ordinary income. Any loss on the disposition of                           definitely determined. This is true whether the          MBF (1,000 board feet) of standing timber lon­
such property is treated as a long­term capital                           timber is cut under contract or whether you cut          ger than 1 year. It had an adjusted basis for de­
loss.                                                                     it yourself.                                             pletion of $40 per MBF. You are a calendar year
                                                                                                                                   taxpayer. On January 1, 2012, the timber had a
Converted wetland. This is generally land that                            Christmas trees. Evergreen trees, such as                FMV of $350 per MBF. It was cut in April for
was drained or filled to make the production of                           Christmas trees, that are more than 6 years old          sale. On your 2012 tax return, you elect to treat
agricultural commodities possible. It includes                            when severed from their roots and sold for or­           the cutting of the timber as a sale or exchange.
converted wetland held by the person who orig­                            namental purposes are included in the term tim­          You report the difference between the FMV and
inally converted it or held by any other person                           ber. They qualify for both rules discussed be­           your adjusted basis for depletion as a gain. This
who used the converted wetland at any time af­                            low.                                                     amount is reported on Form 4797 along with
ter conversion for farming.                                                                                                        your other section 1231 gains and losses to fig­
                                                                          Election to treat cutting as a sale or ex-               ure whether it is treated as a capital gain or as
                                                                          change. Under the general rule, the cutting of           ordinary gain. You figure your gain as follows.

                                                                                                                                     Chapter 8     Gains and Losses          Page 53
 FMV of timber January 1, 2012 . . .       . . . .   $1,400,000   right to cut it for sale on your own account or for   mines the buyer's basis in the business assets.
 Minus: Adjusted basis for depletion       . . . .      160,000   use in your business.                                 For more information, see Sale of a Business in
 Section 1231 gain   . . . . . . . . . . . . . . .   $1,240,000                                                         chapter 2 of Publication 544.
                                                                  Tree stumps. Tree stumps are a capital asset
   The FMV becomes your basis in the cut tim­                     if they are on land held by an investor who is not    Property used in farm operation. The rules
ber, and a later sale of the cut timber, including                in the timber or stump business as a buyer,           for excluding the gain on the sale of your home,
any by­product or tree tops, will result in ordi­                 seller, or processor. Gain from the sale of           described later under Sale of your home, do not
nary business income or loss.                                     stumps sold in one lot by such a holder is taxed      apply to the property used for your farming busi­
                                                                  as a capital gain. However, tree stumps held by       ness. Recognized gains and losses on busi­
Outright sales of timber. Outright sales of                       timber operators after the saleable standing tim­     ness property must be reported on your return
timber by landowners qualify for capital gains                    ber was cut and removed from the land are con­        for the year of the sale. If the property was held
treatment using rules similar to the rules for cer­               sidered by­products. Gain from the sale of            longer than 1 year, it may qualify for section
tain disposal of timber under a contract with re­                 stumps in lots or tonnage by such operators is        1231 treatment (see chapter 9).
tained economic interest (defined later). How­                    taxed as ordinary income.
ever, for outright sales, the date of disposal is                      See Form T (Timber) and its separate in­             Example. You sell your farm, including your
not deemed to be the date the timber is cut be­                   structions for more information about disposi­        main home, which you have owned since De­
cause the landowner can elect to treat the pay­                   tions of timber.                                      cember 2001. You realize gain on the sale as
ment date as the date of disposal (see Date of                                                                          follows.
disposal below).                                                  Sale of a Farm
                                                                                                                                                   Farm                   Farm
Cutting contract. You must treat the disposal                     The sale of your farm will usually involve the                                    With   Home         Without
of standing timber under a cutting contract as a                                                                                                  Home       Only        Home
                                                                  sale of both nonbusiness property (your home)
                                                                                                                         Selling price . . . .  $382,000 $158,000      $224,000
section 1231 transaction if all the following ap­                 and business property (the land and buildings          Cost (or other
ply to you.                                                       used in the farm operation and perhaps machi­          basis)    . . . . . . . . 240,000   110,000    130,000
      You are the owner of the timber.                            nery and livestock). If you have a gain from the       Gain . . . . . . . . . $142,000     $48,000   $94,000
     You held the timber longer than 1 year be­                   sale, you may be allowed to exclude the gain on
     fore its disposal.                                           your home. For more information, see Publica­             You must report the $94,000 gain from the
     You kept an economic interest in the tim­                    tion 523, Selling Your Home.                          sale of the property used in your farm business.
     ber.                                                                                                               All or a part of that gain may have to be repor­
                                                                      The gain on the sale of your business prop­
    You have kept an economic interest in                         erty is taxable. A loss on the sale of your busi­     ted as ordinary income from the recapture of
standing timber if, under the cutting contract,                   ness property to an unrelated person is deduc­        depreciation or soil and water conservation ex­
the expected return on your investment is con­                    ted as an ordinary loss. Your taxable gain or         penses. Treat the balance as section 1231
ditioned on the cutting of the timber.                            loss on the sale of property used in your farm        gain.
    The difference between the amount realized                    business is taxed under the rules for section             The $48,000 gain from the sale of your
from the disposal of the timber and its adjusted                  1231 transactions. See chapter 9. Losses from         home is not taxable as long as you meet the re­
basis for depletion is treated as gain or loss on                 personal­use property, other than casualty or         quirements explained later under Sale of your
its sale. Include this amount on Form 4797                        theft losses, are not deductible. If you receive      home.
along with your other section 1231 gains or los­                  payments for your farm in installments, your
ses to figure whether it is treated as capital or                 gain is taxed over the period of years the pay­       Partial sale. If you sell only part of your farm,
ordinary gain or loss.                                            ments are received, unless you elect not to use       you must report any recognized gain or loss on
                                                                  the installment method of reporting the gain.         the sale of that part on your tax return for the
    Date of disposal. The date of disposal is                     See chapter 10 for information about install­         year of the sale. You cannot wait until you have
the date the timber is cut. However, for outright                 ment sales.                                           sold enough of the farm to recover its entire
sales by landowners or if you receive payment                                                                           cost before reporting gain or loss. For a detailed
under the contract before the timber is cut, you                     When you sell your farm, the gain or loss on       discussion on installment sales, see Publication
can elect to treat the date of payment as the                     each asset is figured separately. The tax treat­      544.
date of disposal.                                                 ment of gain or loss on the sale of each asset is
    This election applies only to figure the hold­                determined by the classification of the asset.           Adjusted basis of the part sold. This is
ing period of the timber. It has no effect on the                 Each of the assets sold must be classified as         the properly allocated part of your original cost
time for reporting gain or loss (generally when                   one of the following.                                 or other basis of the entire farm plus or minus
the timber is sold or exchanged).                                      Capital asset held 1 year or less.               necessary adjustments for improvements, de­
    To make this election, attach a statement to                                                                        preciation, etc., on the part sold. If your home is
                                                                       Capital asset held longer than 1 year.
the tax return filed by the due date (including                                                                         on the farm, you must properly adjust the basis
                                                                       Property (including real estate) used in         to exclude those costs from your farm asset
extensions) for the year payment is received.
                                                                       your business and held 1 year or less (in­       costs, as discussed below under Sale of your
The statement must identify the advance pay­
                                                                       cluding draft, breeding, dairy, and sporting     home.
ments subject to the election and the contract
                                                                       animals held less than the holding periods
under which they were made.
                                                                       discussed earlier under Livestock).                  Example. You bought a 600­acre farm for
    If you timely filed your return for the year you
                                                                       Property (including real estate) used in         $700,000. The farm included land and build­
received payment without making the election,
                                                                       your business and held longer than 1 year        ings. The purchase contract designated
you can still make the election by filing an
                                                                       (including only draft, breeding, dairy, and      $600,000 of the purchase price to the land. You
amended return within 6 months after the due
                                                                       sporting animals held for the holding peri­      later sold 60 acres of land on which you had in­
date for that year's return (excluding exten­
                                                                       ods discussed earlier).                          stalled a fence. Your adjusted basis for the part
sions). Attach the statement to the amended re­
                                                                       Property held primarily for sale or which is     of your farm sold is $60,000 (1 10 of $600,000),
turn and write “Filed pursuant to section
                                                                       of the kind that would be included in inven­     plus any unrecovered cost (cost not depreci­
301.9100­2” at the top of the statement. File the
                                                                       tory if on hand at the end of your tax year.     ated) of the fence on the 60 acres at the time of
amended return at the same address the origi­
nal return was filed.                                                                                                   sale. Use this amount to determine your gain or
                                                                  Allocation of consideration paid for a farm.          loss on the sale of the 60 acres.
   Owner. An owner is any person who owns                         The sale of a farm for a lump sum is considered
an interest in the timber, including a sublessor                  a sale of each individual asset rather than a sin­       Assessed values for local property
and the holder of a contract to cut the timber.                   gle asset. The residual method is required only       taxes. If you paid a flat sum for the entire farm
You own an interest in timber if you have the                     if the group of assets sold constitutes a trade or    and no other facts are available for properly al­
                                                                  business. This method determines gain or loss         locating your original cost or other basis be­
                                                                  from the transfer of each asset. It also deter­       tween the land and the buildings, you can use

Page 54        Chapter 8           Gains and Losses
the assessed values for local property taxes for     the full amount of the debt canceled by the                           amount she realizes is $170,000. This is the
the year of purchase to allocate the costs.          transfer. The total canceled debt is included in                      canceled debt ($180,000) up to the FMV of the
                                                     the amount realized even if the FMV of the                            land ($170,000). Ann figures her gain or loss on
    Example. Assume that in the preceding ex­        property is less than the canceled debt.                              the foreclosure by comparing the amount real­
ample there was no breakdown of the $700,000                                                                               ized ($170,000) with her adjusted basis
purchase price between land and buildings.               Example 1. Ann paid $200,000 for land                             ($200,000). She has a $30,000 deductible loss,
However, in the year of purchase, local taxes        used in her farming business. She paid $15,000                        which she figures on Form 4797, Part I. She is
on the entire property were based on assessed        down and borrowed the remaining $185,000                              also treated as receiving ordinary income from
valuations of $420,000 for land and $140,000         from a bank. Ann is not personally liable for the                     cancellation of debt. That income is $10,000
for improvements, or a total of $560,000. The        loan (nonrecourse debt), but pledges the land                         ($180,000 − $170,000). This is the part of the
assessed valuation of the land is 3 4 (75%) of the   as security. The bank foreclosed on the loan 2                        canceled debt not included in the amount real­
total assessed valuation. Multiply the $700,000      years after Ann stopped making payments.                              ized. She reports this as other income on
total purchase price by 75% to figure basis of       When the bank foreclosed, the balance due on                          Schedule F, line 10.
$525,000 for the 600 acres of land. The unad­        the loan was $180,000 and the FMV of the land
justed basis of the 60 acres you sold would then     was $170,000. The amount Ann realized on the                          Seller's (lender's) gain or loss on reposses-
be $52,500 (1 10 of $525,000).                       foreclosure was $180,000, the debt canceled                           sion. If you finance a buyer's purchase of prop­
                                                     by the foreclosure. She figures her gain or loss                      erty and later acquire an interest in it through
Sale of your home. Your home is a capital as­        on Form 4797, Part I, by comparing the amount                         foreclosure or repossession, you may have a
set and not property used in the trade or busi­      realized ($180,000) with her adjusted basis                           gain or loss on the acquisition. For more infor­
ness of farming. If you sell a farm that includes    ($200,000). She has a $20,000 deductible loss.                        mation, see Repossession in Publication 537,
a house you and your family occupy, you must                                                                               Installment Sales.
determine the part of the selling price and the          Example 2. Assume the same facts as in
part of the cost or other basis allocable to your    Example 1 except the FMV of the land was                              Cancellation of debt. If property that is repos­
home. Your home includes the immediate sur­          $210,000. The result is the same. The amount                          sessed or foreclosed upon secures a debt for
roundings and outbuildings relating to it that are   Ann realized on the foreclosure is $180,000, the                      which you are personally liable (recourse debt),
not used for business purposes.                      debt canceled by the foreclosure. Because her                         you generally must report as ordinary income
   If you use part of your home for business,        adjusted basis is $200,000, she has a deducti­                        the amount by which the canceled debt is more
you must make an appropriate adjustment to           ble loss of $20,000, which she reports on Form                        than the FMV of the property. This income is
the basis for depreciation allowed or allowable.     4797, Part I.                                                         separate from any gain or loss realized from the
For more information on basis, see chapter 6.                                                                              foreclosure or repossession. Report the income
                                                         Amount realized on a recourse debt. If
   More information. For more information            you are personally liable for repaying the debt                       from cancellation of a business debt on Sched­
on selling your home, see Publication 523.           (recourse debt), the amount realized on the                           ule F, line 10. Report the income from cancella­
                                                     foreclosure or repossession does not include                          tion of a nonbusiness debt as miscellaneous in­
    Gain from condemnation. If you have a            the canceled debt that is income from cancella­                       come on Form 1040.
gain from a condemnation or sale under threat        tion of debt. However, if the FMV of the trans­
of condemnation, you may use the preceding                                                                                              You can use Worksheet 8-1 to figure
                                                     ferred property is less than the canceled debt,                                    your income from cancellation of debt.
rules for excluding the gain, rather than the        the amount realized includes the canceled debt
                                                                                                                             TIP
rules discussed under Postponing Gain in             up to the FMV of the property. You are treated
chapter 11. However, any gain that cannot be         as receiving ordinary income from the canceled                            However, income from cancellation of debt
excluded (because it is more than the limit) may     debt for the part of the debt that is more than                       is not taxed if any of the following apply.
be postponed under the rules discussed under         the FMV. See Cancellation of debt, later.                                  The cancellation is intended as a gift.
Postponing Gain in chapter 11.
                                                                                                                                  The debt is qualified farm debt (see chap­
                                                         Example 3. Assume the same facts as in                                   ter 3).
Foreclosure or                                       Example 1 above except Ann is personally lia­                                The debt is qualified real property business
Repossession                                         ble for the loan (recourse debt). In this case, the                          debt (see chapter 5 of Publication 334).

If you do not make payments you owe on a loan
secured by property, the lender may foreclose        Worksheet 8­1. Worksheet for Foreclosures
on the loan or repossess the property. The fore­                    and Repossessions                                                      Keep for Your Records
closure or repossession is treated as a sale or
                                                      Part 1. Use Part 1 to figure your ordinary income from the cancellation of debt
exchange from which you may realize gain or
                                                      upon foreclosure or repossession. Complete this part only if you were personally
loss. This is true even if you voluntarily return
                                                      liable for the debt. Otherwise, go to Part 2.
the property to the lender. You may also realize
ordinary income from cancellation of debt if the      1. Enter the amount of outstanding debt immediately before the transfer of
loan balance is more than the FMV of the prop­        property reduced by any amount for which you remain personally liable after the
erty.                                                 transfer of property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
                                                      2. Enter the Fair Market Value of the transferred property . . . . . . . . . . . . . . . . .
Buyer's (borrower's) gain or loss. You figure
                                                      3.Ordinary income from cancellation of debt upon foreclosure or
and report gain or loss from a foreclosure or re­
                                                      repossession.* Subtract line 2 from line 1. If zero or less, enter ­0­ . . . . . . . . . .
possession in the same way as gain or loss
from a sale or exchange. The gain or loss is the      Part 2. Figure your gain or loss from foreclosure or repossession.
difference between your adjusted basis in the
transferred property and the amount realized.         4. If you completed Part 1, enter the smaller of line 1 or line 2. If you did not
See Determining Gain or Loss, earlier.                complete Part 1, enter the outstanding debt immediately before the transfer of
                                                      property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
         You can use Worksheet 8-1 to figure          5. Enter any proceeds you received from the foreclosure sale . . . . . . . . . . . . . .
 TIP     your gain or loss from a foreclosure or
                                                      6. Add lines 4 and 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
         repossession.
                                                      7. Enter the adjusted basis of the transferred property                  ...................
    Amount realized on a nonrecourse debt.            8. Gain or loss from foreclosure or repossession. Subtract line 7
If you are not personally liable for repaying the        from line 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
debt (nonrecourse debt) secured by the trans­
ferred property, the amount you realize includes      *
                                                          The income may not be taxable. See Cancellation of debt.

                                                                                                                              Chapter 8          Gains and Losses    Page 55
     You are insolvent or bankrupt (see              lender must file Form 1099­C, the lender may                                   rules is a section 1231 gain, which may be
     chapter 3).                                     include the information about the foreclosure,                                 taxed as a capital gain.
     The debt is qualified principal residence in­   repossession, or abandonment on that form in­                                      Gains and losses from property used in
     debtedness (see chapter 3).                     stead of Form 1099­A. The lender must file                                     farming are reported on Form 4797, Sales of
                                                     Form 1099­C and send you a copy if the can­                                    Business Property. Table 9­1 contains exam­
   Use Form 982 to report the income exclu­
                                                     celed debt is $600 or more and the lender is a                                 ples of items reported on Form 4797 and refers
sion.
                                                     financial institution, credit union, federal govern­                           to the part of that form on which they first should
                                                     ment agency, or any organization that has a sig­                               be reported.
Abandonment                                          nificant trade or business of lending money. For
                                                     foreclosures, repossessions, abandonments of                                   Topics
The abandonment of property is a disposition of      property, and debt cancellations occurring in                                  This chapter discusses:
property. You abandon property when you vol­         2012, these forms should be sent to you by
untarily and permanently give up possession          January 31, 2013.
and use of the property with the intention of                                                                                              Section 1231 gains and losses
ending your ownership, but without passing it                                                                                              Depreciation recapture
on to anyone else.                                                                                                                         Other gains
Business or investment property. Loss from
abandonment of business or investment prop­                                                                                         Useful Items
erty is deductible as a loss. Loss from abandon­
ment of business or investment property that is
                                                     9.                                                                             You may want to see:

not treated as a sale or exchange generally is                                                                                           Publication
an ordinary loss. If your adjusted basis is more
than the amount you realize (if any), then you
have a loss. If the amount you realize (if any) is
                                                     Dispositions of                                                                       544 Sales and Other Dispositions
                                                                                                                                               of Assets
more than your adjusted basis, then you have a
gain. This rule also applies to leasehold im­        Property Used                                                                       Form (and Instructions)
provements the lessor made for the lessee.                                                                                                 4797 Sales of Business Property
However, if the property is foreclosed on or re­
possessed in lieu of abandonment, gain or loss
                                                     in Farming                                                                     See chapter 16 for information about getting
is figured as discussed earlier under Foreclo-                                                                                      publications and forms.
sure or Repossession.
    If the abandoned property is secured by          Introduction                                                                   Section 1231
debt, special rules apply. The tax consequen­
                                                         When you dispose of property used in your
ces of abandonment of property that secures a
debt depend on whether you are personally lia­       farm business, your taxable gain or loss is usu­                               Gains and Losses
ble for the debt (recourse debt) or were not per­    ally treated as ordinary income (which is taxed
sonally liable for the debt (nonrecourse debt).      at the same rates as wages and interest in­                                    Section 1231 gains and losses are the taxable
For more information, see chapter 3 of Publica­      come) or capital gain (which is generally taxed                                gains and losses from section 1231 transac­
tion 4681, Canceled Debts, Foreclosures, Re­         at lower rates) under the rules for section 1231                               tions (explained below). Their treatment as ordi­
possessions, and Abandonments (for Individu­         transactions.                                                                  nary or capital gains depends on whether you
als).                                                    When you dispose of depreciable property                                   have a net gain or a net loss from all of your
                                                     (section 1245 property or section 1250 prop­                                   section 1231 transactions in the tax year.
   The abandonment loss is deducted in the           erty) at a gain, you may have to recognize all or
tax year in which the loss is sustained. Report      part of the gain as ordinary income under the
the loss on Form 4797, Part II, line 10.             depreciation recapture rules. Any gain remain­
                                                     ing after applying the depreciation recapture
Personal-use property. You cannot deduct
any loss from abandonment of your home or            Table 9­1. Where to First Report Certain Items on Form 4797
other property held for personal use.
                                                                                                                                               Held 1 year          Held more than
Canceled debt. If the abandoned property se­                                     Type of property                                                or less                1 year
cures a debt for which you are personally liable      1   Depreciable trade or business property:
and the debt is canceled, you will realize ordi­          a Sold or exchanged at a gain . . . . . .          . . . . . . . . . . . . .     Part II            Part III (1245, 1250)
nary income equal to the canceled debt. This              b Sold or exchanged at a loss . . . . . .          . . . . . . . . . . . . .     Part II            Part I
income is separate from any loss realized from
                                                      2   Farmland held less than 10 years for which soil, water, or
abandonment of the property. Report income
                                                          land clearing expenses were deducted:
from cancellation of a debt related to a business         a Sold at a gain                                                                 Part II            Part III (1252)
or rental activity as business or rental income.          b Sold at a loss                                                                 Part II            Part I
Report income from cancellation of a nonbusi­
                                                      3   All other farmland                                                               Part II            Part I
ness debt as miscellaneous income on Form
1040.                                                 4   Disposition of cost­sharing payment property described in                        Part II            Part III (1255)
    However, income from cancellation of debt             section 126
is not taxed in certain circumstances. See Can-
                                                      5   Cattle and horses used in a trade or business for draft,                              Held less              Held 24 mos.
cellation of debt earlier under Foreclosure or
                                                          breeding, dairy, or sporting purposes:                                              than 24 mos.               or more
Repossession.
                                                          a Sold at a gain . . . . . . . . . . . . . . . . .   . . . . . . . . . . . .     Part II            Part III (1245)
Forms 1099-A and 1099-C. A lender who ac­                 b Sold at a loss . . . . . . . . . . . . . . . . .   . . . . . . . . . . . .     Part II            Part I
                                                          c Raised cattle and horses sold at a gain              . . . . . . . . . . .     Part II            Part I
quires an interest in your property in a foreclo­
sure, repossession, or abandonment should             6   Livestock other than cattle and horses used in a trade or                             Held less              Held 12 mos.
send you Form 1099­A showing the information              business for draft, breeding, dairy, or sporting purposes:                          than 12 mos.               or more
you need to figure your loss from the foreclo­
                                                          a Sold at a gain . . . . . . . . . . .   . . . . . . . . . . . . . . . . . .     Part II            Part III (1245)
sure, repossession, or abandonment. However,
                                                          b Sold at a loss . . . . . . . . . . .   . . . . . . . . . . . . . . . . . .     Part II            Part I
if the lender cancels part of your debt and the           c Raised livestock sold at a gain          . . . . . . . . . . . . . . . . .     Part II            Part I


