The typical farming couple has both off-farm and farm income. The farming operation probably reports a loss as often as it reports profits. The loss is usually deducted against off-farm income when the couple calculates their income tax liability.
There is a limit on the amount of farming loss a couple can deduct, with deductions limited to a couple’s investment. The following information details the limits in place on deducting farm losses.
Section 465 of the Internal Revenue Code states that in the case of an individual, “any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk (within the meaning of subsection (b)) for such activity at the close of the taxable year.” IRC 465(a)(1).
It also states that “a taxpayer shall be considered at risk for an activity with respect to amounts including – (A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and (B) amounts borrowed with respect to such activity” if he, “(A) is personally liable for the repayment of such amounts, or (B) has pledged property, other than property used in such activity, as security for such borrowed amount.” IRC 465(b)(1) and (2).
The amount at risk in subsequent years is reduced by the amount of loss allowed. IRC 465(b)(5). Any loss not allowed in a current year shall be treated as a deduction allocable to such activity in a succeeding year. IRC 465(a)(2).
Consider a young farmer who is renting land and has invested $300,000 in equipment and cattle by borrowing $250,000 and paying $50,000 from his own funds. His amount at risk is $300,000. If he has a net loss after depreciation of $125,000 the first year, he will be able to deduct that amount against other income, but the next year his amount at risk is $175,000.
Section 704 of the Internal Revenue Code states that in the case of a partnership, “A partner’s distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership year in which such loss occurred.” IRC 704(d)(1).
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The loss may be further limited by the at-risk rule described above.
A partner’s basis in his or her partnership interest is referred to as outside basis. The outside basis is not the same as the partner’s capital account.
For example, Partner A contributes property to the AB partnership with a value of $10,000 but a basis of $4,000. Partner B contributes $10,000 in cash. Partner A and Partner B each have a capital account of $10,000, but Partner A’s outside basis is only $4,000.
A partner’s share of partnership liabilities also affects the partner’s basis.
A father and son form a limited liability company (LLC) taxed as a partnership. The father contributed $40,000 in cash and $50,000 of equipment that had been completely depreciated. The son contributed $10,000 in cash. The LLC borrowed $250,000 and the father guaranteed the note.
The father’s outside basis is $290,000 ($40,000 in cash and the $250,000 note he guaranteed). The son’s outside basis, and therefore loss limitation, is $10,000. The father’s capital account is $90,000 and the son’s is $10,000.
If the LLC earned $70,000 this year and the son is a 10 percent partner, $7,000 would be added to his basis and capital account. If the LLC also distributed $15,000 to the son, then at the end of the year his basis and capital account would be $2,000.