Starting or running a small farm, sometimes called a hobby farm, can be incredibly rewarding. You might produce your own food, raise livestock, or cultivate crops. But when tax time rolls around, understanding which farm expenses you can deduct can feel daunting. This article cuts through the confusion, explaining the critical difference between a farm run as a business and one classified as a hobby by the IRS, and detailing common tax deductions you might be eligible for. Reading this can help you understand your tax obligations, potentially reduce your tax burden, and avoid common pitfalls when filing your tax return, ensuring you maximize their tax deductions and ensure your farming operation is handled correctly for tax purposes.
Is Your Farm a Business or Just a Hobby According to the IRS?
The most crucial distinction the IRS makes when it comes to farm tax deductions is whether your farming activities constitute a business or are merely a hobby. This classification determines whether you can deduct expenses from your farm income and potentially offset other income. A true farm business operates with the intent to make a profit, even if it doesn't consistently do so every single year. According to the IRS, nine factors are considered to determine profit motive, including the way you carry on the activity, the expertise of yourself and your advisors, the time and effort you spend on the activity, whether there's an expectation that assets used in the activity may appreciate in value, your success in carrying on other similar or dissimilar activities, your history of income or losses from the activity, the amount of occasional profits, if any, that are earned, and whether you make a profit in some years.
If your farm is classified as a hobby, the tax rules are significantly different and far less favorable. While you must report any income generated by your hobby farm on your tax return, you can only deduct expenses up to the amount of that income, and these deductions were previously limited and subject to certain thresholds before recent tax law changes. This means you cannot use hobby losses to offset other income, such as wages or investment earnings. Therefore, understanding the IRS criteria for a business is paramount for anyone hoping to deduct farm expenses effectively and reduce their overall tax burden.
Why Does the IRS Care About Your Farm's Profit Motive?
The IRS cares deeply about whether your farm has a genuine profit motive because it directly impacts whether you can deduct expenses that exceed your farm income. A business is generally allowed to deduct all ordinary and necessary expenses incurred in carrying on that business, which can result in a net operating loss that might be used to offset income in other tax years. However, if the activity is deemed a hobby, the IRS views the expenses primarily as personal expenses, even if related to the farming activities. The tax laws are designed to prevent individuals from using personal pursuits with incidental income as a way to generate artificial losses to reduce their taxable income from other sources.
To demonstrate a profit motive, you should operate your farm in a businesslike manner. This includes maintaining accurate recordkeeping, having a business plan, changing methods of operation to improve profitability, and having the necessary expertise or seeking advice from experts. Keeping a separate bank account for your farm business transactions can also help establish that it is a legitimate farm business. The IRS scrutinizes activities that consistently show losses, particularly if those losses are substantial and the activity seems to have personal enjoyment aspects. Proving a profit motive is key to unlocking valuable tax breaks associated with a farming operation.
What Farm Expenses Can You Deduct on Schedule F?
If your farm is considered a business, you will typically report your farm income and expenses on Schedule F (Form 1040), Profit or Loss From Farming. Schedule F lists various categories of deductible farm expenses that are ordinary and necessary for running your farm. These can range from feed costs and seeds to depreciation on equipment and repairs and maintenance. Each line on Schedule F corresponds to specific types of expenses, allowing farmers to detail the costs associated with their farming operation. Proper recordkeeping is essential to accurately report these expenses and support your deductions if questioned by the IRS.
Many common costs incurred in running your farm are deductible farm expenses. These include expenses related to raising livestock, cultivating crops, and maintaining farm property. Understanding what qualifies as an ordinary and necessary expense for your specific farming activities is vital. The farmer’s tax guide, published by the Internal Revenue Service, provides comprehensive information on deductible farm expenses and other tax laws relevant to farming operations. Consulting this guide or a tax professional can help ensure you are claiming all eligible business deductions.
Further Reading: Discover how Schedule F helps self-employed farmers
Can You Deduct the Cost of Livestock and Feed?
Yes, the cost of feed and goods purchased for resale are generally deductible farm expenses for a farm business. For livestock raised for sale, the cost of purchasing and raising the animals, including feed, veterinary expenses, and other care costs, are typically deductible. If you are using the cash method of accounting, which most small farms do, you generally deduct the cost of purchased feed and goods in the year that they're purchased, even if the livestock or goods are sold in a later tax year.