Page 56      Chapter 9     Dispositions of Property Used in Farming
          If you have a gain from a section 1231            your casualty or theft gains, neither the       1) Net section 1231 gain (2012) . . . .             $2,000
   !      transaction, first determine whether              gains nor the losses are taken into account     2) Net section 1231 loss
 CAUTION  any of the gain is ordinary income un-            in the section 1231 computation. Section           (2009) . . . . . . . . . . . . . . . ($2,500)
der the depreciation recapture rules (explained             1231 does not apply to personal casualty        3) Net section 1231 gain
later). Do not take that gain into account as sec-          gains and losses. See chapter 11 for infor­        (2011) . . . . . . . . . . . . . . .    1,800
tion 1231 gain.                                             mation on how to treat those gains and los­     4) Remaining net section
                                                            ses.                                               1231 loss from
Section 1231 transactions. Gain or loss on                    If the property is not held for the re-          prior 5 years . . . . . . . . . . ($700)
the following transactions is subject to section              quired holding period, the transaction        5) Gain treated as
1231 treatment.
                                                        !
                                                     CAUTION  is not subject to section 1231 treat-            ordinary income . . . . . . . . . . . . . .        $700
     Sale or exchange of cattle and horses.          ment, and any gain or loss is ordinary income          6) Gain treated as long-term
     The cattle and horses must be held for                                                                    capital gain . . . . . . . . . . . . . . . . .   $1,300
                                                     reported in Part II of Form 4797. See Table 9-1.
     draft, breeding, dairy, or sporting purposes
     and held for 24 months or longer.                                                                        His remaining net section 1231 loss from
                                                     Property for sale to customers. A sale, ex­           2009 is completely recaptured in 2012.
     Sale or exchange of other livestock.
                                                     change, or involuntary conversion of property
     This livestock must be held for draft,
                                                     held mainly for sale to customers is not a sec­
     breeding, dairy, or sporting purposes and
     held for 12 months or longer. Other live­
                                                     tion 1231 transaction. If you will get back all, or   Depreciation Recapture
                                                     nearly all, of your investment in the property by
     stock includes hogs, mules, sheep, goats,
                                                     selling it rather than by using it up in your busi­
     donkeys, and other fur­bearing animals.                                                               If you dispose of depreciable or amortizable
                                                     ness, it is property held mainly for sale to cus­
     Other livestock does not include poultry.                                                             property at a gain, you may have to treat all or
                                                     tomers.
     Sale or exchange of depreciable per-                                                                  part of the gain (even if it is otherwise nontaxa­
     sonal property. This property must be                                                                 ble) as ordinary income.
                                                     Treatment as ordinary or capital. To deter­
     used in your business and held longer than      mine the treatment of section 1231 gains and                    To figure any gain that must be repor­
     1 year. Generally, property held for the        losses, combine all of your section 1231 gains                  ted as ordinary income, you must
     production of rents or royalties is consid­     and losses for the year.                                        keep permanent records of the facts
     ered to be used in a trade or business. Ex­
                                                                                                           RECORDS
                                                          If you have a net section 1231 loss, it is an    necessary to figure the depreciation or amorti­
     amples of depreciable personal property              ordinary loss.                                   zation allowed or allowable on your property.
     include farm machinery and trucks. It also           If you have a net section 1231 gain, it is or­   For more information, see chapter 3 of Publica­
     includes amortizable section 197 intangi­            dinary income up to your nonrecaptured           tion 544.
     bles.                                                section 1231 losses from previous years,
     Sale or exchange of real estate. This                explained next. The rest, if any, is
     property must be used in your business
     and held longer than 1 year. Examples are
                                                          long­term capital gain.                          Section 1245 Property
     your farm or ranch (including barns and            Nonrecaptured section 1231 losses.
     sheds).                                         Your nonrecaptured section 1231 losses are            A gain on the disposition of section 1245 prop­
     Sale or exchange of unharvested                 your net section 1231 losses for the previous 5       erty is treated as ordinary income to the extent
     crops.The crop and land must be sold, ex­       years that have not been applied against a net        of depreciation allowed or allowable.
     changed, or involuntarily converted at the      section 1231 gain by treating the gain as ordi­
     same time and to the same person, and           nary income. These losses are applied against             Any recognized gain that is more than the
     the land must have been held longer than        your net section 1231 gain beginning with the         part that is ordinary income because of depreci­
     1 year. You cannot keep any right or option     earliest loss in the 5­year period.                   ation is a section 1231 gain. See Treatment as
     to reacquire the land directly or indirectly                                                          ordinary or capital under Section 1231 Gains
     (other than a right customarily incident to a       Example. In 2012, Ben has a $2,000 net            and Losses, earlier.
     mortgage or other security transaction).        section 1231 gain. To figure how much he has
                                                     to report as ordinary income and long­term cap­          Section 1245 property includes any property
     Growing crops sold with a leasehold on the
                                                     ital gain, he must first determine his section        that is or has been subject to an allowance for
     land, even if sold to the same person in a
                                                     1231 gains and losses from the previous 5­year        depreciation or amortization and that is any of
     single transaction, are not included.
                                                     period. From 2007 through 2011 he had the fol­        the following types of property.
     Distributive share of partnership gains
     and losses. Your distributive share must        lowing section 1231 gains and losses.                   1. Personal property (either tangible or intan­
     be from the sale or exchange of property                                                                   gible).
     listed earlier and held longer than 1 year       Year                                Amount
                                                      2007                                   ­0­             2. Other tangible property (except buildings
     (or for the required period for certain live­
                                                      2008                                   ­0­                and their structural components) used as
     stock).
                                                      2009                                ($2,500)              any of the following. See Buildings and
     Cutting or disposal of timber. You must          2010                                   ­0­                structural components below.
     treat the cutting or disposal of timber as a     2011                                 $1,800
     sale, as described in chapter 8 under Tim-                                                                    a. An integral part of manufacturing, pro­
     ber.                                               Ben uses this information to figure how to                    duction, or extraction, or of furnishing
     Condemnation. The condemned property            report his net section 1231 gain for 2012 as                     transportation, communications, elec­
     (defined in chapter 11) must have been          shown below.                                                     tricity, gas, water, or sewage disposal
     held longer than 1 year. It must be busi­                                                                        services.
     ness property or a capital asset held in
                                                                                                                   b. A research facility in any of the activi­
     connection with a trade or business or a
                                                                                                                      ties in (a).
     transaction entered into for profit, such as
     investment property. It cannot be property                                                                    c. A facility in any of the activities in (a)
     held for personal use.                                                                                           above, for the bulk storage of fungible
     Casualty or theft. The casualty or theft                                                                         commodities (discussed later).
     must have affected business property,
                                                                                                             3. That part of real property (not included in
     property held for the production of rents or
                                                                                                                (2)) with an adjusted basis reduced by (but
     royalties, or investment property (such as
                                                                                                                not limited to) the following.
     notes and bonds). You must have held the
     property longer than 1 year. However, if                                                                      a. Amortization of certified pollution con­
     your casualty or theft losses are more than                                                                      trol facilities.

                                                                                   Chapter 9    Dispositions of Property Used in Farming                        Page 57
      b. The section 179 expense deduction.           For any other disposition of section 1245 prop­      $7,000. The MACRS deduction in 2012, the
                                                      erty, ordinary income is the lesser of (1) above     year of sale, is $893 (1 2 of $1,785). Figure the
      c. Deduction for clean­fuel vehicles and
                                                      or the amount by which its fair market value         gain treated as ordinary income as follows.
         certain refueling property.
                                                      (FMV) is more than its adjusted basis. For de­
      d. Certain expenditures for child care fa­      tails, see chapter 3 of Publication 544.              1) Amount realized . . . . . . . . . . . . . . . . .        $7,000
         cilities. (Repealed by Public Law                                                                  2) Cost (February 2010)           . . . . . . $10,000
         101­58, Omnibus Budget Reconcilia­              Use Part III of Form 4797 to figure the ordi­      3) Depreciation allowed or
         tion Act of 1990, section 11801(a)(13)       nary income part of the gain.                            allowable (MACRS deductions:
                                                                                                               $1,500 + $2,550 + $893) . . . .                4,943
         except with regards to deductions
                                                      Depreciation claimed on other property or             4) Adjusted basis (subtract line 3
         made prior to November 5, 1990.)                                                                                                                               $5,057
                                                                                                               from line 2) . . . . . . . . . . . . . . . . . . . . .
                                                      claimed by other taxpayers. Depreciation
      e. Expenditures to remove architectural         and amortization include the amounts you
                                                                                                            5) Gain realized (subtract line 4
         and transportation barriers to the                                                                    from line 1) . . . . . . . . . . . . . . . . . . . . .    1,943
                                                      claimed on the section 1245 property as well as       6) Gain treated as ordinary income
         handicapped and elderly.                     the following depreciation and amortization                                                                       $1,943
                                                                                                               (lesser of line 3 or line 5) . . . . . . . . . .
       f. Certain reforestation expenditures.         amounts.
                                                           Amounts you claimed on property you ex­
  4. Single purpose agricultural (livestock) or                                                            Depreciation allowed or allowable. You
                                                           changed for, or converted to, your section
     horticultural structures.                                                                             generally use the greater of the depreciation al­
                                                           1245 property in a like­kind exchange or
                                                                                                           lowed or allowable when figuring the part of
  5. Storage facilities (except buildings and              involuntary conversion. For details on ex­
                                                           changes of property that are not taxable,       gain to report as ordinary income. If, in prior
     their structural components) used in dis­
                                                           see Like-Kind Exchanges in chapter 8.           years, you have consistently taken proper de­
     tributing petroleum or any primary product
                                                           Amounts a previous owner of the section         ductions under one method, the amount al­
     of petroleum.
                                                           1245 property claimed if your basis is de­      lowed for your prior years will not be increased
                                                           termined with reference to that person's        even though a greater amount would have been
Buildings and structural components. Sec­
                                                           adjusted basis (for example, the donor's        allowed under another proper method. If you
tion 1245 property does not include buildings
                                                           depreciation deductions on property you         did not take any deduction at all for deprecia­
and structural components. The term building
                                                           received as a gift).                            tion, your adjustments to basis for depreciation
includes a house, barn, warehouse, or garage.
The term structural component includes walls,                                                              allowable are figured by using the straight line
floors, windows, doors, central air conditioning          Example. Jeff Free paid $120,000 for a           method. This treatment applies only when figur­
systems, light fixtures, etc.                         tractor in 2011. On February 23, 2012, he tra­       ing what part of the gain is treated as ordinary
     Do not treat a structure that is essentially     ded it for a chopper and paid an additional          income under the rules for section 1245 depre­
machinery or equipment as a building or struc­        $30,000. To figure his depreciation deduction        ciation recapture.
tural component. Also, do not treat a structure       for the current year, Jeff continues to use the
that houses property used as an integral part of      basis of the tractor as he would have before the     Disposition of plants and animals. If you
an activity as a building or structural component     trade to depreciate the chopper. Jeff can also       elect not to use the uniform capitalization rules
if the structure's use is so closely related to the   depreciate the additional $30,000 basis on the       (see chapter 6), you must treat any plant you
property's use that the structure can be expec­       chopper.                                             produce as section 1245 property. If you have a
ted to be replaced when the property it initially                                                          gain on the property's disposition, you must re­
houses is replaced.                                   Depreciation and amortization. Depreciation          capture the pre­productive expenses you would
     The fact that the structure is specially de­     and amortization deductions that must be re­         have capitalized if you had not made the elec­
signed to withstand the stress and other de­          captured as ordinary income include (but are         tion by treating the gain, up to the amount of
mands of the property and cannot be used eco­         not limited to) the following items. See Depreci-    these expenses, as ordinary income. For sec­
nomically for other purposes indicates it is          ation Recapture in chapter 3 of Publication 544      tion 1231 transactions, show these expenses
closely related to the use of the property it         for more details.                                    as depreciation on Form 4797, Part III, line 22.
houses. Structures such as oil and gas storage                                                             For plant sales that are reported on Schedule F
                                                        1. Ordinary depreciation deductions.               (1040), Profit or Loss From Farming, this recap­
tanks, grain storage bins, and silos are not trea­
ted as buildings, but as section 1245 property.         2. Section 179 deduction (see chapter 7).          ture rule does not change the reporting of in­
                                                                                                           come because the gain is already ordinary in­
                                                        3. Any special depreciation allowance.
Facility for bulk storage of fungible com-                                                                 come. You can use the farm­price method or
modities. This is a facility used mainly for the        4. Amortization deductions for all the follow­     the unit­livestock­price method discussed in
bulk storage of fungible commodities. Bulk stor­           ing costs.                                      chapter 2 to figure these expenses.
age means storage of a commodity in a large                 a. Acquiring a lease.
mass before it is used. For example, if a facility                                                             Example. Janet Maple sold her apple or­
is used to store oranges that have been sorted              b. Lessee improvements.                        chard in 2012 for $80,000. Her adjusted basis
and boxed, it is not used for bulk storage. To be                                                          at the time of sale was $60,000. She bought the
                                                            c. Pollution control facilities.
fungible, a commodity must be such that one                                                                orchard in 2005, but the trees did not produce a
part may be used in place of another.                       d. Reforestation expenses.                     crop until 2008. Her pre­productive expenses
                                                                                                           were $6,000. She elected not to use the uniform
                                                            e. Section 197 intangibles.
                                                                                                           capitalization rules. Janet must treat $6,000 of
Gain Treated as Ordinary Income                              f. Childcare facility expenses incurred       the gain as ordinary income.
                                                                before 1982.
The gain treated as ordinary income on the
sale, exchange, or involuntary conversion of                g. Franchises, trademarks, and trade           Section 1250 Property
section 1245 property, including a sale and                    names acquired before August 11,
leaseback transaction, is the lesser of the fol­               1993.                                       Section 1250 property includes all real property
lowing amounts.                                                                                            subject to an allowance for depreciation that is
                                                          Example. You file your returns on a calen­
  1. The depreciation (which includes any sec­                                                             not and never has been section 1245 property.
                                                      dar year basis. In February 2010, you bought
     tion 179 deduction claimed) and amortiza­                                                             It includes buildings and structural components
                                                      and placed in service for 100% use in your
     tion allowed or allowable on the property.                                                            that are not section 1245 property (discussed
                                                      farming business a light­duty truck (5­year prop­
                                                                                                           earlier). It includes a leasehold of land or sec­
  2. The gain realized on the disposition (the        erty) that cost $10,000. You used the half­year
                                                                                                           tion 1250 property subject to an allowance for
     amount realized from the disposition mi­         convention and your MACRS deductions for the
                                                                                                           depreciation. A fee simple interest in land is not
     nus the adjusted basis of the property).         truck were $1,500 in 2010 and $2,550 in 2011.
                                                                                                           section 1250 property because, like land, it is
                                                      You did not claim the section 179 expense de­
                                                                                                           not depreciable.
                                                      duction for the truck. You sold it in May 2012 for

Page 58      Chapter 9     Dispositions of Property Used in Farming
   Gain on the disposition of section 1250                                                               have to recognize ordinary income under this
property is treated as ordinary income to the ex­                                                        provision.
tent of additional depreciation allowed or allow­   Other Gains
able. To determine the additional depreciation                                                               Amount to report as ordinary income.
on section 1250 property, see Depreciation Re-      This section discusses gain on the disposition       You report as ordinary income the lesser of the
capture in chapter 3 of Publication 544.            of farmland for which you were allowed either of     following amounts.
                                                    the following.                                            The applicable percentage of the total ex­
   You will not have additional depreciation if           Deductions for soil and water conservation          cluded cost­sharing payments.
any of the following apply to the property dis­           expenditures (section 1252 property).               The gain on the disposition of the property.
posed of.                                                 Exclusions from income for certain cost
    You figured depreciation for the property             sharing payments (section 1255 property).      You do not report ordinary income under this
    using the straight line method or any other                                                          rule to the extent the gain is recognized as ordi­
    method that does not result in depreciation     Section 1252 property. If you disposed of            nary income under sections 1231 through 1254,
    that is more than the amount figured by the     farmland you held more than 1 year and less          1256, and 1257. However, you do report as or­
    straight line method and you have held the      than 10 years at a gain and you were allowed         dinary income under this rule a gain or a part of
    property longer than 1 year.                    deductions for soil and water conservation ex­       a gain regardless of any contrary provisions (in­
    You chose the alternate ACRS (straight          penses for the land, as discussed in chapter 5,      cluding nonrecognition provisions) under any
    line) method for the property, which was a      you must treat part of the gain as ordinary in­      other section.
    type of 15­, 18­, or 19­year real property      come and treat the balance as section 1231               Applicable percentage. The applicable
    covered by the section 1250 rules.              gain.                                                percentage of the excluded cost­sharing pay­
    The property was nonresidential real prop­
                                                       Exceptions. Do not treat gain on the fol­         ments to be reported as ordinary income is
    erty placed in service after 1986 (or after
                                                    lowing transactions as gain on section 1252          based on the length of time you hold the prop­
    July 31, 1986, if the choice to use MACRS
                                                    property.                                            erty after receiving the payments. If the property
    was made) and you held it longer than 1
                                                         Disposition of farmland by gift.                is held less than 10 years after you receive the
    year. These properties are depreciated us­
    ing the straight line method.                                                                        payments, the percentage is 100%. After 10
                                                         Transfer of farm property at death (except      years, the percentage is reduced by 10% a
                                                         for income in respect of a decedent).           year, or part of a year, until the rate is 0%.
Installment Sale                                    For more information, see Regulations section
                                                    1.1252­2.                                            Form 4797, Part III. Use Form 4797, Part III,
If you report the sale of property under the in­                                                         to figure the ordinary income part of a gain from
stallment method, any depreciation recapture            Amount to report as ordinary income.             the sale, exchange, or involuntary conversion of
under section 1245 or 1250 is taxable as ordi­      You report as ordinary income the lesser of the      section 1252 property and section 1255 prop­
nary income in the year of sale. This applies       following amounts.                                   erty.
even if no payments are received in that year. If        Your gain (determined by subtracting the
the gain is more than the depreciation recapture         adjusted basis from the amount realized
income, report the rest of the gain using the            from a sale, exchange, or involuntary con­
rules of the installment method. For this pur­           version, or the FMV for all other disposi­
pose, include the recapture income in your in­           tions).
stallment sale basis to determine your gross             The total deductions allowed for soil and
profit on the installment sale.                          water conservation expenses multiplied by
                                                         the applicable percentage, discussed next.
                                                                                                         10.
    If you dispose of more than one asset in a
single transaction, you must separately figure          Applicable percentage. The applicable
the gain on each asset so that it may be prop­
erly reported. To do this, allocate the selling
                                                    percentage is based on the length of time you
                                                    held the land. If you dispose of your farmland
                                                                                                         Installment
price and the payments you receive in the year      within 5 years after the date you acquired it, the
of sale to each asset. Report any depreciation
recapture income in the year of sale before us­
                                                    percentage is 100%. If you dispose of the land
                                                    within the 6th through 9th year after you ac­
                                                                                                         Sales
ing the installment method for any remaining        quired it, the applicable percentage is reduced
gain.                                               by 20% a year for each year or part of a year
   For more information on installment sales,
                                                    you hold the land after the 5th year. If you dis­    Introduction
                                                    pose of the land 10 or more years after you ac­      An installment sale is a sale of property where
see chapter 10.                                     quired it, the percentage is 0%, and the entire      you receive at least one payment after the tax
                                                    gain is a section 1231 gain.                         year of the sale. If you realize a gain on an in­
Other Dispositions                                                                                       stallment sale, you may be able to report part of
                                                        Example. You acquired farmland on Janu­
                                                                                                         your gain when you receive each payment. This
Chapter 3 of Publication 544 discusses the tax      ary 19, 2004. On October 3, 2012, you sold the
                                                                                                         method of reporting gain is called the install­
treatment of the following transfers of deprecia­   land at a $30,000 gain. Between January 1 and
                                                                                                         ment method. You cannot use the installment
ble property.                                       October 3, 2012, you incur soil and water con­
                                                                                                         method to report a loss. You can choose to re­
     By gift.                                       servation expenditures of $15,000 for the land
                                                                                                         port all of your gain in the year of sale.
    At death.                                       that are fully deductible in 2012. The applicable
                                                    percentage is 40% since you sold the land            Installment obligation. The buyer's obligation
    In like­kind exchanges.                         within the 8th year after you acquired it. You       to make future payments to you can be in the
    In involuntary conversions.                     treat $6,000 (40% of $15,000) of the $30,000         form of a deed of trust, note, land contract,
                                                    gain as ordinary income and the $24,000 bal­         mortgage, or other evidence of the buyer's debt
Publication 544 also explains how to handle a       ance as a section 1231 gain.
single transaction involving multiple properties.                                                        to you.
                                                    Section 1255 property. If you receive certain
                                                    cost­sharing payments on property and you ex­        Topics
                                                    clude those payments from income (as dis­            This chapter discusses:
                                                    cussed in chapter 3), you may have to treat part
                                                    of any gain as ordinary income and treat the              The general rules that apply to using the
                                                    balance as a section 1231 gain. If you chose              installment method
                                                    not to exclude these payments, you will not               Installment sale of a farm

                                                                                                          Chapter 10     Installment Sales        Page 59
Useful Items                                         Electing out of the installment method. If                  Figuring Installment
                                                     you elect not to use the installment method, you
You may want to see:
                                                     generally report the entire gain in the year of
                                                                                                                 Sale Income
  Publication                                        sale, even though you do not receive all the
                                                                                                                 Each payment on an installment sale usually
                                                     sale proceeds in that year.
     523 Selling Your Home                                                                                       consists of the following three parts.
                                                         To make this election, do not report your
                                                                                                                     Interest income.
     535 Business Expenses                           sale on Form 6252. Instead, report it on Sched­
                                                     ule D (Form 1040), Form 4797, or both.                              Return of your adjusted basis in the prop­
     537 Installment Sales                                                                                               erty.
                                                         When to elect out. Make this election by                        Gain on the sale.
     538 Accounting Periods and Methods              the due date, including extensions, for filing
     544 Sales and Other Dispositions of             your tax return for the year the sale takes place.          In each year you receive a payment, you must
         Assets                                          However, if you timely file your tax return for         include in income both the interest part and the
                                                     the year the sale takes place without making the            part that is your gain on the sale. You do not in­
  Form (and Instructions)                            election, you still can make the election by filing         clude in income the part that is the return of
                                                     an amended return within 6 months of the due                your basis in the property. Basis is the amount
     4797 Sales of Business Property                 date of the return (excluding extensions). Write            of your investment in the property for install­
     6252 Installment Sale Income                    “Filed pursuant to section 301.9100­2” at the               ment sale purposes.
                                                     top of the amended return and file it where the
See chapter 16 for information about getting         original return was filed.                                  Interest income. You must report interest as
publications and forms.                                                                                          ordinary income. Interest is generally not inclu­
                                                        Revoking the election. Once made, the                    ded in a down payment. However, you may
                                                     election can be revoked only with IRS approval.             have to treat part of each later payment as inter­
Installment Sale                                     A revocation is retroactive.                                est, even if it is not called interest in your agree­
                                                                                                                 ment with the buyer. Interest provided in the
of a Farm                                                More information. See Electing Out of the
                                                                                                                 agreement is called stated interest. If the agree­
                                                     Installment Method in Publication 537 for more
                                                     information.                                                ment does not provide for enough stated inter­
The installment sale of a farm for one overall                                                                   est, there may be unstated interest or original
price under a single contract is not the sale of a                                                               issue discount. See Unstated interest, later.
                                                     Inventory. The sale of farm inventory items
single asset. It generally includes the sale of
                                                     cannot be reported on the installment method.                           You must continue to report the inter-
real property and personal property reportable
                                                     All gain or loss on their sale must be reported in                      est income on payments you receive
on the installment method. It may also include                                                                       !
                                                     the year of sale, even if you receive payment in                        in subsequent years as interest in-
the sale of property for which you must maintain
                                                     later years.
                                                                                                                  CAUTION

an inventory, which cannot be reported on the                                                                    come.
                                                         If inventory items are included in an install­
installment method. See Inventory, later. The
                                                     ment sale, you may have an agreement stating
selling price must be allocated to determine the                                                                 Adjusted basis and installment sale income
                                                     which payments are for inventory and which are
amount received for each class of asset.                                                                         (gain on sale). After you have determined
                                                     for the other assets being sold. If you do not,
    The tax treatment of the gain or loss on the     each payment must be allocated between the                  how much of each payment to treat as interest,
sale of each class of assets is determined by its    inventory and the other assets sold.                        you treat the rest of each payment as if it were
classification as a capital asset, as property                                                                   made up of two parts.
used in the business, or as property held for        Sale at a loss. If your sale results in a loss,                  A tax­free return of your adjusted basis in
sale and by the length of time the asset was         you cannot use the installment method. If the                    the property, and
held. (See chapter 8 for a discussion of capital     loss is on an installment sale of business as­                   Your gain (referred to as “installment sale
assets and chapter 9 for a discussion of prop­       sets, you can deduct it only in the tax year of                  income” on Form 6252).
erty used in the business.) Separate computa­        sale.
tions must be made to figure the gain or loss for                                                                Figuring adjusted basis for installment sale
each class of asset sold. See Sale of a Farm in                                                                  purposes. You can use Worksheet 10­1 to fig­
chapter 8.                                                                                                       ure your adjusted basis in the property for

    If you report the sale of property on the in­    Worksheet 10­1. Figuring Adjusted Basis and Gross Profit Percentage
stallment method, any depreciation recapture
under section 1245 or 1250 of the Internal Rev­
enue Code is generally taxable as ordinary in­
come in the year of sale. See Depreciation re-                                                                                 Keep for Your Records
capture, later. This applies even if no payments
are received in that year.                            1. Enter the selling price for the property . . . . . . . . . . . . . . . . . . . . . . . .
                                                      2. Enter your adjusted basis for the property . . . . . . . . . . . .
Installment Method                                    3. Enter your selling expenses . . . . . . . . . . . . . . . . . . . . . . . . .
                                                      4. Enter any depreciation recapture . . . . . . . . . . . . . . . . . . . .
An installment sale is a sale of property where
you receive at least one payment after the tax        5. Add lines 2, 3, and 4.
year of the sale. A farmer who is not required to        This is your adjusted basis
maintain an inventory can use the installment            for installment sale purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
method to report gain from the sale of property
used or produced in farming. See Inventory,           6. Subtract line 5 from line 1. If zero or less, enter ­0­.
later, for information on the sale of farm prop­         This is your gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
erty where inventory items are included in the           If the amount entered on line 6 is zero, Stop here. You cannot
assets sold.
                                                         use the installment method.
   If a sale qualifies as an installment sale, the    7. Enter the contract price for the property . . . . . . . . . . . . . . . . . . . . . .
gain must be reported under the installment
method unless you elect out of using the install­     8. Divide line 6 by line 7. This is your gross
ment method.                                             profit percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Page 60      Chapter 10      Installment Sales
installment sale purposes. When you have                       acquire the property. The basis of property you        1. The selling price, minus
completed the worksheet, you will also have de­                buy is generally its cost. The basis of property
                                                                                                                      2. The mortgages, debts, and other liabilities
termined the gross profit percentage necessary                 you inherit, receive as a gift, build yourself, or
                                                                                                                         assumed or taken by the buyer, plus
to figure your installment sale income (gain) for              receive in a tax­free exchange is figured differ­
this year.                                                     ently.                                                 3. The amount by which the mortgages,
                                                                   While you own property, various events may            debts, and other liabilities assumed or
   Selling price. The selling price is the total               change your original basis. Some events, such             taken by the buyer exceed your adjusted
cost of the property to the buyer and includes                 as adding rooms or making permanent im­                   basis for installment sale purposes.
the following.                                                 provements, increase basis. Others, such as
     Any money you are to receive.                             deductible casualty losses or depreciation pre­          Gross profit percentage. A certain per­
     The fair market value (FMV) of any prop­                  viously allowed or allowable, decrease basis.        centage of each payment (after subtracting in­
     erty you are to receive (FMV is discussed                 The result is adjusted basis. See chapter 6 for      terest) is reported as installment sale income.
     at Property used as a payment under Pay-                  more information.                                    This percentage is called the gross profit per­
                                                                                                                    centage and is figured by dividing your gross
     ments Received or Considered Received).
                                                                   Selling expenses. Selling expenses relate        profit from the sale by the contract price.
     Any existing mortgage or other debt the
                                                               to the sale of the property. They include com­           The gross profit percentage generally re­
     buyer pays, assumes, or takes (a note,
                                                               missions, attorney fees, and any other expen­        mains the same for each payment you receive.
     mortgage, or any other liability, such as a
                                                               ses paid on the sale. Selling expenses are           However, see the example under Selling price
     lien, accrued interest, or taxes you owe on
                                                               added to the basis of the sold property.             reduced, later, for a situation where the gross
     the property).
                                                                                                                    profit percentage changes.
     Any of your selling expenses the buyer
                                                               Depreciation recapture. If the property you
     pays.
                                                               sold was depreciable property, you may need          Amount to report as installment sale in-
Do not include stated interest, unstated interest,             to recapture part of the gain on the sale as ordi­   come. Multiply the payments you receive each
any amount recomputed or recharacterized as                    nary income. See Depreciation Recapture in           year (less interest) by the gross profit percent­
interest, or original issue discount.                          chapter 9 and Depreciation Recapture Income          age. The result is your installment sales income
                                                               in Publication 537.                                  for the tax year. In certain circumstances, you
    Adjusted basis for installment sale pur-                                                                        may be treated as having received a payment,
poses. Your adjusted basis is the total of the                     Gross profit. Gross profit is the total gain     even though you received nothing directly. A re­
following three items.                                         you report on the installment method.                ceipt of property or the assumption of a mort­
     Adjusted basis.                                               To figure your gross profit, subtract your ad­   gage on the property sold may be treated as a
     Selling expenses.                                         justed basis for installment sale purposes from      payment. For a detailed discussion, see Pay-
                                                               the selling price. If the property you sold was      ments Received or Considered Received, later.
     Depreciation recapture.                                   your home, subtract from the gross profit any
                                                               gain you can exclude.                                    Selling price reduced. If the selling price
    Adjusted basis. Basis is your investment                                                                        is reduced at a later date, the gross profit on the
in the property for installment sale purposes.                      Contract price. Contract price equals:          sale also will change. You then must refigure
The way you figure basis depends on how you                                                                         the gross profit percentage for the remaining
                                                                                                                    payments. Refigure your gross profit using
Worksheet 10­2. New Gross Profit Percentage — Selling Price Reduced                                                 Worksheet 10­2. New Gross Profit Percent­
                                                                                                                    age — Selling Price Reduced. You will spread
                                                                                                                    any remaining gain over future installments.
                                                                             Keep for Your Records                      Example. In 2010, you sold land with a ba­
                                                                                                                    sis of $40,000 for $100,000. Your gross profit
     1. Enter the reduced selling
                                                                                                                    was $60,000. You received a $20,000 down
        price for the property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                    payment and the buyer's note for $80,000. The
     2. Enter your adjusted                                                                                         note provides for monthly payments of $1,953
        basis for the                                                                                               each, figured at 8% interest, amortized over
                                                                                                                    four years, beginning in 2011. Your gross profit
        property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                    percentage is 60%. You received total pay­
     3. Enter your selling                                                                                          ments of $20,000 in 2010 and $23,436 in 2011.
        expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                      You reported a gain of $12,000 on the payment
                                                                                                                    received in 2010 and $10,605 ($17,675 X 60%
     4. Enter any depreciation                                                                                      (.60)) in 2011.
        recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                         In 2012, you and the buyer agreed to reduce
     5. Add lines 2, 3, and 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                      the purchase price to $85,000 and payments
                                                                                                                    during 2012, 2013, and 2014 are reduced to
     6. Subtract line 5 from line 1.                                                                                $1,483 a month amortized over the remaining
        This is your adjusted                                                                                       three years.
        gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  The new gross profit percentage, 47.32%, is
                                                                                                                    figured in Example — Worksheet 10­2.
     7. Enter any installment sale                                                                                      You will report a gain of $6,878 (47.32% of
        income reported in                                                                                          $14,535) in 2012, $7,449 (47.32% of $15,742)
        prior year(s) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             in 2013, and $8,067 (47.32% of $17,048) in
                                                                                                                    2014.
     8. Subtract line 7 from line 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
     9. Future installments . . . . . . . . . . . . . . . . . . . . . .
    10. Divide line 8 by line 9.
        This is your new
        gross profit percentage*. . . . . . . . . . . . . . . . . . . . . . . . . . . .

 * Apply this percentage to all future payments to determine how much of each of those payments is
 installment sale income.

                                                                                                                     Chapter 10      Installment Sales        Page 61
                                                                   transferred to the buyer because of the death of         Mortgage less than basis. If the buyer as­
Example —       New Gross Profit                                   the holder of the obligation, it is a disposition.   sumes a mortgage that is not more than your in­
Worksheet 10­2. Percentage — Selling                               The estate must figure its gain or loss on the       stallment sale basis in the property, it is not con­
                Price Reduced                                      disposition. If the holder and the buyer were re­    sidered a payment to you. It is considered a
                                                                   lated, the FMV of the installment obligation is      recovery of your basis. The contract price is the
                                                                   considered to be no less than its full face value.   selling price minus the mortgage.
Keep for Your Records                                                 More information. For more information                Example. You sell property with an adjus­
                                                                   on the disposition of an installment obligation,     ted basis of $19,000. You have selling expen­
 1.   Enter the reduced selling
      price for the property . .     . . . . . . . .      85,000   see Publication 537.                                 ses of $1,000. The buyer assumes your existing
 2.   Enter your adjusted                                                                                               mortgage of $15,000 and agrees to pay you
      basis for the                                                Sale of depreciable property. You generally          $10,000 (a cash down payment of $2,000 and
      property . . . . . . . . . .   . .       40,000              cannot report gain from the sale of depreciable      $2,000 (plus 8% interest) in each of the next 4
 3.   Enter your selling                                           property to a related person on the installment      years).
      expenses . . . . . . . . .     . .            ­0­            method. See Sale to a Related Person in Publi­           The selling price is $25,000 ($15,000 +
 4.   Enter any depreciation                                       cation 537.                                          $10,000). Your gross profit is $5,000 ($25,000 −
                                                   ­0­
      recapture . . . . . . . . .    . .                               You cannot use the installment method to         $20,000 installment sale basis). The contract
 5.   Add lines 2, 3, and 4. . .     . . . . . . . .      40,000   report any depreciation recapture income up to       price is $10,000 ($25,000 − $15,000 mortgage).
 6.   Subtract line 5 from line 1.                                 the gain on the sale. However, report any gain       Your gross profit percentage is 50% ($5,000 ÷
      This is your adjusted                                        greater than the recapture income on the install­    $10,000). You report half of each $2,000 pay­
      gross profit . . . . . . . . . . . . . . .          45,000
                                                                   ment method.                                         ment received as gain from the sale. You also
 7.   Enter any installment sale                                       The recapture income reported in the year        report all interest you receive as ordinary in­
      income reported in
                                                          22,605   of sale is included in your installment sale basis   come.
      prior year(s) . . . . . . . . . . . . . . .
                                                                   to determine your gross profit on the installment
 8.   Subtract line 7 from line 6 . . . . . . .           22,395                                                            Mortgage more than basis. If the buyer
                                                                   sale.
 9.   Future installments    . . . . .                    47,325       Figure your depreciation recapture income        assumes a mortgage that is more than your in­
 10. Divide line 8 by line 9.                                      (including the section 179 deduction and the         stallment sale basis in the property, you recover
     This is your new                                              section 179A deduction recapture) in Part III of     your entire basis. The part of the mortgage
                                                          47.32%
     gross profit percentage*.             . . . . . .
                                                                   Form 4797. Report the depreciation recapture         greater than your basis is treated as a payment
                                                                   income in Part II of Form 4797 as ordinary in­       received in the year of sale.
 * Apply this percentage to all future payments to                 come in the year of sale.                                To figure the contract price, subtract the
 determine how much of each of those payments                                                                           mortgage from the selling price. This is the total
 is installment sale income.                                                 If you sell depreciable business prop-     amount (other than interest) you will receive di­
                                                                    TIP      erty, prepare Form 4797 first in order     rectly from the buyer. Add to this amount the
Form 6252. Use Form 6252 to report an in­                                    to figure the amount to enter on line 12   payment you are considered to have received
stallment sale in the year it takes place and to                   of Part I, Form 6252. See the Form 6252 in-          (the difference between the mortgage and your
report payments received, or considered re­                        structions for details.                              installment sale basis). The contract price is
ceived because of related party resales, in later                                                                       then the same as your gross profit from the
years. Attach it to your tax return for each year.                    For more information on the section 179 de­       sale.
                                                                   duction, see Section 179 Expense Deduction in
                                                                   chapter 7. For more information on depreciation              If the mortgage the buyer assumes is
Disposition of                                                     recapture, see Depreciation Recapture in              TIP    equal to or more than your installment
Installment Obligation                                             chapter 9.                                                   sale basis, the gross profit percentage
                                                                                                                        always will be 100%.
If you are using the installment method and you
dispose of the installment obligation, generally                   Payments Received or                                     Example. The selling price for your prop­
you will have a gain or loss to report. It is con­                 Considered Received                                  erty is $9,000. The buyer will pay you $1,000
sidered gain or loss on the sale of the property
                                                                                                                        annually (plus 8% interest) over the next 3
for which you received the installment obliga­
                                                                   You must figure your gain each year on the pay­      years and assume an existing mortgage of
tion.
                                                                   ments you receive, or are treated as receiving,      $6,000. Your adjusted basis in the property is
                                                                   from an installment sale.                            $4,400. You have selling expenses of $600, for
Cancellation. If an installment obligation is
                                                                                                                        a total installment sale basis of $5,000. The part
canceled or otherwise becomes unenforceable,
                                                                       In certain situations, you are considered to     of the mortgage that is more than your install­
it is treated as a disposition other than a sale or
                                                                   have received a payment, even though the             ment sale basis is $1,000 ($6,000 − $5,000).
exchange. Your gain or loss is the difference
                                                                   buyer does not pay you directly. These situa­        This amount is included in the contract price
between your basis in the obligation and its fair
                                                                   tions occur when the buyer assumes or pays           and treated as a payment received in the year
market value (FMV) at the time you cancel it. If
                                                                   any of your debts, such as a loan, or pays any       of sale. The contract price is $4,000:
the parties are related, the FMV of the obliga­
tion is considered to be no less than its full face                of your expenses, such as a sales commission.
value.                                                             However, as discussed later, the buyer's as­          Selling price . . .   . . . . . . . . . . . . . . . . . . .     $9,000
                                                                   sumption of your debt is treated as a recovery        Minus: Mortgage       . . . . . . . . . . . . . . . . . . .     (6,000)
Transfer due to death. The transfer of an in­                      of basis, rather than as a payment, in many ca­       Amount actually received          . . . . . . . . . . . . .     $3,000
stallment obligation (other than to a buyer) as a                  ses.                                                  Add difference:
result of the death of the seller is not a disposi­                                                                        Mortgage . . . . . . . . . . . . .      . . .   $6,000
tion. Any unreported gain from the installment                     Buyer pays seller's expenses. If the buyer              Minus: Installment sale basis             . .    5,000         1,000

obligation is not treated as gross income to the                   pays any of your expenses related to the sale of      Contract price      . . . . . . . . . . . . . . . . . . . .     $4,000
decedent. No income is reported on the dece­                       your property, it is considered a payment to you
dent's return due to the transfer. Whoever re­                     in the year of sale. Include these expenses in           Your gross profit on the sale is also $4,000:
ceives the installment obligation as a result of                   the selling and contract prices when figuring the
the seller's death is taxed on the installment                     gross profit percentage.                              Selling price . . . . . . . . . . .   . . . . . . . . . . . .   $9,000
payments the same as the seller would have                                                                               Minus: Installment sale basis           . . . . . . . . . . .   (5,000)
been had the seller lived to receive the pay­                      Buyer assumes mortgage. If the buyer as­              Gross profit      . . . . . . . . . . . . . . . . . . . . . .   $4,000
ments.                                                             sumes or pays off your mortgage, or otherwise
    However, if the installment obligation is can­                 takes the property subject to the mortgage, the         Your gross profit percentage is 100%. Re­
celed,     becomes      unenforceable,      or   is                following rules apply.                               port 100% of each payment (less interest) as

Page 62         Chapter 10            Installment Sales
gain from the sale. Treat the $1,000 difference           Third-party note. If the property the buyer            Like­kind property received in the trade is
between the mortgage and your installment             gives you is a third­party note (or other obliga­          not considered payment on the installment
sale basis as a payment and report 100% of it         tion of a third party), you are considered to have         obligation.
as gain in the year of sale.                          received a payment equal to the note's FMV.
                                                      Because the FMV of the note is itself a payment       Unstated interest. An installment sale con­
Buyer assumes other debts. If the buyer as­           on your installment sale, any payments you            tract may provide that each deferred payment
sumes any other debts, such as a loan or back         later receive from the third party are not consid­    on the sale will include interest or that there will
taxes, it may be considered a payment to you in       ered payments on the sale. The excess of the          be an interest payment in addition to the princi­
the year of sale.                                     note's face value over its FMV is interest. Ex­       pal payment. Interest provided in the contract is
     If the buyer assumes the debt instead of         clude this interest in determining the selling        called stated interest.
paying it off, only part of it may have to be trea­   price of the property. However, see Exception             If an installment sale contract does not pro­
ted as a payment. Compare the debt to your in­        under Property used as a payment, earlier.            vide for adequate stated interest, part of the sta­
stallment sale basis in the property being sold.                                                            ted principal amount of the contract may be re­
If the debt is less than your installment sale ba­        Example. You sold real estate in an install­      characterized as interest. If Internal Revenue
sis, none of it is treated as a payment. If it is     ment sale. As part of the down payment, the           Code section 483 applies to the contract, this
more, only the difference is treated as a pay­        buyer assigned to you a $50,000, 8%                   interest is called unstated interest.
ment. If the buyer assumes more than one debt,        third­party note. The FMV of the third­party note         If Internal Revenue Code section 1274 ap­
any part of the total that is more than your in­      at the time of the sale was $30,000. This             plies to the contract, this interest is called origi­
stallment sale basis is considered a payment.         amount, not $50,000, is a payment to you in the       nal issue discount (OID).
These rules are the same as the rules dis­            year of sale. The third­party note had an FMV             Generally, if a buyer gives a debt in consid­
cussed earlier under Buyer assumes mortgage.          equal to 60% of its face value ($30,000 ÷             eration for personal use property, the unstated
However, they apply only to the following types       $50,000), so 60% of each principal payment            interest rules do not apply. Therefore, the buyer
of debt the buyer assumes.                            you receive on this note is a nontaxable return       cannot deduct the unstated interest. The seller
       Those acquired from ownership of the           of capital. The remaining 40% is interest taxed       must report the unstated interest as income.
       property you are selling, such as a mort­      as ordinary income.                                   Personal­use property is any property in which
       gage, lien, overdue interest, or back taxes.                                                         substantially all of its use by the buyer is not in
                                                           Bond. A bond or other evidence of debt
       Those acquired in the ordinary course of                                                             connection with a trade or business or an in­
                                                      you receive from the buyer that is payable on
       your business, such as a balance due for                                                             vestment activity.
                                                      demand or readily tradable in an established
       inventory you purchased.                                                                                 If the debt is subject to the Internal Revenue
                                                      securities market is treated as a payment in the
                                                                                                            Code section 483 rules and is also subject to
   If the buyer assumes any other type of debt,       year you receive it. For more information on the
                                                                                                            the below­market loan rules, such as a gift loan,
such as a personal loan or your legal fees relat­     amount you should treat as a payment, see Ex-
                                                                                                            compensation­related         loan    or     corpora­
ing to the sale, it is treated as if the buyer had    ception under Property used as a payment, ear­
                                                                                                            tion­shareholder loan, then both parties are
paid off the debt at the time of the sale. The        lier.
                                                                                                            subject to the below­market loan rules rather
value of the assumed debt is then considered a             If you receive a government or corporate
                                                                                                            than the unstated interest rules.
payment to you in the year of sale.                   bond for a sale before October 22, 2004, and
                                                                                                                Unstated interest reduces the stated selling
                                                      the bond has interest coupons attached or can
                                                                                                            price of the property and the buyer's basis in the
Property used as a payment. If you receive            be readily traded in an established securities
                                                                                                            property. It increases the seller's interest in­
property rather than money from the buyer, it is      market, you are considered to have received
                                                                                                            come and the buyer's interest expense.
still considered a payment in the year received.      payment equal to the bond's FMV. However,
                                                      see Exception under Property used as a pay-               In general, an installment sale contract pro­
However, see Trading property for like-kind
                                                      ment, earlier.                                        vides for adequate stated interest if the stated
property, later. Generally, the amount of the
                                                                                                            interest rate (based on an appropriate com­
payment is the property's FMV on the date you
                                                          Buyer's note. The buyer's note (unless            pounding period) is at least equal to the appli­
receive it.
                                                      payable on demand) is not considered payment          cable federal rate (AFR).
   Exception. If the property the buyer gives         on the sale. However, its full face value is inclu­
                                                      ded when figuring the selling price and the con­               The AFRs are published monthly in
you is payable on demand or readily tradable,
                                                      tract price. Payments you receive on the note                  the Internal Revenue Bulletin (IRB).
the amount you should consider as payment in
                                                      are used to figure your gain in the year re­                   You can get this information by con­
the year received is:
                                                      ceived.                                               tacting an IRS office. IRBs are also available at
     The FMV of the property on the date you                                                                IRS.gov.
     receive it if you use the cash method of ac­
     counting,                                        Sale to a related person. If you sell deprecia­
                                                      ble property to a related person and the sale is         More information. For more information,
     The face amount of the obligation on the
                                                      an installment sale, you may not be able to re­       see Unstated Interest and Original Issue Dis-
     date you receive it if you use an accrual
                                                      port the sale using the installment method. For       count (OID) in Publication 537.
     method of accounting, or
     The stated redemption price at maturity          information on these rules, see the Instructions
                                                      for Form 6252 and Sale to a Related Person in             Example. You sell property at a contract
     less any original issue discount (OID) or, if                                                          price of $6,000 and your gross profit is $1,500.
     there is no OID, the stated redemption           Publication 537.
                                                                                                            Your gross profit percentage is 25% ($1,500 ÷
     price at maturity appropriately discounted                                                             $6,000). After subtracting interest, you report
                                                      Trading property for like-kind property. If
     to reflect total unstated interest. See Un-                                                            25% of each payment, including the down pay­
                                                      you trade business or investment property
     stated interest, later.                                                                                ment, as installment sale income from the sale
                                                      solely for the same kind of property to be held
   Debt not payable on demand. Any evi­               as business or investment property, you can           for the tax year you receive the payment. The
dence of debt you receive from the buyer that is      postpone reporting the gain. See Like-Kind Ex-        remainder (balance) of each payment is the
not payable on demand is not considered a             changes in chapter 8 for a discussion of              tax­free return of your adjusted basis.
payment. This is true even if the debt is guaran­     like­kind property.
teed by a third party, including a government             If, in addition to like­kind property, you re­
agency.                                               ceive an installment obligation in the exchange,      Example
                                                      the following rules apply to determine install­
    Fair market value (FMV). This is the price        ment sale income each year.                           On January 3, 2012, you sold your farm, includ­
at which property would change hands between                The contract price is reduced by the FMV        ing the home, farm land and buildings. You re­
a willing buyer and a willing seller, neither being         of the like­kind property received in the       ceived $50,000 down and the buyer's note for
under any compulsion to buy or sell and both                trade.                                          $200,000. In addition, the buyer assumed an
having a reasonable knowledge of all the nec­               The gross profit is reduced by any gain on      outstanding $50,000 mortgage on the farm
essary facts.                                               the trade that can be postponed.                land. The total selling price was $300,000. The

                                                                                                             Chapter 10      Installment Sales         Page 63
note payments of $25,000 each, plus adequate                       This is the selling price ($300,000) minus the                                Summary. The installment income (roun­
interest, are due every July 1 and January 1,                      mortgage assumed ($50,000).                                                ded to the nearest dollar) from the sale of the
beginning in July 2012. Your selling expenses                          Gross profit percentage for the sale is                                farm is reported as follows:
were $15,000.                                                      47.70% ($119,260 gross profit ÷ $250,000 con­
                                                                   tract price). The gross profit percentage for                               Selling price . . . . . . . . . . . . . . . . . . . . .        $190,000
Adjusted basis and depreciation. The adjus­                        each asset is figured as follows:                                           Minus: Installment basis . . . . . . . . . . . . .             (108,740)
ted basis and depreciation claimed on each as­                                                                                                 Gross profit         . . . . . . . . . . . . . . . . . . . .    $81,260
set sold are as follows:                                                                                                            Percent
                                                                                                                                               Gain reported in 2011 (year of sale)             . . . . .      $35,778
                                                                    Farm land ($83,140 ÷ $250,000)                . . . . . . . .    33.256
                                   Depreciation         Adjusted                                                                               Gain reported in 2012:
                                                                    Buildings ($36,120 ÷ $250,000)                . . . . . . . .    14.448
 Asset                                 Claimed             Basis                                                                                 $50,000 × 47.70% . . . . . . . . . .           . . . . .       23,850
                                                                    Total   . . . . . . . . . . . . . . . . . . . . . . . . . . .     47.70    Gain reported in 2013:
 Home* . .   . . . . . . . . . .              ­0­        $33,743                                                                                 $50,000 × 47.70% . . . . . . . . . .           . . . . .       23,850
 Farm land     . . . . . . . . .              ­0­         73,610                                                                               Gain reported in 2014:
 Buildings   . . . . . . . . . .         $31,500          35,130   Figuring the gain to report on the install-                                   $50,000 × 47.70% . . . . . . . . . .           . . . . .       23,850
                                                                   ment method. One hundred percent (100%)                                     Gain reported in 2015:
 * Owned and used as main home for at least 2 of the 5
 years prior to the sale
                                                                   of each payment is reported on the installment                                $25,000 × 47.70% . . . . . . . . . .           . . . . .       11,925
                                                                   method. The total amount received on the sale                               Total gain reported           . . . . . . . . . . . . . . .    $119,253
                                                                   in 2012 is $75,000 ($50,000 down payment +
Gain on each asset. The following schedule                         $25,000 payment on July 1). The installment
shows the assets included in the sale, each as­                    sale part of the total payments received in 2012
set's selling price based on its respective value,                 is also $75,000. Figure the gain to report for
the selling expense allocated to each asset, the                   each asset by multiplying its gross profit per­
adjusted basis of each asset, and the gain on                      centage times $75,000.
each asset. The selling expense for each asset
is 5% of the selling price ($15,000 selling ex­
pense ÷ $300,000 selling price).
                                                                                                                                    Income    11.
                                                                    Farm land—33.256% × $75,000                   . . . . . . . .   $24,942
                                                                    Buildings—14.448% × $75,000                                      10,836
                                                                                                                                              Casualties,
                                                                                                                . . . . . . . . .
                 Selling Selling Adjusted
                                                                    Total installment income for 2012                   . . . . .   $35,778
                  Price Expense     Basis                  Gain
 Home*     $60,000                 $3,000   $33,743     $23,257
 Farm land 165,000
 Buildings  75,000
                                    8,250
                                    3,750
                                             73,610
                                             35,130
                                                         83,140
                                                         36,120
                                                                   Reporting the sale. Report the installment
                                                                   sale on Form 6252. Then report the amounts
                                                                                                                                              Thefts, and
             $300,000 $15,000 $142,483 $142,517

 * Owned and used as main home for at least 2 of
                                                                   from Form 6252 on Form 4797 and Schedule D
                                                                   (Form 1040). Attach a separate page to Form                                Condemnations
                                                                   6252 that shows the computations in the exam­
 the 5 years prior to the sale
                                                                   ple.

Depreciation recapture. The buildings are                                     If you sell depreciable business prop-                          Introduction
section 1250 property. There is no depreciation                     TIP       erty, prepare Form 4797 first in order
                                                                                                                                                   This chapter explains the tax treatment of
recapture income for them because they were                                   to figure the amount to enter on line 12
                                                                                                                                              casualties, thefts, and condemnations. A casu­
depreciated using the straight line method. See                    of Part I, Form 6252.
                                                                                                                                              alty occurs when property is damaged, de­
chapter 9 for more information on depreciation                                                                                                stroyed, or lost due to a sudden, unexpected, or
recapture.                                                            Section 1231 gains. The gains on the farm                               unusual event. A theft occurs when property is
    Special rules may apply when you sell sec­                     land and buildings are section 1231 gains. They                            stolen. A condemnation occurs when private
tion 1250 assets depreciated under the straight                    may be reported as either capital or ordinary                              property is legally taken for public use without
line method. See the Unrecaptured Section                          gain depending on the net balance when com­                                the owner's consent. A casualty, theft, or con­
1250 Gain Worksheet in the Instructions for                        bined with other section 1231 losses. A net                                demnation may result in a deductible loss or
Schedule D (Form 1040). See chapter 3 of Pub­                      1231 gain is capital gain and a net 1231 loss is                           taxable gain on your federal income tax return.
lication 544, Sales and Other Dispositions of                      an ordinary loss.                                                          You may have a deductible loss or a taxable
Assets, for more information on section 1250                                                                                                  gain even if only a portion of your property was
assets.                                                            Installment income for years after 2012.                                   affected by a casualty, theft, or condemnation.
                                                                   You figure installment income for the years after                               An involuntary conversion occurs when you
Installment sale basis and gross profit. The                       2012 by applying the same gross profit percen­                             receive money or other property as reimburse­
following table shows each asset reported on                       tages to the payments you receive each year. If                            ment for a casualty, theft, condemnation, dispo­
the installment method, its selling price, install­                you receive $50,000 during the year, the entire                            sition of property under threat of condemnation,
ment sale basis, and gross profit.                                 $50,000 is considered received on the install­                             or certain other events discussed in this chap­
                                                                   ment sale (100% × $50,000). You realize in­                                ter.
                                          Installment
                                                                   come as follows:                                                                If an involuntary conversion results in a gain
                                   Selling       Sale     Gross                                                                               and you buy qualified replacement property
                                    Price       Basis     Profit                                                                    Income    within the specified replacement period, you
 Farm land     . . . . . .    $165,000       $73,610     $83,140    Farm land—33.256% × $50,000                   . . . . . . . .   $16,628   can postpone reporting the gain on your income
 Buildings   . . . . . . .      75,000        35,130      36,120    Buildings—14.448% × $50,000                 . . . . . . . . .     7,224   tax return. For more information, see Postpon-
                              $240,000 $108,740 $119,260            Total installment income              . . . . . . . . . . . .   $23,852   ing Gain, later.