Livestock purchased for draft, breeding, or dairy purposes are considered assets and are generally depreciated over their useful life rather than being fully deducted in the year of purchase. However, the ongoing costs of feeding and caring for this livestock remain deductible feed and goods expenses. Proper recordkeeping distinguishing between livestock held for sale and those held for draft, breeding, or dairy is necessary for accurate tax reporting. These expenses are significant costs for many farming operations and represent substantial potential tax deductions.
What About Repairs and Maintenance for Farm Property?
Repairs and maintenance on farm property are generally deductible expenses. This includes the cost of keeping farm buildings, fences, and equipment in good operating condition. For example, fixing a leaky barn roof, repairing a fence, or servicing a tractor are all considered ordinary and necessary repairs and maintenance expenses. These are distinct from capital improvements, which add significant value or prolong the life of the property and must be depreciated over time.
The line between personal expenses and business expenses is particularly important when it comes to repairs and maintenance, especially if the farm property also includes your personal residence. Only the portion of repairs and maintenance costs attributable to the business use of the property is deductible. Keeping detailed records, such as invoices and receipts, that clearly show the nature of the repair and which farm asset it relates to, is crucial for supporting these tax deductions. These expenses are reported on Schedule F and contribute to calculating the total income and expenses of your farm business.
Are There Special Rules for Deducting Farm Equipment?
Yes, there are special rules and options for deducting the cost of farm equipment and machinery used in your farming operation. Instead of fully deducting the cost of significant equipment purchases in the year they are bought, these costs are typically recovered over time through depreciation. However, the tax laws provide beneficial options like Section 179 depreciation and bonus depreciation, which allow small businesses, including farm businesses, to deduct a much larger portion, or even the full cost, of eligible equipment in the year it is placed in service.
Section 179 allows businesses to expense the full cost of certain qualifying property, up to a limit, in the year the property is placed in service. Bonus depreciation allows businesses to deduct an additional percentage of the cost of eligible property in the first year. These tax breaks can significantly reduce a farm's taxable income in the year equipment is purchased, providing substantial tax benefits. Understanding how to utilize these depreciation methods is a key part of tax planning for a farming operation.
Further Reading: Learn IRS-approved deductions and Schedule F filing
How Does Recordkeeping Impact Your Farm Tax Deductions?
Maintaining accurate and comprehensive recordkeeping is fundamental to claiming farm tax deductions and demonstrating to the IRS that your farm is indeed a business. Without proper records, it can be difficult to prove that your expenses are legitimate business deductions or that you operate with a profit motive. Good records include documentation of all income and expenses, such as sales receipts, invoices for purchases (like feed and goods, repairs and maintenance), bank statements, and logs detailing farming activities.
Detailed records support the figures you report on your tax return, including Schedule F. In the event of an IRS audit, your records are your primary defense for the deductions you claimed. Beyond just tracking expenses, good recordkeeping should also document your efforts to make the farm profitable, such as changes in farming practices, marketing efforts, and participation in agricultural education programs. Using accounting software, spreadsheets, or even manual ledgers to track income and expenses related to running your business is highly recommended for any farm business aiming to maximize their tax deductions.
What Happens If Your Farm Shows a Loss?
If your farm is treated as a business, it is expected that there may be years when expenses exceed income, resulting in a net loss. For a legitimate farm business, these losses can generally be used to offset other taxable income, subject to certain limitations like the passive activity loss rules and the excess business loss limitations. This is a significant advantage of being classified as a business rather than a hobby, where losses are not deductible beyond the amount of hobby income.
However, consistent and significant losses year after year will likely draw scrutiny from the IRS and raise questions about whether the farm genuinely has a profit motive. The IRS often presumes an activity is for profit if it makes a profit in at least three out of the last five tax years (or two out of seven years for activities mainly involving horses). Failing this test doesn't automatically mean it's a hobby, but it shifts the burden of proof to the taxpayer to demonstrate the profit motive using the nine factors mentioned earlier. Strategic tax planning can help manage the impact of farm losses.
Further Reading: Learn how farmers can take advantage of tax deductions
How can Taxfyle help?
Finding an accountant to manage your bookkeeping and file taxes is a big decision. Luckily, you don't have to handle the search on your own.
At Taxfyle, we connect small businesses with licensed, experienced CPAs or EAs in the US. We handle the hard part of finding the right tax professional by matching you with a Pro who has the right experience to meet your unique needs and will manage your bookkeeping and file taxes for you.