Section 1231 gains. The gain on the farm
                                                                       In this example, no gain ever is recognized                            Topics
                                                                   from the sale of your home. You will combine                               This chapter discusses:
land and buildings is reported as section 1231
                                                                   your section 1231 gains from this sale with sec­
gains. See Section 1231 Gains and Losses in
                                                                   tion 1231 gains and losses from other sales in                                   Casualties and thefts
chapter 9.
                                                                   each of the later years to determine whether to
                                                                                                                                                    How to figure a loss or gain
Contract price and gross profit percentage.                        report them as ordinary or capital gains. The in­
                                                                   terest received with each payment will be inclu­                                 Other involuntary conversions
The contract price is $250,000 for the part of
the sale reported on the installment method.                       ded in full as ordinary income.                                                  Postponing gain


Page 64          Chapter 11              Casualties, Thefts, and Condemnations
     Disaster area losses                                  Storms, including hurricanes and torna­              for investment if the decline is caused by disclo­
     Reporting gains and losses                            does.                                                sure of accounting fraud or other illegal miscon­
                                                           Terrorist attacks.                                   duct by the officers or directors of the corpora­
     Drought involving property connected with                                                                  tion that issued the stock. However, you can
     a trade or business or a transaction                  Vandalism.
                                                                                                                deduct as a capital loss the loss you sustain
     entered into for profit                               Volcanic eruptions.                                  when you sell or exchange the stock or the
                                                                                                                stock becomes completely worthless. You re­
Useful Items                                             Nondeductible losses. A casualty loss is
                                                                                                                port a capital loss on Schedule D (Form 1040).
You may want to see:                                  not deductible if the damage or destruction is
                                                                                                                For more information about stock sales, worth­
                                                      caused by the following.                                  less stock, and capital losses, see chapter 4 of
                                                           Accidentally breaking articles such as               Publication 550.
  Publication
                                                           glassware or china under normal condi­
     523 Selling Your Home                                 tions.                                                   Mislaid or lost property. The simple dis­
                                                           A family pet (explained below).                      appearance of money or property is not a theft.
     525 Taxable and Nontaxable Income
                                                           A fire if you willfully set it, or pay someone       However, an accidental loss or disappearance
     536 Net Operating Losses (NOLs) for                   else to set it.                                      of property can qualify as a casualty if it results
         Individuals, Estates, and Trusts                  A car, truck, or farm equipment accident if          from an identifiable event that is sudden, unex­
                                                           your willful negligence or willful act caused        pected, or unusual.
     544 Sales and Other Dispositions of
         Assets                                            it. The same is true if the willful act or willful
                                                           negligence of someone acting for you                    Example. A car door is accidentally slam­
     547 Casualties, Disasters, and Thefts                 caused the accident.                                 med on your hand, breaking the setting of your
                                                           Progressive deterioration (explained be­             diamond ring. The diamond falls from the ring
     584 Casualty, Disaster, and Theft Loss                                                                     and is never found. The loss of the diamond is a
         Workbook (Personal­Use Property)                  low).
                                                                                                                casualty.
     584-B Business Casualty, Disaster, and               Family pet. Loss of property due to dam­
         Theft Loss Workbook                          age by a family pet is not deductible as a casu­
                                                      alty loss unless the requirements discussed
                                                                                                                Farming Losses
  Form (and Instructions)                             above under Casualty are met.
                                                                                                                You can deduct certain casualty or theft losses
     Sch A (Form 1040) Itemized                                                                                 that occur in the business of farming. The fol­
                                                          Example. You keep your horse in your
         Deductions                                                                                             lowing is a discussion of some losses you can
                                                      yard. The ornamental fruit trees in your yard
                                                                                                                deduct and some you cannot deduct.
     Sch D (Form 1040) Capital Gains and              were damaged when your horse stripped the
         Losses                                       bark from them. Some of the trees were com­
                                                                                                                Livestock or produce bought for resale.
                                                      pletely girdled and died. Because the damage
     Sch F (Form 1040) Profit or Loss From                                                                      Casualty or theft losses of livestock or produce
                                                      was not unexpected or unusual, the loss is not
         Farming                                                                                                bought for resale are deductible if you report
                                                      deductible.
                                                                                                                your income on the cash method. If you report
     4684 Casualties and Thefts
                                                          Progressive deterioration. Loss of prop­              your income on an accrual method, take casu­
     4797 Sales of Business Property                  erty due to progressive deterioration is not de­          alty and theft losses on property bought for re­
                                                      ductible as a casualty loss. This is because the          sale by omitting the item from the closing inven­
See chapter 16 for information about getting                                                                    tory for the year of the loss. You cannot take a
                                                      damage results from a steadily operating cause
publications and forms.                                                                                         separate deduction.
                                                      or a normal process, rather than from a sudden
                                                      event. Examples of damage due to progressive
                                                                                                                Livestock, plants, produce, and crops
Casualties and Thefts                                 deterioration include damage from rust, corro­
                                                      sion, or termites. However, weather­related               raised for sale. Losses of livestock, plants,
                                                      conditions or disease may cause another type              produce, and crops raised for sale are generally
If your property is destroyed, damaged, or sto­                                                                 not deductible if you report your income on the
                                                      of involuntary conversion. See Other Involun-
len, you may have a deductible loss. If the in­                                                                 cash method. You have already deducted the
                                                      tary Conversions, later.
surance or other reimbursement is more than                                                                     cost of raising these items as farm expenses,
the adjusted basis of the destroyed, damaged,         Theft. A theft is the taking and removing of              so their basis is equal to zero.
or stolen property, you may have a taxable gain.      money or property with the intent to deprive the              For plants with a preproductive period of
                                                      owner of it. The taking of property must be ille­         more than 2 years, you may have a deductible
Casualty. A casualty is the damage, destruc­                                                                    loss if you have a tax basis in the plants. You
                                                      gal under the law of the state where it occurred
tion, or loss of property resulting from an identi­                                                             usually have a tax basis if you capitalized the
                                                      and it must have been done with criminal intent.
fiable event that is sudden, unexpected, or un­                                                                 expenses associated with these plants under
                                                      You do not need to show a conviction for theft.
usual.                                                                                                          the uniform capitalization rules. The uniform
                                                          Theft includes the taking of money or prop­
                                                      erty by the following means:                              capitalization rules are discussed in chapter 6.
   Deductible losses. Deductible casualty
                                                           Blackmail,                                               If you report your income on an accrual
losses can result from a number of different
                                                                                                                method, casualty or theft losses are deductible
causes, including the following.                           Burglary,                                            only if you included the items in your inventory
     Airplane crashes.
                                                           Embezzlement,                                        at the beginning of your tax year. You get the
     Car, truck, or farm equipment accidents                                                                    deduction by omitting the item from your inven­
                                                           Extortion,
     not resulting from your willful act or willful                                                             tory at the close of your tax year. You cannot
     negligence.                                           Kidnapping for ransom,
                                                                                                                take a separate casualty or theft deduction.
     Earthquakes.                                          Larceny,
     Fires (but see Nondeductible losses next              Robbery, or                                          Income loss. A loss of future income is not de­
     for exceptions).                                                                                           ductible.
                                                           Threats.
     Floods.
     Freezing.                                        The taking of money or property through fraud                 Example. A severe flood destroyed your
                                                      or misrepresentation is theft if it is illegal under      crops. Because you are a cash method tax­
     Government­ordered demolition or reloca­                                                                   payer and already deducted the cost of raising
     tion of a home that is unsafe to use be­         state or local law.
                                                                                                                the crops as farm expenses, this loss is not de­
     cause of a disaster as discussed under               Decline in market value of stock. You                 ductible, as explained above under Livestock,
     Disaster Area Losses, in Publication 547.        cannot deduct as a theft loss the decline in mar­         plants, produce, and crops raised for sale. You
     Lightning.                                       ket value of stock acquired on the open market            estimate that the crop loss will reduce your farm

                                                                                      Chapter 11       Casualties, Thefts, and Condemnations              Page 65
income by $25,000. This loss of future income         Personal-use property. Personal­use prop­                    The repairs are necessary to bring the
is also not deductible.                               erty is property used by you or your family                  property back to its condition before the
                                                      members for personal purposes and not used in                casualty.
Loss of timber. If you sell timber downed as a        your farm business or for income­producing                   The amount spent for repairs is not exces­
result of a casualty, treat the proceeds from the     purposes. The following items are examples of                sive.
sale as a reimbursement. If you use the pro­          personal­use property:                                       The repairs fix the damage only.
ceeds to buy qualified replacement property,               Your main home.                                         The value of the property after the repairs
you can postpone reporting the gain. See Post-             Furniture and electronics used in your                  is not, due to the repairs, more than the
poning Gain, later.                                        main home and not used in a home office                 value of the property before the casualty.
                                                           or for business purposes.
Property used in farming. Casualty and theft               Clothing and jewelry.                               Related expenses. The incidental expen­
losses of property used in your farm business                                                               ses due to a casualty or theft, such as expen­
usually result in deductible losses. If a fire or          An automobile used for nonbusiness pur­          ses for the treatment of personal injuries, tem­
storm destroyed your barn, or you lose by casu­            poses.                                           porary housing, or a rental car, are not part of
alty or theft an animal you bought for draft,         You figure the casualty or theft loss on this         your casualty or theft loss. However, they may
breeding, dairy, or sport, you may have a de­         property by taking the following steps.               be deductible as farm business expenses if the
ductible loss. See How To Figure a Loss, later.                                                             damaged or stolen property is farm property.
                                                        1. Determine your adjusted basis in the prop­
    Raised draft, breeding, dairy, or sporting             erty before the casualty or theft.
                                                                                                            Separate computations for more than one
animals. Generally, losses of raised draft,             2. Determine the decrease in fair market            item of property. Generally, if a single casu­
breeding, dairy, or sporting animals do not re­            value of the property as a result of the         alty or theft involves more than one item of
sult in deductible casualty or theft losses be­            casualty or theft.                               property, you must figure your loss separately
cause you have no basis in the animals. How­                                                                for each item of property. Then combine the los­
ever, you may have a basis in the animal and            3. From the smaller of the amounts you de­
                                                                                                            ses to determine your total loss.
therefore may be able to claim a deduction if ei­          termined in (1) and (2), subtract any insur­
ther of the following situations applies to you.           ance or other reimbursement you receive                      There is an exception to this rule for
     You use inventories to determine your in­             or expect to receive.                                        personal-use real property. See Ex­
     come and you included the animals in your
                                                                                                               !        ception for personal­use real property,
                                                      You must apply the deduction limits, discussed
                                                                                                            CAUTION

     inventory.                                                                                             later.
                                                      later, to determine your deductible loss.
     You capitalized the expenses associated
     with the animals under the uniform capitali­              You can use Publication 584 to list              Example. A fire on your farm damaged a
     zation rules and therefore have a tax basis       TIP     your stolen or damaged personal-use          tractor and the barn in which it was stored. The
     in the animals subject to a casualty or theft.            property and figure your loss. It in-        tractor had an adjusted basis of $3,300. Its FMV
                                                      cludes schedules to help you figure the loss on       was $28,000 just before the fire and $10,000
When you include livestock in inventory, its last
                                                      your home, its contents, and your motor vehi-         immediately afterward. The barn had an adjus­
inventory value is its basis. When you lose an
                                                      cles.                                                 ted basis of $28,000. Its FMV was $55,000 just
inventoried animal held for draft, breeding,
dairy, or sport by casualty or theft during the                                                             before the fire and $25,000 immediately after­
                                                          Adjusted basis. Adjusted basis is your ba­        ward. You received insurance reimbursements
year, decrease ending inventory by the amount
                                                      sis (usually cost) increased or decreased by          of $2,100 on the tractor and $26,000 on the
you included in inventory for the animal. You
                                                      various events, such as improvements and              barn. Figure your deductible casualty loss sepa­
cannot take a separate deduction.
                                                      casualty losses. For more information about ad­       rately for the two items of property.
                                                      justed basis, see chapter 6.
How To Figure a Loss
                                                         Decrease in fair market value (FMV).                                                              Tractor      Barn
                                                      The decrease in FMV is the difference between           1) Adjusted basis       . . . . . . . . .     $3,300      $28,000
How you figure a deductible casualty or theft         the property's value immediately before the             2) FMV before fire      . . . . . . . . .    $28,000      $55,000
loss depends on whether the loss was to farm          casualty or theft and its value immediately after­      3) FMV after fire .     . . . . . . . . .     10,000       25,000
or personal­use property and whether the prop­        ward. FMV is defined in chapter 10 under Pay-           4) Decrease in FMV
erty was stolen or partly or completely de­           ments Received or Considered Received.                     (line 2 − line 3) . . . . .     . . . .   $18,000      $30,000
stroyed.                                                                                                      5) Loss (lesser of line 1 or
                                                          Appraisal. To figure the decrease in FMV               line 4) . . . . . . . . . . .   . . . .    $3,300      $28,000
Farm property. Farm property is the property          because of a casualty or theft, you generally           6) Minus: Insurance . . .          . . . .     2,100       26,000
you use in your farming business. If your farm        need a competent appraisal. But other meas­             7) Deductible casualty loss            . .    $1,200       $2,000
property was completely destroyed or stolen,          ures, such as the cost of cleaning up or making         8) Total deductible casualty loss             . . . . .    $3,200
your loss is figured as follows:                      repairs (discussed next) can be used to estab­
                                                      lish decreases in FMV.                                    Exception for personal-use real prop-
          Your adjusted basis in the property             An appraisal to determine the difference be­      erty. In figuring a casualty loss on per­
                                                      tween the FMV of the property immediately be­         sonal­use real property, the entire property (in­
                       MINUS
                                                      fore a casualty or theft and immediately after­       cluding any improvements, such as buildings,
                  Any salvage value                   ward should be made by a competent                    trees, and shrubs) is treated as one item. Figure
                       MINUS                          appraiser. The appraiser must recognize the ef­       the loss using the smaller of the following.
                                                      fects of any general market decline that may oc­           The decrease in FMV of the entire prop­
       Any insurance or other reimbursement you
                                                      cur along with the casualty. This information is           erty.
              receive or expect to receive
                                                      needed to limit any deduction to the actual loss           The adjusted basis of the entire property.
                                                      resulting from damage to the property.
          You can use the schedules in Publica-
 TIP      tion 584-B to list your stolen, dam-            Cost of cleaning up or making repairs.
          aged, or destroyed business property        The cost of cleaning up after a casualty is not          Example. You bought a farm in 1960 for
and to figure your loss.                              part of a casualty loss. Neither is the cost of re­   $20,000. The adjusted basis of the residential
                                                      pairing damaged property after a casualty. But        part is now $16,000. In 2012, a windstorm blew
    If your farm property was partially damaged,      you can use the cost of cleaning up or making         down shade trees and three ornamental trees
use the steps shown under Personal-use prop-          repairs after a casualty as a measure of the de­      planted at a cost of $600 on the residential part.
erty next to figure your casualty loss. However,      crease in FMV if you meet all the following con­      The adjusted basis of the residential part in­
the deduction limits, discussed later, do not ap­     ditions.                                              cludes the $600. The fair market value (FMV) of
ply to farm property.                                       The repairs are actually made.                  the residential part immediately before the

Page 66       Chapter 11        Casualties, Thefts, and Condemnations
storm was $130,000, and $126,000 immedi­                            your tax for the year you claimed the deduction.         Example. In June, you discovered that your
ately after the storm. The trees were not cov­                      See Recoveries in Publication 525 to find out        house had been burglarized. Your loss after in­
ered by insurance.                                                  how much extra reimbursement to include in in­       surance reimbursement was $2,000. Your ad­
                                                                    come.                                                justed gross income for the year you discovered
 1) Adjusted basis     . . . . . . . . . . . . . . . .    $16,000                                                        the burglary is $57,000. Figure your theft loss
                                                                             If the total of all the reimbursements      deduction as follows:
 2) FMV before the storm         . . . . . . . . . . .   $130,000            you receive is more than your adjusted
 3) FMV after the storm        . . . . . . . . . . . .    126,000      !
                                                                     CAUTION basis in the destroyed or stolen prop-
 4) Decrease in FMV (line 2 − line 3)                      $4,000                                                         1. Loss after insurance       . . . . . . . . . . . . . . .    $2,000
                                                                    erty, you will have a gain on the casualty or
 5) Loss before insurance                                                                                                 2. Subtract $100 . . . .    . . . . . . . . . . . . . . . .       100
                                                                    theft. See Publication 547 for information on
    (lesser of line 1 or line 4)     . . . . . . . . .     $4,000                                                         3. Loss after $100 rule . . . . . . . . . .     . . . . . .    $1,900
                                                                    how to treat a gain from the reimbursement you
 6) Minus: Insurance . . . .       . . . . . . . . . .        ­0­                                                         4. Subtract 10% (.10) × $57,000 AGI             . . . . . .    $5,700
                                                                    receive because of a casualty or theft.
 7) Amount of loss       . . . . . . . . . . . . . . .     $4,000                                                         5. Theft loss deduction         . . . . . . . . . . . . . .       -0-

                                                                       Actual reimbursement same as expec-
                                                                                                                            You do not have a theft loss deduction be­
Insurance and other reimbursements. If you                          ted. If you receive exactly the reimbursement
                                                                                                                         cause your loss ($1,900) is less than 10% of
receive an insurance or other type of reimburse­                    you expected to receive, you do not have to in­
                                                                                                                         your adjusted gross income ($5,700).
ment, you must subtract the reimbursement                           clude any of the reimbursement in your income
when you figure your loss. You do not have a                        and you cannot deduct any additional loss.                     If you have a casualty or theft gain in
casualty or theft loss to the extent you are reim­                                                                                 addition to a loss, you will have to
bursed.
                                                                       Lump-sum reimbursement. If you have a                !      make a special computation before
                                                                    casualty or theft loss of several assets at the
                                                                                                                          CAUTION
    If you expect to be reimbursed for part or all                                                                       you figure your 10% limit. See 10% Rule in Pub-
                                                                    same time without an allocation of reimburse­
of your loss, you must subtract the expected re­                                                                         lication 547.
                                                                    ment to specific assets, divide the lump­sum re­
imbursement when you figure your loss. You
                                                                    imbursement among the assets according to
must reduce your loss even if you do not re­
ceive payment until a later tax year.
                                                                    the fair market value of each asset at the time of
                                                                    the loss. Figure the gain or loss separately for
                                                                                                                         When Loss Is Deductible
          Do not subtract from your loss any in-                    each asset that has a separate basis.
          surance payments you receive for liv-                                                                          Generally, you can deduct casualty losses that
   !
CAUTION   ing expenses if you lose the use of                       Adjustments to basis. If you have a casualty         are not reimbursable only in the tax year in
your main home or are denied access to it be-                       or theft loss, you must decrease your basis in       which they occur. You generally can deduct
cause of a casualty. You may have to include a                      the property by any insurance or other reim­         theft losses that are not reimbursable only in the
portion of these payments in your income. See                       bursement you receive and by any deductible          year you discover your property was stolen.
Publication 547 for details.                                        loss. The result is your adjusted basis in the       However, losses in federally declared disaster
                                                                    property. If you make either of the basis adjust­    areas are subject to different rules. See Disas-
                                                                    ments described above, amounts you spend on          ter Area Losses, later, for an exception.
    Disaster relief. Food, medical supplies,
and other forms of assistance you receive do                        repairs to restore your property to its pre­casu­
                                                                    alty condition increase your adjusted basis. See        If you are not sure whether part of your
not reduce your casualty loss, unless they are
                                                                    Adjusted Basis in chapter 6 for more informa­        casualty or theft loss will be reimbursed, do not
replacements for lost or destroyed property. Ex­
                                                                    tion.                                                deduct that part until the tax year when you be­
cludable cash gifts you receive also do not re­
                                                                                                                         come reasonably certain that it will not be reim­
duce your casualty loss if there are no limits on
                                                                        Example. You built a new silo for $25,000.       bursed.
how you can use the money.
    Generally, disaster relief grants received un­                  This is the basis in your silo because that is the
                                                                    total cost you incurred to build it. During the      Leased property. If you lease property from
der the Robert T. Stafford Disaster Relief and
                                                                    year, a tornado damaged your silo and your al­       someone else, you can deduct a loss on the
Emergency Assistance Act are not included in
                                                                    lowable casualty loss deduction was $1,000. In       property in the year your liability for the loss is
your income. See Federal disaster relief grants,
                                                                    addition, your insurance company reimbursed          fixed. This is true even if the loss occurred or
later, under Disaster Area Losses.
                                                                    you $4,000 for the damage and you spent              the liability was paid in a different year. You are
    Qualified disaster relief payments for expen­
                                                                    $6,000 to restore the silo to its pre­casualty       not entitled to a deduction until your liability un­
ses you incurred as a result of a federally de­
                                                                    condition. Your adjusted basis in the silo after     der the lease can be determined with reasona­
clared disaster are not taxable income to you.
                                                                    the casualty is $26,000 ($25,000 ­ $1,000 ­          ble accuracy. Your liability can be determined
See Qualified disaster relief payments, later,
                                                                    $4,000 + $6,000).                                    when a claim for recovery is settled, adjudica­
under Disaster Area Losses.
                                                                                                                         ted, or abandoned.
   Reimbursement received after deduct-
ing loss. If you figure your casualty or theft
                                                                    Deduction Limits on Losses                               Example. Robert leased a tractor from First
loss using your expected reimbursement, you                         of Personal-Use Property                             Implement, Inc., for use in his farm business.
may have to adjust your tax return for the tax                                                                           The tractor was destroyed by a tornado in June
year in which you get your actual reimburse­                        Casualty and theft losses of property held for       2012. The loss was not insured. First Implement
ment.                                                               personal use may be deductible if you itemize        billed Robert for the fair market value of the
                                                                    deductions on Schedule A (Form 1040).                tractor on the date of the loss. Robert disagreed
    Actual reimbursement less than expec-                                                                                with the bill and refused to pay it. First Imple­
ted. If you later receive less reimbursement                           There are two limits on the deduction for         ment later filed suit in court against Robert. In
than you expected, include that difference as a                     casualty or theft loss of personal­use property.     2013, Robert and First Implement agreed to
loss with your other losses (if any) on your re­                    You figure these limits on Form 4684.                settle the suit for $20,000, and the court entered
turn for the year in which you can reasonably                                                                            a judgment in favor of First Implement. Robert
expect no more reimbursement.                                       $100 rule. You must reduce each casualty or          paid $20,000 in June 2013. He can claim the
                                                                    theft loss on personal­use property by $100.         $20,000 as a loss on his 2013 tax return.
    Actual reimbursement more than expec-                           This rule applies after you have subtracted any
ted. If you later receive more reimbursement                        reimbursement.                                       Net operating loss (NOL). If your deductions,
than you expected after you have claimed a de­
                                                                                                                         including casualty or theft loss deductions, are
duction for the loss, you may have to include                       10% rule. You must further reduce the total of       more than your income for the year, you may
the extra reimbursement in your income for the                      all your casualty or theft losses on personal­use    have an NOL. An NOL can be carried back or
year you receive it. However, if any part of your                   property by 10% of your adjusted gross income.       carried forward and deducted from income in
original deduction did not reduce your tax for                      Apply this rule after you reduce each loss by        other years. See Publication 536 for more infor­
the earlier year, do not include that part of the                   $100. Adjusted gross income is on line 38 of         mation on NOLs.
reimbursement in your income. Do not refigure                       Form 1040.

                                                                                                 Chapter 11      Casualties, Thefts, and Condemnations                                  Page 67
Proof of Loss                                        1) Insurance reimbursement             . . . . . . . . . .   $40,000   Livestock Losses
                                                     2) Legal expenses . . . . . .        . . . . . . . . . . .     2,000
To deduct a casualty or theft loss, you must be      3) Amount received
                                                        (line 1 − line 2) .   . . . . . . . . . . . . . . . . .   $38,000   Diseased livestock. If your livestock die from
able to prove that there was a casualty or theft.
                                                     4) Adjusted basis .      . . . . . . . . . . . . . . . . .    25,000
You must have records to support the amount                                                                                 disease, or are destroyed, sold, or exchanged
                                                     5) Gain on casualty (line 3 − line 4)              . . . .   $13,000   because of disease, even though the disease is
you claim for the loss.
                                                                                                                            not of epidemic proportions, treat these occur­
Casualty loss proof. For a casualty loss, your                                                                              rences as involuntary conversions. If the live­
records should show all the following informa­      Other Involuntary                                                       stock were raised or purchased for resale, fol­
tion.                                                                                                                       low the rules for livestock discussed earlier
      The type of casualty (car accident, fire,     Conversions                                                             under Farming Losses. Otherwise, figure the
      storm, etc.) and when it occurred.                                                                                    gain or loss from these conversions using the
      That the loss was a direct result of the      In addition to casualties and thefts, other events                      rules discussed under Determining Gain or
      casualty.                                     cause involuntary conversions of property.                              Loss in chapter 8. If you replace the livestock,
      That you were the owner of the property or,   Some of these are discussed in the following                            you may be able to postpone reporting the gain.
      if you leased the property from someone       paragraphs.                                                             See Postponing Gain below.
      else, that you were contractually liable to
      the owner for the damage.                        Gain or loss from an involuntary conversion                              Reporting dispositions of diseased live-
      Whether a claim for reimbursement exists      of your property is usually recognized for tax                          stock. If you choose to postpone reporting
      for which there is a reasonable expectation   purposes. You report the gain or deduct the                             gain on the disposition of diseased livestock,
      of recovery.                                  loss on your tax return for the year you realize it.                    you must attach a statement to your return ex­
                                                    However, depending on the type of property                              plaining that the livestock were disposed of be­
Theft loss proof. For a theft loss, your records    you receive, you may not have to report your                            cause of disease. You must also include other
should show all the following information.          gain on the involuntary conversion. See Post-                           information on this statement. See How To
    When you discovered your property was           poning Gain, later.                                                     Postpone Gain, later, under Postponing Gain.
    missing.
                                                                                                                            Weather-related sales of livestock. If you
    That your property was stolen.
                                                    Condemnation                                                            sell or exchange livestock (other than poultry)
    That you were the owner of the property.                                                                                held for draft, breeding, or dairy purposes solely
    Whether a claim for reimbursement exists        Condemnation is the process by which private                            because of drought, flood, or other weather­re­
    for which there is a reasonable expectation     property is legally taken for public use without                        lated conditions, treat the sale or exchange as
    of recovery.                                    the owner's consent. The property may be                                an involuntary conversion. Only livestock sold in
                                                    taken by the federal government, a state gov­                           excess of the number you normally would sell
Figuring a Gain                                     ernment, a political subdivision, or a private or­                      under usual business practice, in the absence
                                                                                                                            of weather­related conditions, are considered
                                                    ganization that has the power to legally take
                                                    property. The owner receives a condemnation                             involuntary conversions. Figure the gain or loss
A casualty or theft may result in a taxable gain.   award (money or property) in exchange for the                           using the rules discussed under Determining
If you receive an insurance payment or other re­    property taken. A condemnation is a forced                              Gain or Loss in chapter 8. If you replace the
imbursement that is more than your adjusted         sale, the owner being the seller and the con­                           livestock, you may be able to postpone report­
basis in the destroyed, damaged, or stolen          demning authority being the buyer.                                      ing the gain. See Postponing Gain below.
property, you have a gain from the casualty or
theft. You generally report your gain as income     Threat of condemnation. Treat the sale of                                   Example. It is your usual business practice
in the year you receive the reimbursement.          your property under threat of condemnation as                           to sell five of your dairy animals during the year.
However, depending on the type of property          a condemnation, provided you have reasonable                            This year you sold 20 dairy animals because of
you receive, you may not have to report your        grounds to believe that your property will be                           drought. The sale of 15 animals is treated as an
gain. See Postponing Gain, later.                   condemned.                                                              involuntary conversion.

   Your gain is figured as follows:                 Main home condemned. If you have a gain                                           If you do not replace the livestock, you
    The amount you receive, minus                   because your main home is condemned, you                                 TIP      may be able to report the gain in the
    Your adjusted basis in the property at the      generally can exclude the gain from your in­                                      following year's income. This rule also
    time of the casualty or theft.                  come as if you had sold or exchanged your                               applies to other livestock (including poultry).
                                                    home. For information on this exclusion, see                            See Sales Caused by Weather­Related Condi­
    Even if the decrease in FMV of your prop­       Publication 523. If your gain is more than the                          tions in chapter 3.
erty is smaller than the adjusted basis of your     amount you can exclude, but you buy replace­
property, use your adjusted basis to figure the
gain.
                                                    ment property, you may be able to postpone re­
                                                    porting the excess gain. See Postponing Gain,
                                                                                                                            Tree Seedlings
                                                    later. (You cannot deduct a loss from the con­
Amount you receive. The amount you receive          demnation of your main home.)                                           If, because of an abnormal drought, the failure
includes any money plus the value of any prop­                                                                              of planted tree seedlings is greater than nor­
erty you receive, minus any expenses you have       More information. For information on how to                             mally anticipated, you may have a deductible
in obtaining reimbursement. It also includes any    figure the gain or loss on condemned property,                          loss. Treat the loss as a loss from an involuntary
reimbursement used to pay off a mortgage or         see chapter 1 in Publication 544. Also see Post-                        conversion. The loss equals the previously cap­
other lien on the damaged, destroyed, or stolen     poning Gain, later, to find out if you can post­                        italized reforestation costs you had to duplicate
property.                                           pone reporting the gain.                                                on replanting. You deduct the loss on the return
                                                                                                                            for the year the seedlings died.
   Example. A tornado severely damaged
your barn. The adjusted basis of the barn was
$25,000. Your insurance company reimbursed
                                                    Irrigation Project                                                      Postponing Gain
you $40,000 for the damaged barn. However,
you had legal expenses of $2,000 to collect that    The sale or other disposition of property located                       Do not report a gain if you receive reimburse­
insurance. Your insurance minus your expen­         within an irrigation project to conform to the                          ment in the form of property similar or related in
ses to collect the insurance is more than your      acreage limits of federal reclamation laws is an                        service or use to the destroyed, stolen, or other
adjusted basis in the barn, so you have a gain.     involuntary conversion.                                                 involuntarily converted property. Your basis in

Page 68      Chapter 11     Casualties, Thefts, and Condemnations
the new property is generally the same as your        than $100,000. If the property is owned by a          under Livestock Losses) and it is not practical
adjusted basis in the property it replaces.           partnership, the $100,000 limit applies to the        for you to reinvest the sales proceeds in prop­
                                                      partnership and each partner. If the property is      erty similar or related in service or use to the
    You must ordinarily report the gain on your       owned by an S corporation, the $100,000 limit         livestock, you can treat other property (exclud­
stolen, destroyed, or other involuntarily conver­     applies to the S corporation and each share­          ing real property) used for farming purposes, as
ted property if you receive money or unlike           holder.                                               property similar or related in service or use to
property as reimbursement. However, you can                                                                 the livestock you sold.
choose to postpone reporting the gain if you              Exception. This rule does not apply if the
purchase replacement property similar or rela­        related person acquired the property from an              Example. Each year you normally sell 25
ted in service or use to your destroyed, stolen,      unrelated person within the period of time al­        cows from your beef herd. However, this year
or other involuntarily converted property within      lowed for replacing the involuntarily converted       you had to sell 50 cows. This is because a se­
a specific replacement period.                        property.                                             vere drought significantly reduced the amount
    If you have a gain on damaged property,               Related persons. Under this rule, related         of hay and pasture yield needed to feed your
you can postpone reporting the gain if you            persons include, for example, a parent and            herd for the rest of the year. Because it is not
spend the reimbursement to restore the prop­          child, a brother and sister, a corporation and an     practical for you to use the proceeds from sell­
erty.                                                 individual who owns more than 50% of its out­         ing the extra cows to buy new cows, you can
                                                      standing stock, and two partnerships in which         treat other property (excluding real property)
    To postpone reporting all the gain, the cost      the same C corporations own more than 50% of          used for farming purposes, as property similar
of your replacement property must be at least                                                               or related in service or use to the cows you
                                                      the capital or profits interests. For more infor­
as much as the reimbursement you receive. If                                                                sold.
                                                      mation on related persons, see Nondeductible
the cost of the replacement property is less than     Loss under Sales and Exchanges Between Re-
the reimbursement, you must include the gain in                                                             Standing crop destroyed by casualty. If a
                                                      lated Persons in chapter 2 of Publication 544.
your income up to the amount of the unspent re­                                                             storm or other casualty destroyed your standing
imbursement.                                                                                                crop and you use the insurance money to ac­
                                                      Death of a taxpayer. If a taxpayer dies after
                                                                                                            quire either another standing crop or a harves­
                                                      having a gain, but before buying replacement
    Example 1. In 1985, you constructed a                                                                   ted crop, this purchase qualifies as replacement
                                                      property, the gain must be reported for the year
barn to store farm equipment at a cost of                                                                   property. The costs of planting and raising a
                                                      in which the decedent realized the gain. The ex­
$20,000. In 1987, you added a silo to the barn                                                              new crop qualify as replacement costs for the
                                                      ecutor of the estate or the person succeeding to
at a cost of $15,000 to store grain. In May of this                                                         destroyed crop only if you use the crop method
                                                      the funds from the involuntary conversion can­
year, the property was worth $100,000. In June                                                              of accounting (discussed in chapter 2). In that
                                                      not postpone reporting the gain by buying re­
the barn and silo were destroyed by a tornado.                                                              case, the costs of bringing the new crop to the
                                                      placement property.
At the time of the tornado, you had an adjusted                                                             same level of maturity as the destroyed crop
basis of $0 in the property. You received                                                                   qualify as replacement costs to the extent they
$85,000 from the insurance company. You had           Replacement Property                                  are incurred during the replacement period.
a gain of $85,000 ($85,000 – $0).
    You spent $80,000 to rebuild the barn and         You must buy replacement property for the spe­        Timber loss. Standing timber you bought with
silo. Since this is less than the insurance pro­      cific purpose of replacing your property. Your        the proceeds from the sale of timber downed as
ceeds received, you must include $5,000               replacement property must be similar or related       a result of a casualty, such as high winds, earth­
($85,000 – $80,000) in your income.                   in service or use to the property it replaces. You    quakes, or volcanic eruptions, qualifies as re­
                                                      do not have to use the same funds you receive         placement property. If you bought the standing
   Example 2. In 1970, you bought a cabin in          as reimbursement for your old property to ac­         timber within the replacement period, you can
the mountains for your personal use at a cost of      quire the replacement property. If you spend          postpone reporting the gain.
$18,000. You made no further improvements or          the money you receive for other purposes, and
additions to it. When a storm destroyed the           borrow money to buy replacement property,             Business or income-producing property lo-
cabin this January, the cabin was worth               you can still choose to postpone reporting the        cated in a federally declared disaster area.
$250,000. You received $146,000 from the in­          gain if you meet the other requirements. Prop­        If your destroyed business or income­producing
surance company in March. You had a gain of           erty you acquire by gift or inheritance does not      property was located in a federally declared dis­
$128,000 ($146,000 − $18,000).                        qualify as replacement property.                      aster area, any tangible replacement property
   You spent $144,000 to rebuild the cabin.                                                                 you acquire for use in any business is treated
Since this is less than the insurance proceeds        Owner-user. If you are an owner­user, similar         as similar or related in service or use to the de­
received, you must include $2,000 ($146,000 −         or related in service or use means that replace­      stroyed property. For more information, see
$144,000) in your income.                             ment property must function in the same way as        Disaster Area Losses in Publication 547.
                                                      the property it replaces. Examples of property
Buying replacement property from a related            that functions in the same way as the property it     Substituting replacement property. Once
person. You cannot postpone reporting a gain          replaces are a home that replaces another             you have acquired qualified replacement prop­
from a casualty, theft, or other involuntary con­     home, a dairy cow that replaces another dairy         erty that you designate as replacement property
version if you buy the replacement property           cow, and farm land that replaces other farm           in a statement attached to your tax return, you
from a related person (discussed later). This         land. A passenger automobile that replaces a          cannot substitute other qualified replacement
rule applies to the following taxpayers.              tractor does not qualify. Neither does a breed­       property. This is true even if you acquire the
                                                      ing or draft animal that replaces a dairy cow.        other property within the replacement period.
  1. C corporations.                                                                                        However, if you discover that the original re­
  2. Partnerships in which more than 50% of           Soil or other environmental contamination.            placement property was not qualified replace­
     the capital or profits interest is owned by C    If, because of soil or other environmental con­       ment property, you can, within the replacement
     corporations.                                    tamination, it is not practical for you to reinvest   period, substitute the new qualified replacement
                                                      your insurance money from destroyed livestock         property.
  3. Individuals, partnerships (other than those
     in (2) above), and S corporations if the to­     in property similar or related in service or use to
                                                                                                            Basis of replacement property. You must re­
     tal realized gain for the tax year on all in­    the livestock, you can treat other property (in­
                                                                                                            duce the basis of your replacement property (its
     voluntarily converted properties on which        cluding real property) used for farming purpo­
                                                                                                            cost) by the amount of postponed gain. In this
     there are realized gains is more than            ses, as property similar or related in service or
                                                                                                            way, tax on the gain is postponed until you dis­
     $100,000.                                        use to the destroyed livestock.
                                                                                                            pose of the replacement property.
For involuntary conversions described in (3)          Weather-related sales of livestock. If you
above, gains cannot be offset by any losses           sell or exchange livestock because of
when determining whether the total gain is more       weather­related conditions (discussed earlier

                                                                                    Chapter 11      Casualties, Thefts, and Condemnations            Page 69
Replacement Period                                     your gain from the sale or exchange. The IRS              Replacement property acquired before
                                                       may extend the replacement period on a re­            return filed. If you acquire replacement prop­
To postpone reporting your gain, you must buy          gional basis if the weather­related conditions        erty before you file your return for the year you
replacement property within a specified period         continue for longer than 3 years.                     have the gain, your statement should also in­
of time. This is the replacement period.                    For information on extensions of the re­         clude detailed information about all the follow­
                                                       placement period because of persistent                ing items.
   The replacement period begins on the date           drought, see Notice 2006­82, 2006­39 I.R.B.                 The replacement property.
your property was damaged, destroyed, stolen,          529, available at                                          The postponed gain.
sold, or exchanged. The replacement period             www.irs.gov/irb/2006-39_IRB/ar11.html. For a
                                                                                                                  The basis adjustment that reflects the
generally ends 2 years after the close of the first    list of counties for which exceptional, extreme,
                                                                                                                  postponed gain.
tax year in which you realize any part of your         or severe drought was reported during the 12
                                                                                                                  Any gain you are reporting as income.
gain from the involuntary conversion.                  months ending August 31, 2012, see Notice
                                                       2012­62, which is on page 489 of Internal Reve­           Replacement property acquired after re-
    Example. You are a calendar year tax­              nue Bulletin 2012­42 at                               turn filed. If you intend to buy replacement
payer. While you were on vacation, farm equip­         www.irs.gov/pub/irs-irbs/irb12-42.pdf.                property after you file your return for the year
ment that cost $2,200 was stolen from your                                                                   you realize gain, your statement should also
farm. You discovered the theft when you re­            Condemnation. The replacement period for a
                                                                                                             say that you are choosing to replace the prop­
turned to your farm on November 11, 2011.              condemnation begins on the earlier of the fol­        erty within the required replacement period.
Your insurance company investigated the theft          lowing dates.                                             You should then attach another statement to
and did not settle your claim until January 5,              The date on which you disposed of the            your return for the year in which you buy the re­
2012, when they paid you $3,000. You first real­            condemned property.                              placement property. This statement should con­
ized a gain from the reimbursement for the theft            The date on which the threat of condemna­        tain detailed information on the replacement
during 2012, so you have until December 31,                 tion began.                                      property. If you acquire part of your replace­
2014, to replace the property.                                                                               ment property in one year and part in another
                                                       The replacement period generally ends 2 years
                                                       after the close of the first tax year in which any    year, you must attach a statement to each
Main home in disaster area. For your main
                                                       part of the gain on the condemnation is real­         year's return. Include in the statement detailed
home (or its contents) located in a federally de­
                                                       ized. But see Main home in disaster area, Prop-       information on the replacement property bought
clared disaster area, the replacement period                                                                 in that year.
                                                       erty in the Midwestern disaster areas, Property
ends 4 years after the close of the first tax year
                                                       in the Kansas disaster area, and Property in the
in which you realize any part of your gain from                                                                  Reporting weather-related sales of live-
                                                       Hurricane Katrina disaster area, earlier, for ex­
the involuntary conversion. See Disaster Area                                                                stock. If you choose to postpone reporting the
                                                       ceptions.
Losses, later.                                                                                               gain on weather­related sales or exchanges of
                                                            Business or investment real property. If         livestock, show all the following information on
Property in the Midwestern disaster areas.             real property held for use in a trade or business     a statement attached to your return for the tax
For property located in the Midwestern disaster        or for investment (not including property held        year in which you first realize any of the gain.
areas (defined in Table 4 in the 2008 Publica­         primarily for sale) is condemned, the replace­             Evidence of the weather­related conditions
tion 547) that was destroyed, damaged, stolen,         ment period ends 3 years after the close of the            that forced the sale or exchange of the live­
or condemned, the replacement period ends 5            first tax year in which any part of the gain on the        stock.
years after the close of the first tax year in which   condemnation is realized.                                  The gain realized on the sale or exchange.
any part of your gain is realized. This 5­year re­                                                                The number and kind of livestock sold or
placement period applies only if substantially all     Extension. You can apply for an extension of               exchanged.
of the use of the replacement property is in the       the replacement period. Send your written ap­              The number of livestock of each kind you
Midwestern disaster areas.                             plication to the Internal Revenue Service Center           would have sold or exchanged under your
                                                       where you file your tax return. See your tax re­           usual business practice.
Property in the Kansas disaster area. For              turn instructions for the address. Include all the
property located in the Kansas disaster area                                                                     Show all the following information and the
                                                       details about your need for an extension. Make
that was destroyed, damaged, stolen, or con­                                                                 preceding information on the return for the year
                                                       your application before the end of the replace­
demned after May 3, 2007, as a result of the                                                                 in which you replace the livestock.
                                                       ment period. However, you can file an applica­
Kansas storms and tornadoes, the replacement                                                                      The dates you bought the replacement
                                                       tion within a reasonable time after the replace­
period ends 5 years after the close of the first                                                                  property.
                                                       ment period ends if you can show a good
tax year in which any part of your gain is real­                                                                  The cost of the replacement property.
                                                       reason for the delay. You will get an extension
ized. This 5­year replacement period applies           of the replacement period if you can show rea­             Description of the replacement property
only if substantially all of the use of the replace­   sonable cause for not making the replacement               (for example, the number and kind of the
ment property is in the Kansas disaster area.          within the regular period.                                 replacement livestock).

Property in the Hurricane Katrina disaster                                                                   Amended return. You must file an amended
area. For property located in the Hurricane Ka­        How To Postpone Gain                                  return (Form 1040X) for the tax year of the gain
trina disaster area that was destroyed, dam­                                                                 in either of the following situations.
aged, stolen, or condemned after August 24,            You postpone reporting your gain by reporting               You do not acquire replacement property
2005, as a result of Hurricane Katrina, the re­        your choice on your tax return for the year you             within the replacement period, plus exten­
placement period ends 5 years after the close          have the gain. You have the gain in the year you            sions. On this amended return, you must
of the first tax year in which any part of your        receive insurance proceeds or other reimburse­              report the gain and pay any additional tax
gain is realized. This 5­year replacement period       ments that result in a gain.                                due.
applies only if substantially all of the use of the                                                                You acquire replacement property within
replacement property is in the Hurricane Katrina       Required statement. You should attach a                     the required replacement period, plus ex­
disaster area.                                         statement to your return for the year you have              tensions, but at a cost less than the
                                                       the gain. This statement should include all the             amount you receive from the casualty,
Weather-related sales of livestock in an               following information.                                      theft, or other involuntary conversion. On
area eligible for federal assistance. For the               The date and details of the casualty, theft,           this amended return, you must report the
sale or exchange of livestock due to drought,               or other involuntary conversion.                       part of the gain that cannot be postponed
flood, or other weather­related conditions in an            The insurance or other reimbursement you               and pay any additional tax due.
area eligible for federal assistance, the replace­          received.
ment period ends 4 years after the close of the             How you figured the gain.
first tax year in which you realize any part of

Page 70       Chapter 11     Casualties, Thefts, and Condemnations
                                                       employment taxes (social security, Medicare,          cise, and employment tax returns, paying in­
                                                       and federal unemployment taxes). No withhold­         come, excise, and employment taxes, and mak­
Disaster Area Losses                                   ing applies to these payments.                        ing contributions to a traditional IRA or Roth
                                                           Qualified disaster relief payments include        IRA.
Special rules apply to federally declared disas­       payments you receive (regardless of the                  If any tax deadline is postponed, the IRS will
ter area losses. A federally declared disaster is      source) for the following expenses.                   publicize the postponement in your area and
a disaster that occurred in an area declared by             Reasonable and necessary personal, fam­          publish a news release, revenue ruling, revenue
the President to be eligible for federal assis­             ily, living, or funeral expenses incurred as a   procedure, notice, announcement, or other
tance under the Robert T. Stafford Disaster Re­             result of a federally declared disaster.         guidance in the Internal Revenue Bulletin (IRB).
lief and Emergency Assistance Act. It includes              Reasonable and necessary expenses in­
a major disaster or emergency declaration un­                                                                   Who is eligible. If the IRS postpones a tax
                                                            curred for the repair or rehabilitation of a
der the act.                                                                                                 deadline, the following taxpayers are eligible for
                                                            personal residence due to a federally de­
                                                                                                             the postponement.
          A list of the areas warranting public or          clared disaster. (A personal residence can
                                                                                                                  Any individual whose main home is located
          individual assistance (or both) under             be a rented residence or one you own.)
 TIP                                                                                                              in a covered disaster area (defined next).
          the Act is available at the Federal               Reasonable and necessary expenses in­
                                                                                                                  Any business entity or sole proprietor
Emergency Management Agency (FEMA) web                      curred for the repair or replacement of the
                                                                                                                  whose principal place of business is loca­
site at www.fema.gov.                                       contents of a personal residence due to a
                                                                                                                  ted in a covered disaster area.
                                                            federally declared disaster.
                                                                                                                  Any individual who is a relief worker affili­
    This part discusses the special rules for             Qualified disaster relief payments include              ated with a recognized government or phil­
when to deduct a disaster area loss and what           amounts paid by a federal, state, or local gov­            anthropic organization and who is assisting
tax deadlines may be postponed. For other spe­         ernment in connection with a federally declared            in a covered disaster area.
cial rules, see Publication 547.                       disaster to individuals affected by the disaster.          Any individual, business entity, or sole pro­
                                                                                                                  prietorship whose records are needed to
When to deduct the loss. You generally must                       Qualified disaster relief payments do
                                                                                                                  meet a postponed tax deadline, provided
deduct a casualty loss in the year it occurred.           !       not include:
                                                                                                                  those records are maintained in a covered
However, if you have a deductible loss from a          CAUTION
                                                                                                                  disaster area. The main home or principal
disaster that occurred in an area warranting                  Payments for expenses otherwise paid for
                                                                                                                  place of business does not have to be lo­
public or individual assistance (or both), you                by insurance or other reimbursements, or
                                                                                                                  cated in the covered disaster area.
can choose to deduct that loss on your return or              Income replacement payments, such as                Any estate or trust that has tax records
amended return for the tax year immediately                   payments of lost wages, lost business in-           necessary to meet a postponed tax dead­
preceding the tax year in which the disaster                  come, or unemployment compensation.                 line, provided those records are main­
happened. If you make this choice, the loss is                                                                    tained in a covered disaster area.
treated as having occurred in the preceding            Qualified disaster mitigation payments.                    The spouse on a joint return with a tax­
year.                                                  Qualified disaster mitigation payments made                payer who is eligible for postponements.
          Claiming a qualifying disaster loss on       under the Robert T. Stafford Disaster Relief and           Any individual, business entity, or sole pro­
          the previous year's return may result in     Emergency Assistance Act or the National                   prietorship not located in a covered disas­
 TIP
          a lower tax for that year, often produc-     Flood Insurance Act (as in effect on April 15,             ter area, but whose necessary records to
ing or increasing a cash refund.                       2005) are not included in income. These are                meet a postponed tax deadline are located
                                                       payments you, as a property owner, receive to              in the covered disaster area.
   You must make this choice to take your              reduce the risk of future damage to your prop­             Any individual visiting the covered disaster
casualty loss for the disaster in the preceding        erty. You cannot increase your basis in prop­              area who was killed or injured as a result of
year by the later of the following dates.              erty, or take a deduction or credit, for expendi­          the disaster.
     The due date (without extensions) for filing      tures made with respect to those payments.                 Any other person determined by the IRS to
     your tax return for the tax year in which the                                                                be affected by a federally declared disas­
     disaster actually occurred.                       Sale of property under hazard mitigation                   ter.
     The due date (with extensions) for the re­        program. Generally, if you sell or otherwise
                                                       transfer property, you must recognize any gain            Covered disaster area. This is an area of
     turn for the preceding tax year.                                                                        a federally declared disaster area in which the
                                                       or loss for tax purposes unless the property is
                                                       your main home. You report the gain or deduct         IRS has decided to postpone tax deadlines for
Federal disaster relief grants. Do not include                                                               up to 1 year.
post­disaster relief grants received under the         the loss on your tax return for the year you real­
Robert T. Stafford Disaster Relief and Emer­           ize it. (You cannot deduct a loss on per­
                                                                                                             Abatement of interest and penalties. The
gency Assistance Act in your income if the grant       sonal­use property unless the loss resulted
                                                                                                             IRS may abate the interest and penalties on the
payments are made to help you meet neces­              from a casualty, as discussed earlier.) How­
                                                                                                             underpaid income tax for the length of any post­
sary expenses or serious needs for medical,            ever, if you sell or otherwise transfer property to
                                                                                                             ponement of tax deadlines.
dental, housing, personal property, transporta­        the Federal Government, a state or local gov­
tion, or funeral expenses. Do not deduct casu­         ernment, or an Indian tribal government under a
                                                       hazard mitigation program, you can choose to
alty losses or medical expenses to the extent
                                                       postpone reporting the gain if you buy qualifying
                                                                                                             Reporting Gains
they are specifically reimbursed by these disas­
ter relief grants. If the casualty loss was specifi­   replacement property within a certain period of       and Losses
cally reimbursed by the grant and you received         time. See Postponing Gain, earlier, for the rules
the grant after the year in which you deducted         that apply.                                           You will have to file one or more of the following
the casualty loss, see Reimbursement received                                                                forms to report your gains or losses from invol­
after deducting loss, earlier. Unemployment as­        Other federal assistance programs. For                untary conversions.
sistance payments under the Act are taxable            more information about other federal assistance
unemployment compensation.                             programs, see Crop Insurance and Crop Disas-          Form 4684. Use this form to report your gains
                                                       ter Payments and Feed Assistance and Pay-             and losses from casualties and thefts.
Qualified disaster relief payments. Qualified          ments in chapter 3 earlier.
disaster relief payments are not included in the                                                             Form 4797. Use this form to report involuntary
income of individuals to the extent any expen­         Postponed tax deadlines. The IRS may post­            conversions (other than from casualty or theft)
ses compensated by these payments are not              pone for up to 1 year certain tax deadlines of        of property used in your trade or business and
otherwise compensated for by insurance or              taxpayers who are affected by a federally de­         capital assets held in connection with a trade or
other reimbursement. These payments are not            clared disaster. The tax deadlines the IRS may        business or a transaction entered into for profit.
subject to income tax, self­employment tax, or         postpone include those for filing income, ex­         Also use this form if you have a gain from a

                                                                                     Chapter 11      Casualties, Thefts, and Condemnations            Page 71
casualty or theft on trade, business or in­         2013 will be discussed in the 2012 Publication        retirement benefits, disability benefits, survivor
come­producing property held for more than 1        334.                                                  benefits, and hospital insurance (Medicare)
year and you have to recapture some or all of                                                             benefits.
your gain as ordinary income.

                                                    Introduction
                                                                                                          How to become insured under social secur-
Form 8949. Use this form to report gain from                                                              ity. You must be insured under the social se­
an involuntary conversion (other than from          Self­employment tax (SE tax) is a social secur­       curity system before you begin receiving social
casualty or theft) of personal­use property.        ity and Medicare tax primarily for individuals        security benefits. You are insured if you have
                                                    who work for themselves. It is similar to the so­     the required number of credits (also called
Schedule A (Form 1040). Use this form to de­        cial security and Medicare taxes withheld from        quarters of coverage).
duct your losses from casualties and thefts of      the pay of most wage earners.
personal­use property and income­producing              You usually have to pay SE tax if you are         Earning credits in 2012. You can earn a max­
property, that you reported on Form 4684.           self­employed. You are usually self­employed if       imum of four credits per year. For 2012, you
                                                    you operate your own farm on land you either          earn one credit for each $1,130 of combined
Schedule D (Form 1040). Use this form to                                                                  wages and self­employment earnings subject to
                                                    own or rent. You have to figure SE tax on
carry over the following gains.                                                                           social security tax. You need $4,520 ($1,130 ×
                                                    Schedule SE (Form 1040).
     Net gain shown on Form 4797 from an in­                                                              4) of combined wages and self­employment
                                                        Farmers who have employees may have to
     voluntary conversion of business property                                                            earnings subject to social security tax to earn
                                                    pay the employer's share of social security and
     held for more than 1 year.                                                                           four credits in 2012. It does not matter whether
                                                    Medicare taxes, as well. See chapter 13 for in­
     Net gain shown on Form 4684 from the                                                                 the income is earned in 1 quarter or is spread
                                                    formation on employment taxes.
     casualty or theft of personal­use property.                                                          over 2 or more quarters.
   Also use this form to figure the overall gain    Self-employment tax rate. For tax years be­               For an explanation of the number of credits
or loss from transactions reported on Form          ginning in 2012, the self­employment tax rate is      you must have to be insured and the benefits
8949.                                               13.3%. The rate consists of two parts: 10.4% for      available to you and your family under the so­
                                                    social security (old­age, survivors, and disability   cial security program, consult your nearest So­
Schedule F (Form 1040). Use this form to de­        insurance) and 2.9% for Medicare (hospital in­        cial Security Administration (SSA) office or visit
duct your losses from casualty or theft of live­    surance).                                             the SSA website at www.socialsecurity.gov.
stock or produce bought for sale under Other
expenses in Part II, line 32, if you use the cash   Topics                                                           Making false statements to get or to
method of accounting and have not otherwise         This chapter discusses:                                  !       increase social security benefits may
deducted these losses.                                                                                    CAUTION    subject you to penalties.
                                                         Why pay self­employment tax
                                                                                                          The Social Security Administration (SSA)
                                                         How to pay self­employment tax
                                                                                                          time limit for posting self-employment earn-
                                                         Who must pay self­employment tax                 ings. Generally, the SSA will give you credit
                                                         Figuring self­employment earnings                only for self­employment earnings reported on a

12.                                                      Landlord participation in farming
                                                         Methods for figuring net earnings
                                                                                                          tax return filed within 3 years, 3 months, and 15
                                                                                                          days after the tax year you earned the income.
                                                                                                                   If you file your tax return or report a
                                                         Reporting self­employment tax
                                                                                                                   change in your self-employment earn-
Self-Employment                                                                                              !
                                                                                                          CAUTION  ings after the SSA time limit for posting
                                                    Useful Items                                          self-employment earnings, the SSA may
Tax                                                 You may want to see:                                  change its records, but only to remove or re-
                                                                                                          duce the amount. The SSA will not change its
                                                      Publication                                         records to increase your self-employment
                                                                                                          earnings after the SSA time limit listed above.
What's New for 2012                                      541 Partnerships

                                                      Form (and Instructions)
Tax rates. For tax years beginning in 2012, the                                                           How To Pay
social security part of the self­employment tax          1040 U.S. Individual Income Tax Return
remains at 10.4%. The Medicare part of the tax
                                                                                                          Self-Employment Tax
                                                         Sch F (Form 1040) Profit or Loss From
remains at 2.9%. As a result, the self­employ­               Farming
ment tax is 13.3%.                                                                                        To pay SE tax, you must have a social security
                                                         Sch SE (Form 1040) Self­Employment               number (SSN) or an individual taxpayer identifi­
Maximum net earnings. The maximum net                                                                     cation number (ITIN). This section explains how
                                                             Tax
self­employment earnings subject to the social                                                            to:
security part (10.4%) of the self­employment tax         1065 U.S. Return of Partnership Income                Obtain an SSN or ITIN, and
increased to $110,100 for 2012. There is no
                                                         Sch K-1 (Form 1065) Partner's Share of                  Pay your SE tax using estimated tax.
maximum limit on earnings subject to the Medi­
                                                             Income, Deductions, Credits, etc.
care part (2.9%).
                                                                                                                  An ITIN does not entitle you to social
                                                    See chapter 16 for information about getting                  security benefits. Obtaining an ITIN
                                                    publications and forms.                                  !    does not change your immigration or
What's New for 2013
                                                                                                          CAUTION

                                                                                                          employment status under U.S. law.
                                                    Why Pay Self-Employment
Maximum net earnings. The maximum net                                                                     Obtaining a social security number. If you
self­employment earnings subject to the social      Tax?                                                  have never had an SSN, apply for one using
security part of the self­employment tax for                                                              Form SS­5, Application for a Social Security
                                                    Social security benefits are available to self­em­    Card. The application is also available in Span­
                                                    ployed persons just as they are to wage earn­         ish. You can get this form at any Social Security
                                                    ers. Your payments of SE tax contribute to your       office or by calling 1­800­772­1213.
                                                    coverage under the social security system. So­
                                                    cial security coverage provides you with

Page 72      Chapter 12     Self-Employment Tax
       You can also download Form SS­5                to self­employment tax, as they are considered         statement showing the gross income and ex­
       from the Social Security Administra­           U.S. residents for self­employment tax purpo­          penses. The net income may not be subject to
       tion website at                                ses. For more information on aliens, see Publi­        SE tax if the project is primarily for educational
www.socialsecurity.gov.                               cation 519, U.S. Tax Guide for Aliens.                 purposes and not for profit, and is completed by
                                                                                                             the individual under the rules and economic re­
   If you have a social security number from          Are you self-employed? You are self­em­                strictions of the sponsoring 4­H or FFA organi­
the time you were an employee, you must use           ployed if you carry on a trade or business (such       zation. Such a project is generally not consid­
that number. Do not apply for a new one.              as running a farm) as a sole proprietor, an inde­      ered a trade or business.
                                                      pendent contractor, a member of a partnership,
    Replacing a lost social security card. If         or are otherwise in business for yourself. A           Partners in a partnership. Generally, you are
you have a number but lost your card, file Form       trade or business is generally an activity carried     self­employed if you are a member of a partner­
SS­5. You will get a new card showing your            on for a livelihood or in good faith to make a         ship that carries on a trade or business.
original number, not a new number.                    profit.
                                                                                                                Limited partner. If you are a limited part­
   Name change. If your name has changed                                                                     ner, your partnership income is generally not
since you received your social security card,         Share farmer. You are a self­employed farmer
                                                                                                             subject to SE tax. However, guaranteed pay­
complete Form SS­5 to report a name change.           under an income­sharing arrangement if both
                                                                                                             ments you receive for services you perform for
                                                      the following apply.
                                                                                                             the partnership are subject to SE tax and
Obtaining an individual taxpayer identifica-            1. You produce a crop or raise livestock on          should be reported to you in box 14 of your
tion number. The IRS will issue you an ITIN,               land belonging to another person.                 Schedule K­1 (Form 1065).
for tax use only, if you are a nonresident or resi­
dent alien and you do not have, and are not eli­        2. Your share of the crop or livestock, or the
                                                                                                             Husband and wife partners. If you and your
gible to get, an SSN. To apply for an ITIN, file           proceeds from their sale, depends on the
                                                                                                             spouse jointly own and operate a farm as an un­
Form W­7, Application for IRS Individual Tax­              amount produced.                                  incorporated business and share in the profits
payer Identification Number. You can get this         Your net farm profit or loss from the in­              and losses, you are partners in a partnership
form by calling 1­800­829­3676. For more infor­       come­sharing arrangement is reported on                whether or not you have a formal partnership
mation on ITINs, see Publication 1915, Under­         Schedule F (Form 1040) and included in your            agreement. You must file Form 1065, instead of
standing Your IRS Individual Taxpayer Identifi­       self­employment earnings.                              Schedule F, unless you make a joint election to
cation Number. Form W­7 and Publication 1915              If you produce a crop or livestock on land         be treated as a qualified joint venture. Making
are also available in Spanish.                        belonging to another person and are to receive         this election will allow you to avoid the complex­
                                                      a specified rate of pay, a fixed sum of money, or      ity of Form 1065 but still give each spouse
         You can also download Form W­7                                                                      credit for social security earnings on which re­
         from the IRS website at IRS.gov.             a fixed quantity of the crop or livestock, and not
                                                      a share of the crop or livestock or their pro­         tirement benefits are based.
                                                      ceeds, you may be either self­employed or an
                                                      employee of the landowner. This will depend on         Qualified joint venture. If you and your
Paying estimated tax. Estimated tax is the                                                                   spouse each materially participate as the only
method used to pay tax (including SE tax) on in­      whether the landowner has the right to direct or
                                                      control your performance of services.                  members of a jointly owned and operated farm,
come not subject to withholding. You generally                                                               and you file a joint tax return for the tax year,
have to make estimated tax payments if you ex­                                                               you can make a joint election to be treated as a
pect to owe tax, including SE tax, of $1,000 or           Example. A share farmer produces a crop
                                                      on land owned by another person on a 50­50             qualified joint venture instead of a partnership
more when you file your return. Use Form                                                                     for the tax year. For an explanation of “material
1040­ES, Estimated Tax for Individuals, to fig­       crop­share basis. Under the terms of their
                                                      agreement, the share farmer furnishes the labor        participation,” see the instructions for Sched­
ure and pay the tax.                                                                                         ule C, line G, and the instructions for Sched­
    However, if at least two­thirds of your gross     and half the cost of seed and fertilizer. The
                                                      landowner furnishes the machinery and equip­           ule F, line E.
income for 2012 or 2013 was from farming and                                                                     To make this election, you must divide all
you file your 2013 Form 1040 and pay all the tax      ment used to produce and harvest the crop,
                                                                                                             items of income, gain, loss, deduction, and
due by March 3, 2014, you do not have to pay          and half the cost of seed and fertilizer. The
                                                                                                             credit attributable to the business between you
any estimated tax. For more information about         share farmer is provided a house in which to
                                                                                                             and your spouse in accordance with your re­
estimated tax for farmers, see chapter 15.            live. The landowner and the share farmer de­
                                                                                                             spective interests in the venture. Each of you
                                                      cide on a cropping plan.
                                                                                                             must file a separate Schedule F and a separate
   Penalty for underpayment of estimated                  The share farmer is a self­employed farmer
                                                                                                             Schedule SE. For more information, see Quali-
tax. You may have to pay a penalty if you do          for purposes of the agreement to produce the
                                                                                                             fied Joint Venture in the Instructions for Sched­
not pay enough estimated tax by its due date.         crops, and the share farmer's part of the profit
                                                                                                             ule SE (Form 1040).
                                                      or loss from the crops is reported on Sched­
                                                      ule F (Form 1040) and included in self­employ­
                                                                                                             Spouse employee. If your spouse is your em­
Who Must Pay                                          ment earnings.                                         ployee, not your partner, you must withhold and
                                                          The tax treatment of the landowner is dis­
Self-Employment Tax?                                  cussed later under Landlord Participation in
                                                                                                             pay social security and Medicare taxes for him
                                                                                                             or her. For more information about employment
                                                      Farming.                                               taxes, see chapter 13.
You must pay SE tax and file Schedule SE
(Form 1040) if your net earnings from self­em­        Contract farming. Under typical contract                  Community property. If you are a partner
ployment were $400 or more.                           farming arrangements, the grower receives a            and your distributive share of any income or
         The SE tax rules apply no matter how         fixed payment per unit of crops or finished live­      loss from a trade or business carried on by the
         old you are and even if you are al-          stock delivered to the processor or packing            partnership is community property, treat your
   !
 CAUTION ready receiving social security or Med-      company. Since the grower typically furnishes          share as your self­employment earnings. Do
icare benefits.                                       labor and bears some production risk, the pay­         not treat any of your share as self­employment
                                                      ments are reported on Schedule F and are               earnings of your spouse.
                                                      therefore subject to self­employment tax.
Aliens. Generally, resident aliens must pay
self­employment tax under the same rules that         4-H Club or FFA project. If an individual par­
apply to U.S. citizens. Nonresident aliens are        ticipates in a 4­H Club or FFA project, any net
not subject to self­employment tax. However,          income received from sales or prizes related to
residents of the Virgin Islands, Puerto Rico,         the project may be subject to income tax. Re­
Guam, the Commonwealth of the Northern Ma­            port the net income as “Other income” on
riana Islands, or American Samoa are subject          line 21 of Form 1040. If necessary, attach a

                                                                                                           Chapter 12    Self-Employment Tax          Page 73
                                                       following types of property are not included in       the landowner will, and does, materially partici­
                                                       self­employment earnings.                             pate in the production or management of pro­
Figuring Self-Employment                                    Investment property.                             duction of the farm products on the land.
Earnings                                                    Depreciable property or other fixed assets
                                                            used in your trade or business.                  Crop shares. Rent paid in the form of crop
Farmer. If you are self­employed as a farmer,               Livestock held for draft, breeding, sport, or    shares is included in self­employment earnings
use Schedule F (Form 1040) to figure your                   dairy purposes, and not held primarily for       for the year you sell, exchange, give away, or
self­employment earnings.                                   sale, regardless of how long the livestock       use the crop shares if you meet one of the four
                                                            was held, or whether it was raised or pur­       material participation tests (discussed next) at
Partnership income or loss. If you are a                    chased.                                          the time the crop shares are produced. Feeding
member of a partnership that carries on a trade             Unharvested standing crops sold with land        such crop shares to livestock is considered us­
or business, the partnership should report your             held more than 1 year.                           ing them. Your gross income for figuring your
self­employment earnings in box 14, code A, of              Timber, coal, or iron ore held for more than     self­employment earnings includes the fair mar­
your Schedule K­1 (Form 1065). Box 14 of                    1 year if an economic interest was re­           ket value of the crop shares when they are used
Schedule K­1 may also provide amounts for                   tained, such as a right to receive coal roy­     as feed.
gross farming or fishing income (code B) and                alties.
gross nonfarm income (code C). Use these                                                                     Material participation for landlords. You
                                                           A gain or loss from the cutting of timber is      materially participate if you have an arrange­
amounts if you use the farm or nonfarm optional
                                                       not included in self­employment earnings if the       ment with your tenant for your participation and
method to figure net earnings from self­employ­
                                                       cutting is treated as a sale or exchange. For         you meet one of the following tests.
ment (see Methods for Figuring Net Earnings,
                                                       more information on electing to treat the cutting
later).                                                                                                       1. You do any three of the following.
                                                       of timber as a sale or exchange, see Timber in
    If you are a general partner, you may need
                                                       chapter 8.                                                  a. Pay, using cash or credit, at least half
to reduce these reported earnings by amounts
you claim as a section 179 deduction, unreim­                                                                         the direct costs of producing the crop
                                                       Wages and salaries. Wages and salaries re­
bursed partnership expenses, or depletion on                                                                          or livestock.
                                                       ceived for services performed as an employee
oil and gas properties.                                and covered by social security or railroad retire­          b. Furnish at least half the tools, equip­
    If the amount reported is a loss, include only     ment are not included in self­employment earn­                 ment, and livestock used in the pro­
the deductible amount when you figure your to­         ings.                                                          duction activities.
tal self­employment earnings.                             Wages paid in kind to you for agricultural la­
    For more information, see the Partner's In­                                                                    c. Advise or consult with your tenant.
                                                       bor, such as commodity wages, are not inclu­
structions for Schedule K­1 (Form 1065).               ded in self­employment earnings.                            d. Inspect the production activities peri­
    For general information on partnerships, see
                                                                                                                      odically.
Publication 541.                                       Retired partner. Retirement income received
                                                       by a partner from his or her partnership under a       2. You regularly and frequently make, or take
More than one business. If you have self­em­           written plan is not included in self­employment           an important part in making, management
ployment earnings from more than one trade,            earnings if all the following apply.                      decisions substantially contributing to or
business, or profession, you generally must                  The retired partner performs no services            affecting the success of the enterprise.
combine the net profit or loss from each to de­              for the partnership during the year.             3. You work 100 hours or more spread over a
termine your total self­employment earnings. A               The retired partner is owed only the retire­        period of 5 weeks or more in activities con­
loss from one business reduces your profit from              ment payments.
another business. However, do not combine                                                                        nected with agricultural production.
                                                             The retired partner's share (if any) of the
earnings from farm and nonfarm businesses if                 partnership capital was fully paid to the re­    4. You do things that, considered in their to­
you are using one of the optional methods (dis­              tired partner.                                      tality, show you are materially and signifi­
cussed later) to figure net earnings.                        The payments to the retired partner are             cantly involved in the production of the
                                                             lifelong periodic payments.                         farm commodities.
Community property. If any of the income
from a farm or business, other than a partner­                                                               These tests may be used as general guides for
                                                       Conservation Reserve Program (CRP) pay-
ship, is community property under state law, it is                                                           determining whether you are a material partici­
                                                       ments. CRP payments are generally included
included in the self­employment earnings of the                                                              pant.
                                                       in self­employment earnings, except for individ­
spouse carrying on the trade or business.              uals receiving social security benefits for retire­       Example. Drew Houston agrees to produce
                                                       ment or disability. See the Instructions for          a crop on J. Clarke's cotton farm, with each re­
Lost income payments. Lost income pay­
                                                       Schedule SE (Form 1040).                              ceiving half the proceeds. Clarke advises Hous­
ments received from insurance or other sources
for reducing or stopping farming activities are                                                              ton when to plant, spray, and pick the cotton.
                                                       Self-employed health insurance deduction.
included in self­employment earnings. These                                                                  During the growing season, Clarke inspects the
                                                       You cannot deduct the self­employed health in­
include USDA payments to compensate for lost                                                                 crop every few days to determine whether
                                                       surance deduction you report on Form 1040,
income resulting from reductions in tobacco                                                                  Houston is properly taking care of the crop.
                                                       line 29, from self­employment earnings on
quotas and allotments. Even if you are not farm­                                                             Houston furnishes all labor needed to grow and
                                                       Schedule SE (Form 1040).
ing when you receive the payment, it is included                                                             harvest the crop.
in self­employment earnings if it relates to your                                                                The management decisions made by Clarke
farm business (even though it is temporarily in­       Landlord Participation                                in connection with the care of the cotton crop
active). A connection exists if it is clear the pay­   in Farming                                            and his regular inspection of the crop establish
ment would not have been made but for your                                                                   that he participates to a material degree in the
conduct of your farm business.                         As a general rule, income and deductions from         cotton production operations. The income
                                                       rentals and from personal property leased with        Clarke receives from his cotton farm is included
Gain or loss. A gain or loss from the disposi­         real estate are not included in determining           in his self­employment earnings.
tion of property that is neither stock in trade nor    self­employment earnings. However, income
held primarily for sale to customers is not inclu­     and deductions from farm rentals, including
ded in self­employment earnings. It does not           government commodity program payments re­             Methods for Figuring Net
matter whether the disposition is a sale, ex­
change, or involuntary conversion. For exam­
                                                       ceived by a landowner who rents land, are in­
                                                       cluded if the rental arrangement provides that
                                                                                                             Earnings
ple, gains or losses from the disposition of the
                                                                                                             There are three ways to figure your net earnings
                                                                                                             from self­employment.

Page 74       Chapter 12     Self-Employment Tax
Figure 12­1. Can I Use the Optional Methods?

         START here to determine if                                                               START here to determine if
         you can use the nonfarm                                                                  you can use the farm
         optional method.                                                                         optional method.



         Are your net nonfarm pro ts                 No                                           Is your gross farm income
         less than $4,894?                                                                        $6,840 or less?

                            Yes
                                                                                                       Yes                       No
         Are your net nonfarm pro ts
                                                     No
         less than 72.189% of your
         gross nonfarm income?                                                               You can               Yes     Are your net farm pro ts
                                                                                             use the                       less than $4,894?
                            Yes                                                              farm
                                                                                             optional                                    No
         Were your actual net earnings                                                       method.*
         from self-employment $400 or                No                                      See Table                     You cannot use the
         more in at least 2 of the 3 tax                                                     12-1.                         farm optional method.
         years before this year?

                            Yes

         Have you previously used this
         method less than 5 years?                   No
         (Note: There is a 5-year
         lifetime limit.)

                            Yes                       You cannot
                                                      use the
                                                      nonfarm
         You can use the nonfarm                      optional
         optional method.* See                        method.
         Publication 334.


 *If you use both optional methods, see Using Both Optional Methods, later, for limits on the amount to report.

  1. The regular method.                               higher social security disability or retirement            Gross farm income. Your gross farm income
                                                       benefits.                                                  is the total of the amounts from:
  2. The farm optional method.
                                                           If you use either or both optional methods,                  Schedule F (Form 1040), line 9, and
  3. The nonfarm optional method.                      you must figure and pay the SE tax due under                   Schedule K­1 (Form 1065), box 14, code B
                                                       these methods even if you would have had a                     (from farm partnerships).
You must use the regular method unless you             smaller SE tax or no SE tax using the regular
are eligible to use one or both of the optional        method.
methods. See Figure 12­1, shown later.                                                                            Net farm profits. Net farm profits generally are
                                                           The optional methods may be used only to               the total of the amounts from:
                                                       figure your SE tax. To figure your income tax,                  Schedule F (Form 1040), line 34, and
Why use an optional method? You may                    include your actual self­employment earnings in
                                                                                                                      Schedule K­1 (Form 1065), box 14, code A
want to use the optional methods (discussed            gross income, regardless of which method you
                                                                                                                      (from farm partnerships).
later) when you have a loss or a small net profit      use to determine SE tax.
and any one of the following applies.                                                                             However, you may need to adjust the amount
                                                                                                                  reported on Schedule K­1 if you are a general
      You want to receive credit for social secur­
      ity benefit coverage.
                                                       Regular Method                                             partner or if it is a loss. For more information,
      You incurred child or dependent care ex­                                                                    see Partnership income or loss, earlier.
      penses for which you could claim a credit.       Multiply your total self­employment earnings by
      (An optional method may increase your            92.35% (.9235) to get your net earnings under              Figuring farm net earnings. If you meet ei­
      earned income, which could increase your         the regular method. See Short Schedule SE,                 ther of the two tests explained above, use Table
      credit.)                                         line 4, or Long Schedule SE, line 4a.                      12­1. Figuring Farm Net Earnings, to figure your
      You are entitled to the earned income                                                                       net earnings from self­employment under the
      credit. (An optional method may increase           Net earnings figured using the regular                   farm optional method.
      your earned income, which could increase         method are also called “actual net earnings.”
      your credit.)
      You are entitled to the additional child tax     Farm Optional Method
      credit. (An optional method may increase
      your earned income, which could increase         Use the farm optional method only for self­em­
      your credit.)                                    ployment earnings from a farming business.
                                                       You can use this method if you meet either of
Effects of using an optional method. Using
                                                       the following tests.
an optional method could increase your SE tax.
Paying more SE tax may result in you getting              1. Your gross farm income is $6,840 or less.
                                                          2. Your net farm profits are less than $4,894.

                                                                                                             Chapter 12      Self-Employment Tax          Page 75
Table 12­1. Figuring Farm Net                      line 56 of Form 1040 and attach Schedule SE to       law provides an expanded work opportunity tax
Earnings                                           Form 1040.                                           credit to businesses that hire eligible unem­
                                                                                                        ployed veterans and, for the first time, also
                                                      Most taxpayers can use Section A–Short            makes part of the credit available to certain
 IF your gross            THEN your                Schedule SE to figure their SE tax. However,         tax­exempt organizations. Businesses claim the
 farm income              net earnings             certain taxpayers must use Section B–Long            credit as part of the general business credit and
  is...                   are equal to...          Schedule SE. Use the chart on page 1 of              tax­exempt organizations claim it against their
                                                   Schedule SE to find out which one to use.            payroll tax liability using Form 5884­C, Work
 $6,840 or less           Two­thirds of
                                                             If you have to pay SE tax, you must file   Opportunity Credit for Qualified Tax­Exempt Or­
                          your gross farm                                                               ganizations Hiring Qualified Veterans. The lia­
                                                      !      Form 1040 (with Schedule SE at-
                          income.                            tached) even if you do not otherwise       bility reported on Form 943, Employer's Annual
                                                                                                        Federal Tax Return for Agricultural Employees,
                                                   CAUTION

 More than $6,840 $4,520                           have to file a federal income tax return.
                                                                                                        is not reduced by the amount of the credit. The
                                                                                                        credit is available for eligible unemployed veter­
                                                   Deduction for employer-equivalent portion            ans who begin work on or after November 22,
Optional method can reduce or eliminate            of self-employment tax. You can deduct the           2011, and before January 1, 2013. For more in­
SE tax. If your gross farm income is $6,840 or     employer­equivalent portion of your SE tax in        formation about the credit, visit
less and your farm net earnings figured under      figuring your adjusted gross income. This de­        www.irs.gov/form5884c.
the farm optional method are less than your ac­    duction only affects your income tax. It does not
tual net earnings, you can use the farm optional   affect either your net earnings from self­employ­
method to reduce or eliminate your SE tax. Your    ment or your SE tax.
actual net earnings are your net earnings fig­         To deduct the tax, enter on Form 1040,           What's New for 2013
ured using the regular method, explained ear­      line 27, the amount shown on Section A, Line 6,
lier.                                              or Section B, line 13, Deduction for em­             Social security and Medicare tax for 2013.
                                                   ployer­equivalent portion of self­employment         The employee and employer tax rates for social
    Example. Your gross farm income is $540        tax, of the Schedule SE.                             security and the maximum amount of wages
and your net farm profit is $460. Consequently,                                                         subject to social security tax for 2013 will be
your net earnings figured under the farm op­       Joint return. Even if you file a joint return, you   discussed in Publication 51 (Circular A), Agri­
tional method are $360 (2/3 of $540) and your      cannot file a joint Schedule SE. This is true        cultural Employer's Tax Guide (For use in
actual net earnings are $425 (92.35% of $460).     whether one spouse or both spouses have              2013).
You owe no SE tax if you use the optional          self­employment earnings. Your spouse is not
                                                                                                            The Medicare tax rate for 2013 will also be
method because your net earnings under the         considered self­employed just because you
                                                                                                        discussed in Publication 51 (Circular A) (For
farm optional method are less than $400.           are. If both of you have self­employment earn­
                                                                                                        use in 2013). There is no limit on the amount of
                                                   ings, each of you must complete a separate
                                                                                                        wages subject to Medicare tax.
Nonfarm Optional Method                            Schedule SE. However, if one spouse uses the
                                                   Short Schedule SE and the other spouse has to
                                                   use the Long Schedule SE, both can use the
                                                                                                        Reminders
This is an optional method available for deter­
mining net earnings from nonfarm self­employ­      same form. Attach both schedules to the joint
ment, much like the farm optional method.          return. If you and your spouse operate a busi­
                                                   ness as a partnership, see Husband and wife
   If you are also engaged in a nonfarm busi­                                                           Additional employment tax information for
                                                   partners and Qualified joint venture, earlier, un­
ness, you may be able to use this method to fig­                                                        farmers. For more detailed guidance on em­
                                                   der Who Must Pay Self-Employment Tax.                ployment taxes see Publication 51 (Circular A).
ure your nonfarm net earnings. You can use this
method even if you do not use the farm optional                                                         For the latest information about employment tax
method for determining your farm net earnings                                                           developments impacting farmers, go to
and even if you have a net loss from your non­                                                          www.irs.gov/pub51.
farm business. For more information about the                                                           Correcting a previously filed Form 943. If
nonfarm optional method, see Publication 334.                                                           you discover an error on a previously filed Form
         You cannot combine farm and non-          13.                                                  943, make the correction using Form 943­X,
                                                                                                        Adjusted Employer's Annual Federal Tax Re­
  !      farm self-employment earnings to fig-                                                          turn for Agricultural Employees or Claim for Re­
 CAUTION ure your net earnings under either of                                                          fund. Form 943­X is filed separately from Form
the optional methods.
                                                   Employment                                           943. For more information on correcting Form
                                                                                                        943, see the Instructions for Form 943­X.
Using Both Optional                                Taxes                                                Federal tax deposits must be made by elec-
                                                                                                        tronic funds transfer. You must use elec­
Methods                                                                                                 tronic funds transfer to make all federal tax de­
                                                                                                        posits. Generally, electronic funds transfers are
                                                   What's New for 2012
If you use both optional methods, you must add
                                                                                                        made using the Electronic Federal Tax Pay­
the net earnings figured under each method to
                                                                                                        ment System (EFTPS). If you do not want to
arrive at your total net earnings from self­em­
                                                                                                        use EFTPS, you can arrange for your tax pro­
ployment. You can report less than your total      Social security and Medicare tax for 2012.
                                                                                                        fessional, financial institution, payroll service, or
actual farm and nonfarm net earnings but not       The employee tax rate for social security is
                                                                                                        other trusted third party to make deposits on
less than actual nonfarm net earnings. If you      4.2% and the employer tax rate for social secur­
                                                                                                        your behalf. Also, you may arrange for your fi­
use both optional methods, you can report no       ity is 6.2%, unchanged from 2011. The Medi­
                                                                                                        nancial institution to initiate a same­day wire
more than $4,520 as your combined net earn­        care tax rate is 1.45% each for employers and
                                                                                                        payment on your behalf. EFTPS is a free serv­
ings from self­employment.                         employees.
                                                                                                        ice provided by the Department of Treasury.
                                                       Do not withhold or pay social security tax af­   Services provided by your tax professional, fi­
                                                   ter an employee reaches $110,100 in social se­       nancial institution, payroll service, or other third
Reporting Self-Employment                          curity wages for the year. There is no limit on      party may have a fee.
Tax                                                the amount of wages subject to Medicare tax.
                                                                                                            For more information on making federal tax
                                                   VOW to Hire Heroes Act of 2011. On No­               deposits, see section 7 of Publication 51 (Circu­
Use Schedule SE (Form 1040) to figure and re­      vember 21, 2011, the President signed into law       lar A). To get more information about EFTPS or
port your SE tax. Then, enter the SE tax on        the VOW to Hire Heroes Act of 2011. This new         to enroll in EFTPS, visit www.eftps.gov or call

Page 76     Chapter 13     Employment Taxes
1­800­555­4477. Additional information about           claimed exemption from federal income tax                   Family employees,
EFTPS is also available in Publication 966,            withholding last year.                                      Crew leaders,
Electronic Federal Tax Payment System: A               On February 16
Guide to Getting Started.                                                                                          Social security and Medicare taxes,
                                                           Any Form W­4 claiming exemption from                    Federal income tax withholding,
                                                       withholding for the previous year has now ex­
                                                       pired. Begin withholding for any employee who               Reporting and paying social security,
Important Dates for                                    previously claimed exemption from withholding
                                                       but has not given you a new Form W­4 for the
                                                                                                                   Medicare, and withheld federal income
                                                                                                                   taxes, and
2013                                                   current year. If the employee does not give you             FUTA tax.
                                                       a new Form W­4, withhold taxes based on the
You should take the action indicated by the            last valid Form W­4 you have for the employee          Useful Items
dates listed. See By February 15 and On                that does not claim exemption from withholding         You may want to see:
February 16 for Form W­4, Employee's                   or, if one does not exist, as if he or she is single
Withholding Allowance Certificate, information.        with zero withholding allowances. If the em­
                                                       ployee furnishes a new Form W­4 claiming ex­             Publication
Due dates for deposits of withheld federal
income taxes, social security taxes, and               emption from withholding after February 15, you             15   (Circular E), Employer's Tax Guide
Medicare taxes are not listed here. For these          may apply the exemption to future wages, but
                                                                                                                   15-A Employer's Supplemental Tax Guide
dates, see Publication 509, Tax Calendars (For         do not refund taxes withheld while the exempt
use in 2013).                                          status was not in place.                                    15-B Employer's Tax Guide to Fringe
                                                       By February 28                                                  Benefits
Note. If any date shown below for filing a re­
turn, furnishing a form, or depositing taxes, falls        File paper Forms 1099 and 1096. File                    51   (Circular A), Agricultural Employer's
on a Saturday, Sunday, or legal holiday, the           Copy A of all paper Forms 1099 with Form                         Tax Guide
due date is the next business day. A statewide         1096, Annual Summary and Transmittal of U.S.
                                                                                                                   926 Household Employer's Tax Guide
legal holiday delays a filing or furnishing due        Information Returns, with the IRS. For electroni­
date only if the IRS office where you are re­          cally filed returns, see By March 31 below.
                                                                                                                Form (and Instructions)
quired to file a return or furnish a form is located       File paper Forms W-2 and W-3.File Copy
in that state. For any due date, you will meet the                                                                 W-2 Wage and Tax Statement
                                                       A of all paper Forms W­2 with Form W­3, Trans­
“file” or “furnish” date requirement if the enve­      mittal of Wage and Tax Statements, with the                 W-4 Employee's Withholding Allowance
lope containing the tax return or form is properly     Social Security Administration (SSA). For elec­                 Certificate
addressed, contains sufficient postage, and is         tronically filed returns, see By March 31 below.
postmarked by the U.S. Postal Service by the                                                                       W-9 Request for Taxpayer Identification
due date, or sent by an IRS­designated delivery        By March 31                                                     Number and Certification
service by the due date. See Private delivery              File electronic Forms W-2 and 1099. File
                                                                                                                   940 Employer's Annual Federal
services in Publication 51 (Circular A).               electronic Forms W­2 with the SSA and Forms
                                                                                                                       Unemployment (FUTA) Tax Return
     Federal tax deposits can only be made by          1099 with the IRS. For more information on re­
                                                       porting Form W­2 information to the SSA elec­               943 Employer's Annual Federal Tax
electronic funds transfer and are governed by
                                                       tronically, visit the SSA's Employer W­2 Filing                 Return for Agricultural Employees
legal holidays in the District of Columbia. State­
wide holidays no longer apply. For a list of legal     Instructions & Information webpage at                       943-X Adjusted Employer's Annual
holidays that delay the due date of a federal tax      www.socialsecurity.gov/employer. For informa­                   Federal Tax Return for Agricultural
                                                       tion on filing information returns electronically               Employees or Claim for Refund
deposit, see section 7 of Publication 51 (Circu­
                                                       with the IRS, see Publication 1220, Specifica­
lar A).
                                                       tions for Filing Forms 1097, 1098, 1099, 3921,         See chapter 16 for information about getting
Fiscal year taxpayers. Generally, the due              3922, 5498, 8935, and W­2G Electronically.             publications and forms.
dates listed apply whether you use a calendar
                                                       By April 30, July 31, October 31, and
or a fiscal year. However, if you have a fiscal
                                                       January 31
year, see Publication 509 for certain exceptions
                                                          Deposit FUTA taxes. Deposit FUTA tax
                                                                                                              Farm Employment
that may apply to you.
                                                       due if it is more than $500.
By January 31                                                                                                 In general, you are an employer of farmworkers
                                                       Before December 1                                      if your employees do any of the following types
    File Form 943 with the IRS. If you depos­
                                                          Remind employees to submit a new Form               of work.
    ited all Form 943 taxes when due, you
                                                       W­4 if their withholding allowances have                    Raising or harvesting agricultural or horti­
    have 10 additional days to file.
                                                       changed or will change for the next year.                   cultural products on a farm, including rais­
    Furnish each employee with a completed
    Form W­2, Wage and Tax Statement.                                                                              ing and feeding of livestock.
    Furnish each recipient to whom you paid                                                                        Operating, managing, conserving, improv­
    $600 or more in nonemployee compensa­
    tion with a completed Form 1099 (for ex­
                                                       Introduction                                                ing, or maintaining your farm and its tools
                                                                                                                   and equipment.
    ample, Form 1099­MISC).                            You are generally required to withhold federal              Services performed in salvaging timber, or
    File Form 940, Employer's Annual Federal           income tax from the wages of your employees.                clearing land of brush and other debris, left
    Unemployment (FUTA) Tax Return, with               You may also be subject to social security and              by a hurricane (also known as hurricane la­
    the IRS. If you deposited all the FUTA tax         Medicare taxes under the Federal Insurance                  bor).
    when due, you have 10 additional days to           Contributions Act (FICA) and federal unemploy­              Handling, processing, or packaging any
    file.                                              ment tax under the Federal Unemployment Tax                 agricultural or horticultural commodity if
    File Form 945, Annual Return of Withheld           Act (FUTA). This chapter includes information               you produced more than half of the com­
    Federal Income Tax, with the IRS to report         about these taxes.                                          modity (for a group of up to 20 unincorpo­
    any nonpayroll income tax withheld during              You must also pay self­employment tax on                rated operators, all of the commodity).
    2012. If you deposited all Form 945 taxes          your net earnings from farming. See chapter 12              Work related to cotton ginning, turpentine,
    when due, you have 10 additional days to           for information on self­employment tax.                     gum resin products, or the operation and
    file.                                                                                                          maintenance of irrigation facilities.

By February 15                                         Topics                                                 For more information, see Publication 51 (Cir­
                                                       This chapter discusses:                                cular A).
   Ask for a new Form W­4 or Formulario
W­4(SP), Certificado de Exención de Reten­                                                                        Generally, a worker who performs services
ciones del Empleado, from each employee who                 Farm employment,                                  for you is your employee if you have the right to

                                                                                                              Chapter 13    Employment Taxes           Page 77
control what will be done and how it will be        employment taxes. However, certain exemp­              Qualified joint venture. If a husband and wife
done. This is so even when you give the em­         tions may apply to wages paid to your child,           elect to be treated as a qualified joint venture in­
ployee freedom of action. What matters is that      spouse, or parent.                                     stead of a partnership, either spouse may report
you have the right to control the details of how                                                           and pay the employment taxes due on the wa­
the services are performed. You are responsi­       Exemptions for your child. Payments for the            ges paid to employees using the EIN of that
ble for withholding and paying employment           services of your child under age 18 who works          spouse's sole proprietorship. For more informa­
taxes for your employees. You are also required     for you in your trade or business (including a         tion about qualified joint ventures, see
to file employment tax returns. These require­      farm) are not subject to social security and           chapter 12.
ments do not apply to amounts that you pay to       Medicare taxes. However, see Nonexempt
independent contractors. See Publication 15­A       services of a child or spouse, later. Payments
for more information on how to determine            for the services of your child under age 21 em­        Crew Leaders
whether an individual providing services is an      ployed by you in other than a trade or business,
independent contractor or an employee.              such as payments for household services in             If farmworkers are provided by a crew leader,
                                                    your home, are also not subject to social secur­       the crew leader may be the employer of the
    If you employ a family of workers, each
                                                    ity or Medicare taxes. Payments for the services       workers.
worker subject to your control (not just the head
                                                    of your child under age 21 employed by you,
of the family) is an employee.
                                                    whether or not in your trade or business, are not      Social security and Medicare taxes. For so­
   Special rules apply to crew leaders. See         subject to FUTA tax. Although not subject to so­       cial security and Medicare tax purposes, the
Crew Leaders, later.                                cial security, Medicare, or FUTA tax, the child's      crew leader is the employer of the workers if
                                                    wages still may be subject to federal income tax       both of the following requirements are met.
Employer identification number (EIN). If you        withholding.                                                The crew leader pays (either on his or her
have employees, you must have an EIN. If you                                                                    own behalf or on behalf of the farmer) the
do not have an EIN, you may apply for one on­       Exemptions for your spouse. Payments for                    workers for their farm labor.
line. Go to IRS.gov and click on the Apply for an   the services of your spouse who works for you               The crew leader has not entered into a
EIN Online link under Tools. You may also ap­       in your trade or business are subject to federal            written agreement with the farmer under
ply for an EIN by calling 1­800­829­4933 (hours     income tax withholding and social security and              which the crew leader is designated as an
of operation are Monday ­ Friday, 7:00 a.m. to      Medicare taxes, but not FUTA tax.                           employee of the farmer.
7:00 p.m. local time; Alaska and Hawaii follow          Payments for the services of your spouse
Pacific time), or you can fax or mail Form SS­4,    employed by you in other than a trade or busi­         Federal income tax withholding. If the crew
Application for Employer Identification Number,     ness, such as payments for household services          leader is the employer for social security and
to the IRS.                                         in your home, are not subject to social security,      Medicare tax purposes, the crew leader is the
                                                    Medicare, or FUTA taxes.                               employer for federal income tax withholding
Employee's social security number (SSN).                                                                   purposes.
An employee who does not have an SSN                Nonexempt services of a child or spouse.
should submit Form SS­5, Application for a So­      Payments for the services of your child or             Federal unemployment (FUTA) tax. For
cial Security Card, to the Social Security Admin­   spouse are subject to federal income tax with­         FUTA tax purposes, the crew leader is the em­
istration (SSA). Form SS­5 is available from any    holding as well as social security, Medicare,          ployer of the workers if, in addition to the earlier
SSA office or by calling 1­800­772­1213 (oper­      and FUTA taxes if he or she works for any of           requirements, either of the following require­
ates 24 hours per day). It is also available from   the following entities.                                ments are met.
the SSA's website at www.socialsecurity.gov.             A corporation, even if it is controlled by             The crew leader is registered under the Mi­
    The employee must furnish evidence of age,           you.                                                   grant and Seasonal Agricultural Worker
identity, and U.S. citizenship or lawful immigra­        A partnership, even if you are a partner.              Protection Act.
tion status permitting employment with the               This does not apply to wages paid to your              Substantially all crew members operate or
Form SS­5. An employee who is age 18 or older            child if each partner is a parent of the child.        maintain mechanized equipment provided
must appear in person with this evidence at an           An estate or trust, even if it is the estate of        by the crew leader as part of the service to
SSA office.                                              a deceased parent.                                     the farmer.
                                                    In these situations, the child or spouse is con­           The farmer is the employer of workers fur­
Form I-9. You must verify that each new em­
                                                    sidered to work for the corporation, partnership,      nished by a crew leader in all other situations. In
ployee is legally eligible to work in the United
                                                    or estate, not you.                                    addition, the farmer is the employer of workers
States. This includes completing the Form I­9,                                                             furnished by a registered crew leader if the
Employment Eligibility Verification. Form I­9 is
                                                    Exemptions for your parent. Payments for               workers are the employees of the farmer under
available from the U.S. Citizenship and Immi­
                                                    the services of your parent employed by you in         the common­law test. For example, some farm­
gration Services (USCIS) offices or by calling
                                                    your trade or business are subject to federal in­      ers employ individuals to recruit farmworkers
the Bureau of Citizenship and Immigration Serv­
                                                    come tax withholding and social security and           exclusively for them. Although these individuals
ices Forms Request Line at 1­800­870­3676.
                                                    Medicare taxes. Social security and Medicare           may be required to register under the Migrant
Form I­9 is also available from the USCIS web­
                                                    taxes do not apply to wages paid to your parent        and Seasonal Agricultural Worker Protection
site at www.uscis.gov. You can also contact the
                                                    for services not in your trade or business, but        Act, the workers are employed directly by the
USCIS at 1­800­375­5283 for more information.
                                                    they do apply to payments for household serv­          farmer. The farmer is the employer in these ca­
                                                    ices in your home if both the following condi­         ses. For information about common­law em­
New hire reporting. You are required to report
                                                    tions are satisfied.                                   ployees, see section 1 of Publication 15­A. For
any new employee to a designated state new
                                                         You have a child living in your home who is       information about crew leaders, see the Depart­
hire registry. Many states accept a copy of
                                                         under age 18 or has a physical or mental          ment of Labor website at www.dol.gov/whd/
Form W­4 with employer information added.
                                                         condition that requires care by an adult for      regs/compliance/whdfs49.htm.
Call the Office of Child Support Enforcement at
202­401­9267 or visit their Employer Services            at least 4 continuous weeks in a calendar
webpage at                                               quarter.
www.acf.hhs.gov/programs/cse/newhire        for          You are a widow or widower; or divorced
more information.                                        and not remarried; or have a spouse in the
                                                         home who, because of a physical or men­
                                                         tal condition, cannot care for your child for
Family Employees                                         at least 4 continuous weeks in the quarter.
                                                        Wages you pay to your parent are not sub­
Generally, the wages you pay to family mem­         ject to FUTA tax, regardless of the type of serv­
bers who are your employees are subject to          ices provided.

Page 78      Chapter 13     Employment Taxes
                                                   and other goods and services. Noncash wages          amount to withhold is figured on gross wages
                                                   paid to farmworkers, including commodity wa­         without taking out social security and Medicare
Social Security and Medicare                       ges, are not subject to social security and Medi­    taxes, union dues, insurance, etc.
Taxes                                              care taxes. However, they are subject to these
                                                   taxes if the substance of the transaction is a       Form W-4. Generally, the amount of federal in­
All cash wages you pay to an employee during       cash payment. For information on lodging provi­      come tax you withhold is based on the employ­
the year for farmwork are subject to social se­    ded as a condition of employment, see Publica­       ee's marital status and withholding allowances
curity and Medicare taxes if you meet either of    tion 15­B.                                           claimed on the employee's Form W­4. In gen­
the following tests.                                   Report the value of noncash wages in box 1       eral, an employee can claim withholding allow­
     You pay the employee $150 or more in          of Form W­2 together with cash wages. Do not         ances on Form W­4 equal to the number of ex­
     cash wages (count all wages paid on a         show noncash wages in box 3 or in box 5, (un­        emptions the employee will be entitled to claim
     time, piecework, or other basis) during the   less the substance of the transaction is a cash      on his or her tax return. An employee may also
     year for farmwork (the $150 test). The        payment).                                            be able to claim a special withholding allow­
     $150 test applies separately to each farm­                                                         ance and allowances for estimated deductions
     worker that you employ. If you employ a       Tax rates and social security wage limit.            and credits.
     family of workers, each member is treated     For 2012, the employer and the employee will             Do not withhold federal income tax from the
     separately. Do not count wages paid by        pay the following taxes.                             wages of an employee who, by filing Form W­4,
     other employers.                                   The employee pays 4.2% of cash wages            certifies that he or she had no federal income
     You pay cash and noncash wages of                  for social security tax (old­age, survivors,    tax liability last year and anticipates no liability
     $2,500 or more during the year to all your         and disability insurance).                      for the current year.
     employees for farmwork (the $2,500 test).          The employer pays 6.2% of cash wages                You should give each new employee a Form
                                                        for social security tax (old­age, survivors,    W­4 as soon as you hire the employee. For
   If the $2,500 test for the group is not met,         and disability insurance).                      Spanish­speaking employees, you may use
the $150 test for an employee still applies.            The employer and employee each pay              Formulario W­4(SP) which is the Spanish trans­
                                                        1.45% of cash wages for Medicare tax            lation of Form W­4. Have the employee com­
Exceptions. Annual cash wages of less than              (hospital insurance).                           plete and return the form to you before the first
$150 you pay to a seasonal farmworker are not                                                           payday. If the employee does not return the
subject to social security and Medicare taxes,        Wage limit. The limit on wages subject to         completed form, you must withhold federal in­
even if you pay $2,500 or more to all your farm­   the social security tax for 2012 is $110,100.        come tax as if the employee is single and
workers. However, these wages count toward         There is no limit on wages subject to the Medi­      claims no withholding allowances.
the $2,500 test for determining whether other      care tax. All covered wages are subject to the
farmworkers' wages are subject to social secur­    Medicare tax.                                            New Form W-4 for 2013. You should
ity and Medicare taxes.                                                                                 make the 2013 Form W­4 available to your em­
    A seasonal farmworker is a worker who:         Paying employee's share. If you would rather         ployees and encourage them to check their in­
      Works as a hand­harvest laborer,             pay the employee's share of social security and      come tax withholding for 2013. Those employ­
                                                   Medicare taxes without deducting it from his or      ees who owed a large amount of tax or received
    Is paid piece rates in an operation usually
                                                   her wages, you may do so. It is additional in­       a large refund for 2012 may want to file a new
    paid on this basis in the region of employ­
                                                   come to the employee. You must include it in         Form W­4. You cannot accept substitute Forms
    ment,
                                                   box 1 of the employee's Form W­2, but do not         W­4 developed by employees.
    Commutes daily from his or her permanent
    home to the farm, and                          count it as social security and Medicare wages
                                                   (boxes 3 and 5 on Form W­2) or as wages for          How to figure withholding. You can use one
    Worked in agriculture less than 13 weeks                                                            of several methods to determine the amount to
    in the preceding calendar year.                federal unemployment (FUTA) tax purposes.
                                                                                                        withhold. The methods are described in Publi­
   See Family Employees, earlier, for certain          Example. Jane operates a small family fruit      cation 51 (Circular A), which contains tables
exemptions from social security and Medicare       farm. She employs day laborers in the picking        showing the correct amount of federal income
taxes that apply to your child, spouse, and pa­    season to enable her to timely get her crop to       tax you should withhold. Publication 51 (Circu­
rent.                                              market. She does not deduct the employees'           lar A) also contains additional information about
                                                   share of social security and Medicare taxes          federal income tax withholding.
    Religious exemption. An exemption from
social security and Medicare taxes is available    from their pay; instead, she pays it on their be­
                                                                                                        Nonemployee compensation. Generally, you
to members of a recognized religious group or      half. When her accountant, Susan, prepares the
                                                                                                        do not have to withhold federal income tax on
division opposed to public insurance. This ex­     employees' Forms W­2, she adds each employ­
                                                                                                        payments for services to individuals who are
emption is available only if both the employee     ee's share of social security and Medicare
                                                                                                        not your employees. However, you may be re­
and the employer are members of the group or       taxes paid by Jane to the employee's wage in­
                                                                                                        quired to report these payments on Form
division.                                          come (box 1 of Form W­2), but does not in­
                                                                                                        1099­MISC, Miscellaneous Income, and to
    For more information, see Publication 517,     clude it in box 3 (social security wages) or box 5
                                                                                                        withhold under the backup withholding rules.
Social Security and Other Information for Mem­     (Medicare wages and tips).
                                                                                                        For more information, see the Instructions for
bers of the Clergy and Religious Workers.              For 2012, Jane paid Mary $1,000 during the
                                                                                                        Form 1099­MISC.
                                                   year. Susan enters $1,056.50 in box 1 of Mary's
Cash wages. Only cash wages paid to farm­          Form W­2 ($1,000 wages plus $56.50 social se­
workers are subject to social security and Medi­   curity and Medicare taxes paid for Mary). She
                                                   enters $1,000 in boxes 3 and 5 of Mary's Form
                                                                                                        Required Notice to
care taxes. Cash wages include checks, money
orders, and any kind of money or cash.             W­2.                                                 Employee About Earned
   Only cash wages subject to social security
and Medicare taxes are credited to your em­
                                                                                                        Income Credit (EIC)
ployees for social security benefit purposes.      Federal Income
Payments not subject to these taxes, such as                                                            You must provide notification about EIC to each
commodity wages, do not contribute to your
                                                   Tax Withholding                                      employee who worked for you at any time dur­
employees' social security coverage. For infor­                                                         ing the year and from whom you did not with­
mation about social security benefits, contact     If the cash wages you pay to farmworkers are         hold any federal income tax. However, you do
the SSA at 1­800­772­1213 or online at             subject to social security and Medicare taxes,       not have to notify employees who claim exemp­
www.socialsecurity.gov.                            they are also subject to federal income tax with­    tion from federal income tax withholding on
                                                   holding. Although noncash wages are subject
Noncash wages. Noncash wages include               to federal income tax, withhold income tax only
food, lodging, clothing, transportation passes,    if you and the employee agree to do so. The

                                                                                                        Chapter 13     Employment Taxes           Page 79
Form W­4. You meet the notification require­          Form W-2. By January 31, you must furnish                  during the current or preceding calendar
ment by giving each employee any of the fol­          each employee a Form W­2 showing total wa­                 year.
lowing.                                               ges for the previous year and total federal in­            You employed 10 or more farmworkers for
     Form W­2, which contains EIC notification        come tax, social security tax, and Medicare tax            some part of at least 1 day during any 20
     on the back of Copy B.                           withheld. However, if an employee stops work­              or more different calendar weeks during
     A substitute Form W­2 with the exact EIC         ing for you and requests the form earlier, you             the current or preceding calendar year.
     wording shown on the back of copy B of           must give it to the employee within 30 days of        These rules do not apply to exempt services of
     Form W­2.                                        the later of the following dates.                     your spouse, your parents, or your children un­
     Notice 797, Possible Federal Tax Refund                The date the employee requests the form.        der age 21. See Family Employees, earlier.
     Due to the Earned Income Credit (EIC).                The date you make your final payment of
     Your own written statement with the exact             wages to the employee.                           Alien farmworkers. Wages paid to aliens ad­
     wording of Notice 797.
                                                                                                            mitted on a temporary basis to the United
    For more information, see Publication 51          Compensation paid to H-2A visa holders.               States to perform farmwork (also known as
(Circular A).                                         Report compensation of $600 or more paid to           “H­2A visa workers”) are exempt from FUTA
                                                      foreign agricultural workers who entered the          tax. However, include your employment of
                                                      country on H­2A visas in box 1 of Form W­2.           these workers and the wages you paid them to
Reporting and Paying Social                           Compensation paid to H­2A workers for agricul­        determine whether you meet either test above.
                                                      tural labor performed in connection with this
Security, Medicare, and                               visa is not subject to social security and Medi­      Commodity wages. Payments in kind for farm
Withheld Federal Income                               care taxes, and therefore should not be repor­
                                                      ted as wages subject to social security tax
                                                                                                            labor are not cash wages. Do not count them to
                                                                                                            figure whether you are subject to FUTA tax or to
Taxes                                                 (line 2) or Medicare tax (line 4) on Form 943,        figure how much tax you owe.
                                                      and should not be reported as social security
You must withhold federal income, social secur­       wages (box 3) or Medicare wages (box 5) on            Tax rate and credit. The gross FUTA tax rate
ity, and Medicare taxes required to be withheld       Form W­2. An employer is not required to with­        is 6.0% of the first $7,000 cash wages you pay
from the salaries and wages of your employees.        hold federal income tax from compensation it          to each employee during the year. However,
You are liable for the payment of these taxes to      pays to an H­2A worker for agricultural labor         you are given a credit of up to 5.4% of the first
the federal government whether or not you col­        performed in connection with this visa unless         $7,000 cash wages you pay to each employee
lect them from your employees. If, for example,       the worker asks for withholding and the em­           for the state unemployment tax you pay. If your
you withhold less than the correct tax from an        ployer agrees. In this case, the worker must          state tax rate (experience rate) is less than
employee's wages, you are still liable for the full   give the employer a completed Form W­4. Fed­          5.4%, you may still be allowed the full 5.4%
amount. You must also pay the employer's              eral income tax withheld should be reported on        credit.
share of social security and Medicare taxes.          Form 943, line 6, and in box 2 of Form W­2.               If you do not pay the state tax, you cannot
                                                      These reporting rules apply when the H­2A             take the credit. If you are exempt from state un­
Form 943. Report withheld federal income tax,         worker provides his or her taxpayer identifica­       employment tax for any reason, the full 6.0%
social security tax, and Medicare tax on              tion number (TIN) to the employer. For the rules      rate applies. See the Instructions for Form 940
Form 943. Your 2012 Form 943 is due by Janu­          relating to backup withholding and reporting          for additional information.
ary 31, 2013 (or February 11, 2013, if you made       when the H­2A worker does not provide a TIN,
deposits on time in full payment of the taxes         see the Instructions for Form 1099­MISC and           More information. For more information on
due for the year).                                    the Instructions for Form 945.                        FUTA tax, see Publication 51 (Circular A).

Deposits. Generally, you must deposit both
the employer and employee shares of social se­
                                                      Trust fund recovery penalty. If you are re­           Reporting and Paying FUTA
                                                      sponsible for withholding, accounting for, de­
curity and Medicare taxes and federal income          positing, or paying federal withholding taxes         Tax
tax withheld during the year. However, you may        and willfully fail to do so, you can be held liable
make payments with Form 943 instead of de­            for a penalty equal to the withheld tax not paid.     The FUTA tax is imposed on you as the em­
positing them if you accumulate less than a           A responsible person can be an officer of a cor­      ployer. It must not be collected or deducted
$2,500 tax liability during the year (Form 943,       poration, a partner, a sole proprietor, or an em­     from the wages of your employees.
line 9 (line 11 for years prior to 2011)) and you     ployee of any form of business. A trustee or
pay in full with a timely filed return.               agent with authority over the funds of the busi­      Form 940. Report FUTA tax on Form 940. The
    For more information on deposit rules, see        ness can also be held responsible for the pen­        2012 Form 940 is due January 31, 2013 (or
Publication 51 (Circular A).                          alty.                                                 February 11, 2013, if you timely deposited the
                                                          Willfully means voluntarily, consciously, and     full amount of your 2012 FUTA tax).
    Electronic deposit requirement. You
must use electronic funds transfer to make all        intentionally. Paying other expenses of the busi­
                                                      ness instead of the taxes due is acting willfully.    Deposits. If at the end of any calendar quarter
federal tax deposits. Generally, electronic funds                                                           you owe, but have not yet deposited, more than
transfers are made using the Electronic Federal                                                             $500 in FUTA tax for the year, you must make a
Tax Payment System (EFTPS). If you do not             Consequences of treating an employee as
                                                      an independent contractor. If you classify an         deposit by the end of the following month. If the
want to use EFTPS, you can arrange for your                                                                 undeposited tax is $500 or less at the end of a
tax professional, financial institution, payroll      employee as an independent contractor and
                                                      your have no reasonable basis for doing so, you       quarter, you do not have to deposit it. You can
service, or other trusted third party to make de­                                                           add it to the tax for the next quarter. If the total
posits on your behalf. Also, you may arrange for      may be held liable for employment taxes for that
                                                      worker. See Publication 15­A for more informa­        undeposited tax is more than $500 at the end of
your financial institution to initiate a same­day                                                           the next quarter, a deposit will be required. If
wire payment on your behalf. EFTPS is a free          tion.
                                                                                                            the total undeposited tax at the end of the 4th
service provided by the Department of Treas­                                                                quarter is $500 or less, you can either make a
ury. Services provided by your tax professional,
financial institution, payroll service, or other      Federal Unemployment                                  deposit or pay it with your return by the January
                                                                                                            31, 2013, due date.
third party may have a fee.                           (FUTA) Tax
    For more information on making federal tax                                                                  Electronic deposit requirement. You
deposits, see section 7 of Publication 51 (Circu­                                                           must use electronic funds transfer to make all
                                                      You must pay FUTA tax if you meet either of the
lar A). To get more information about EFTPS or                                                              federal tax deposits. Generally, electronic funds
                                                      following tests.
to enroll in EFTPS, visit www.eftps.gov or call                                                             transfers are made using the Electronic Federal
                                                           You paid cash wages of $20,000 or more
1­800­555­4477. Additional information about                                                                Tax Payment System (EFTPS). If you do not
                                                           to farmworkers in any calendar quarter
EFTPS is also available in Publication 966.                                                                 want to use EFTPS, you can arrange for your

Page 80      Chapter 13      Employment Taxes
tax professional, financial institution, payroll            How to claim a credit or refund                      or harvested.
service, or other trusted third party to make de­           Including the credit or refund in income
posits on your behalf. Also, you may arrange for                                                                 Farming purposes. As the owner, tenant, or
your financial institution to initiate a same­day                                                                operator and the ultimate purchaser of fuel that
wire payment on your behalf. EFTPS is a free         Useful Items                                                you purchased, you use the fuel on a farm for
service provided by the Department of Treas­         You may want to see:                                        farming purposes if you use it in any of the fol­
ury. Services provided by your tax professional,                                                                 lowing ways.
financial institution, payroll service, or other       Publication                                                 1. To cultivate the soil or to raise or harvest
third party may have a fee.                                                                                           any agricultural or horticultural commodity.
    For more information on making federal tax               510 Excise Taxes
deposits, see section 7 of Publication 51 (Circu­                                                                  2. To raise, shear, feed, care for, train, or
lar A). To get more information about EFTPS or         Form (and Instructions)                                        manage livestock, bees, poultry, fur­bear­
to enroll in EFTPS, visit www.eftps.gov or call              720 Quarterly Federal Excise Tax Return                  ing animals, or wildlife.
1­800­555­4477. Additional information about                                                                       3. To operate, manage, conserve, improve,
EFTPS is also available in Publication 966.                  4136 Credit for Federal Tax Paid on Fuels
                                                                                                                      or maintain your farm and its tools and
                                                             8849 Claim for Refund of Excise Taxes                    equipment.
                                                     See chapter 16 for information about getting                  4. To handle, dry, pack, grade, or store any
                                                     publications and forms.                                          raw agricultural or horticultural commodity.
                                                                                                                      For this use to qualify, you must have pro­
                                                                                                                      duced more than half the commodity so
14.                                                  Fuels Used in Farming                                            treated during the tax year. The
                                                                                                                      more­than­one­half test applies separately
                                                     Owners, operators, and tenants of farms and                      to each commodity. Commodity means a
                                                     certain other persons may be eligible to claim a                 single raw product. For example, apples
Excise Taxes                                         credit or refund of excise taxes on fuel used on                 and peaches are two separate commodi­
                                                                                                                      ties.
                                                     a farm for farming purposes. See Table 14­1 for
                                                     a list of available fuel tax credits and refunds.             5. To plant, cultivate, care for, or cut trees or
Reminders                                            Fuel is used on a farm for farming purposes
                                                     only if used in carrying on a trade or business of
                                                                                                                      to prepare (other than sawing logs into
                                                                                                                      lumber, chipping, or other milling) trees for
                                                     farming, on a farm in the United States, and for                 market, but only if the planting, etc., is inci­
           Congress may take additional legisla-     farming purposes.                                                dental to your farming operations. Your
   !       tive action that would impact excise                                                                       tree operations are incidental only if they
 CAUTION   tax items for 2012, particularly the      Farm. A farm includes livestock, dairy, fish,                    are minor in nature when compared to the
fuels listed in Table 14-1. To find out if addi-     poultry, fruit, fur­bearing animals, and truck                   total farming operations.
tional legislation has been enacted, go to           farms, orchards, plantations, ranches, nurser­
IRS.gov, and type “excise tax” (or a particular      ies, ranges, and feed yards for finishing cattle. It            If any other person, such as a neighbor or
fuel) in the search box.                             also includes structures such as greenhouses                custom operator, performs a service for you on
                                                     used primarily for raising agricultural or horticul­        your farm for any of the purposes included in list
                                                     tural commodities. A fish farm is an area where             items (1) or (2), earlier, you are considered to
                                                     fish are grown or raised and not merely caught              be the ultimate purchaser who used the fuel on
Introduction
                                                     Table 14­1. Fuel Tax Credits and Refunds at a Glance
You may be eligible to claim a credit on your in­
come tax return for the federal excise tax on        Use this table to see if you can take a credit or refund for a nontaxable use of the fuel listed.
certain fuels. You may also be eligible to claim a
quarterly refund of the fuel taxes during the                                                                                               Household Use or
year, instead of waiting to claim a credit on your                                On a Farm for Farming              Off-Highway            Use Other Than as
income tax return.                                    Fuel Used                         Purposes                     Business Use                a Fuel1
    Whether you can claim a credit or refund de­
pends on whether the fuel was taxed and the           Gasoline                   Credit only                      Credit or refund         None
purpose (nontaxable use) for which you used           Aviation gasoline          Credit only                      None                     None
the fuel. The nontaxable uses of fuel for which a
farmer may claim a credit or refund are gener­        Undyed diesel fuel         Credit or refund                 Credit or refund2        Credit or refund2
ally the following.                                   and undyed
      Use on a farm for farming purposes.             kerosene
       Off­highway business use.                      Kerosene for use in Credit or refund                        None                     None
       Uses other than as a fuel in a propulsion      aviation
       engine, such as home use.                      Dyed diesel fuel           None                             None                     None
    Table 14­1 presents an overview of credits        and dyed kerosene
and refunds that may be claimed for fuels used        Other Fuels                Credit or refund                 Credit or refund         None
for the nontaxable uses listed above. See Publi­      (including
cation 510, Excise Taxes, for more information.       alternative fuels)3
                                                      1
                                                          For a use other than as fuel in a propulsion engine.
Topics
This chapter discusses:                               Applies to undyed kerosene not sold from a blocked pump or, under certain circumstances, for blending
                                                      2

                                                      with undyed diesel fuel to be used for heating purposes.
       Fuels used in farming                          3
                                                        Other Fuels means any liquid except gas oil, fuel oil, or any product taxable under Internal Revenue Code
       Dyed diesel fuel and dyed kerosene             section 4081. It includes the alternative fuels: liquefied petroleum gas (LPG),“P” Series fuels, compressed
                                                      natural gas (CNG), liquefied hydrogen, any liquid fuel derived from coal (including peat) through the
       Fuels used in off­highway business use
                                                      Fischer­Tropsch process, liquid fuel derived from biomass, liquid natural gas (LNG), liquefied gas derived
       Fuels used for household purposes              from biomass, and compressed gas derived from biomass.


                                                                                                                       Chapter 14      Excise Taxes         Page 81
a farm for farming purposes. Therefore, you can         tax, the ultimate vendor must be registered with           Penalty. A penalty is imposed on any person
still claim the credit or refund for the fuel so        the Internal Revenue Service at the time the               who knowingly uses, sells, or alters dyed diesel
used. However, see Custom application of fer­           claim is made. However, registered ultimate                fuel or dyed kerosene for any purpose other
tilizer and pesticide, later. If the other person       vendors cannot make claims for undyed diesel               than a nontaxable use. The penalty is the
performs any other services for you on your             fuel and undyed kerosene sold for use on a                 greater of $1,000 or $10 per gallon of the dyed
farm for purposes not included in list items (1)        farm for farming purposes.                                 diesel fuel or dyed kerosene involved. After the
or (2) above, no one can claim the credit or re­                                                                   first violation, the $1,000 portion of the penalty
fund for fuel used on your farm for those other             Fuel not used for farming. You do not use              increases depending on the number of viola­
services.                                               fuel on a farm for farming purposes when you               tions. For more information on this penalty, see
                                                        use it in any of the following ways.                       Publication 510.
    Buyer of fuel, including undyed diesel                   Off the farm, such as on the highway or in
fuel or undyed kerosene. If doubt exists                     noncommercial aviation, even if the fuel is
whether the owner, tenant, or operator of the
farm bought the fuel, determine who actually
                                                             used in transporting livestock, feed, crops,
                                                             or equipment.
                                                                                                                   Fuels Used in
bore the cost of the fuel. For example, if the               For personal use, such as mowing the                  Off-Highway
owner of a farm and his or her tenant equally                lawn.
share the cost of gasoline used on the farm,                 In processing, packaging, freezing, or can­
                                                                                                                   Business Use
each can claim a credit for the tax on half the              ning operations.
fuel used.                                                   In processing crude gum into gum spirits of           You may be eligible to claim a credit or refund
                                                             turpentine or gum resin or in processing              for the excise tax on fuel used in an off­highway
    Undyed diesel fuel, undyed kerosene,                     maple sap into maple syrup or maple                   business use.
and Other Fuels (including alternative fuel).                sugar.
Usually, the farmer is the only person who can                                                                     Off-highway business use. This is any use of
make a claim for credit or refund for the tax on        All-terrain vehicles (ATVs). Fuel used in                  fuel in a trade or business or in an income­pro­
undyed diesel fuel, undyed kerosene, or other           ATVs on a farm for farming purposes, dis­                  ducing activity. The use must not be in a high­
fuels (including alternative fuel) used for farm­       cussed earlier, is eligible for a credit or refund of      way vehicle registered or required to be regis­
ing purposes. However, see Custom applica-              excise taxes on the fuel. Fuel used in ATVs for            tered for use on public highways. Off­highway
tion of fertilizer and pesticide, next. Also see        nonfarming purposes is not eligible for a credit           business use generally does not include any
Dyed Diesel Fuel and Dyed Kerosene, later.              or refund of the taxes. If ATVs are used both for          use in a recreational motorboat.
                                                        farming and nonfarming purposes, only that
     Example. Farm owner Haleigh Blue hired             portion of the fuel used for farming purposes is           Examples. Off­highway business use includes
custom operator Tyler Steele to cultivate the           eligible for the credit or refund.                         the use of fuels in a trade or business in any of
soil on her farm. Tyler used 200 gallons of                                                                        the following ways.
undyed diesel fuel that he purchased to perform                                                                         In stationary machines such as generators,
the work on Haleigh's farm. In addition, Haleigh
hired contractor Lee Brown to pack and store
                                                        Dyed Diesel Fuel and Dyed                                       compressors, power saws, and similar
                                                                                                                        equipment;
her apple crop. Lee bought 25 gallons of                Kerosene                                                        For cleaning ; and
undyed diesel fuel to use in packing the apples.                                                                        In forklift trucks, bulldozers, and earthmov­
Haleigh can claim the credit for the 200 gallons        If you purchase dyed diesel fuel or dyed kero­                  ers.
of undyed diesel fuel used by Tyler on her farm         sene for a nontaxable use, you must use it only
because it qualifies as fuel used on the farm for       on a farm for farming purposes or for other non­               Off­highway nonbusiness (taxable) use of
farming purposes. No one can claim a credit for         taxable purposes. For example, you should not              fuel includes: use in minibikes, snowmobiles,
the 25 gallons used by Lee because that fuel            use dyed diesel fuel in a truck that is used both          power lawn mowers, chain saws, and other
was not used for a farming purpose included in          on the farm for farming purposes and on the                yard equipment. For more information, see Pub­
list items (1) or (2), above.                           highway, even though the highway use is in                 lication 510.
     In the above example, both Tyler Steele and        connection with farm business. Excise tax ap­
Lee Brown could have purchased dyed (un­                plies to the fuel used by the truck on the high­
taxed) diesel fuel for their tasks.                     ways. In this situation, undyed (taxed) fuel               Fuels Used for Household
     Custom application of fertilizer and pes-
                                                        should be purchased for the truck. You should              Purposes or Other Than as a
                                                        keep fuel records of the use of the truck on the
ticide. Fuel used on a farm for farming purpo­
                                                        farm for farming purposes, and for other uses.             Fuel for Propulsion Engines
ses includes fuel used in the application (includ­
                                                        You may be eligible for a credit or refund for the
ing aerial application) of fertilizer, pesticides, or                                                              You may be eligible to claim a credit or refund
                                                        excise tax on fuel used on the farm for farming
other substances. Generally, the applicator is                                                                     for the excise tax on undyed diesel fuel or
                                                        purposes.
treated as having used the fuel on a farm for
farming purposes. For applicators using high­
way vehicles, only the fuel used on the farm is
                                                        Table 14­2. Claiming a Credit or Refund of Excise Taxes
exempt. Fuel used traveling on the highway to
and from the farm is taxable. Fuel used by an           This table gives the basic rules for claiming a credit or refund of excise taxes on fuels used for a
aerial applicator for the direct flight between the     nontaxable use.
airfield and one or more farms is treated as
used for a farming purpose. For aviation gaso­                                                            Credit                               Refund
line, the aerial applicator makes the claim as
the ultimate purchaser. For kerosene used in             Which form to use                 Form 4136, Credit for Federal          Form 8849, Claim for Refund of
aviation, the ultimate purchaser may make the                                              Tax Paid on Fuels                      Excise Taxes, and Schedule 1
claim or waive the right to make the claim to the                                                                                 (Form 8849), Nontaxable Use
registered ultimate vendor. A sample waiver is                                                                                    of Fuels
included as Model Waiver L in the appendix of            Type of form                      Annual                                 Quarterly
Publication 510.
                                                         When to file                      With your income tax return            By the last day of the quarter
    A registered ultimate vendor is the person                                                                                    following the last quarter
who sells undyed diesel fuel, undyed kerosene,                                                                                    included in the claim
or kerosene for use in aviation to the user (ulti­
mate purchaser) of the fuel for use on a farm for        Amount of tax                     Any amount                             $750 or more1
farming purposes. To claim a credit or refund of         1
                                                             You may carry over an amount less than $750 to the next quarter.


Page 82       Chapter 14      Excise Taxes
kerosene used for home heating, lighting, and              Individuals. You claim the credit on the          How to file a quarterly claim. File the claim
cooking. This also applies to diesel fuel and          “Credit for federal tax on fuels” line of your Form   for refund by filling out Schedule 1 (Form 8849)
kerosene used in a home generator to produce           1040. If you would not otherwise have to file an      and attaching it to Form 8849. Send it to the ad­
electricity for home use. Home use of a fuel           income tax return, you must do so to get a fuel       dress shown in the instructions. If you file Form
does not include use in a propulsion engine and        tax credit.                                           720, you can use its Schedule C for your refund
it is not considered an off­highway business                                                                 claims. See the Instructions for Form 720.