If you are a farmer, you should be aware of the IRS hobby loss rules that limit tax deductions for agricultural losses.
In order to deduct a loss from a farming activity, you must be able to prove to the IRS that the activity was carried out for profit.
If the IRS classifies your farm activity as a hobby, you will not be able to deduct any expenses or take any losses on your tax return, since the government is not interested in subsidizing hobbies.
Activities Not Engage in For Profit (ATG)
Some taxpayers who receive significant income from other sources reduce their tax base by reporting losses from activities that may not be engaged in for profit. For that reason, IRS inspectors make a factual evaluation to determine if an activity is actually engaged in for profit.
IRC § 183(d) is a safe harbor for the taxpayer, since it allows the presumption that the taxpayer is engaged in an activity for profit if in 3 of 5 consecutive years (2 of 7 in the case of breeding, training, exhibition or racing of horses), the activity is profitable.
Under IRC § 183(e), a taxpayer may elect to postpone a determination of whether the IRC § 183(d) presumption applies until the close of the fourth taxable year (or the sixth year for equine-related activities).
Farming Activity and Farmland Appreciation
When purchasing farmland, a taxpayer may primarily intend to benefit from its increased value, but also engage in farming on such land.
In such cases, the farming and holding of the land will be considered as a single activity only if the farming activity reduces the net cost of carrying the land for its appreciation in value.
Hobby or Business? The 9 Factor Test
If the activity is losing money, IRS examiners will need to evaluate each of the nine factors contained in the Treas. Reg. § 1.183-2(b) in order to determine if a taxpayer is engaged in an activity for real and honest profit. Those factors are:
1. How the taxpayer carries on the activity.
2. The taxpayer’s expertise.
3. The time and effort expended by the taxpayer in carrying out the activity.
4. An expectation that the assets used in the activity may appreciate in value.
5. The taxpayer’s success in carrying out other activities.
6. The taxpayer’s history of income or losses from the activity.
7. The relative amounts of the profits and losses.
8. The taxpayer’s financial status.
9. Whether the activity provides personal pleasure or recreation.
It is important for the taxpayer to know that no single defining pattern or factor is conclusive and all facts and circumstances must be considered.
How to Avoid the Limitations of the Hobby Loss Rules
The easiest way to prevent an activity from being considered a hobby and therefore getting caught in the hobby loss rules is by making a profit.
The IRS will not dispute that an activity is for-profit if it generated profits in 3 of the last 5 consecutive years, or in 2 of the last 7 years in the case of breeding, training, showing or racing of horses.
To prevent the IRS from deeming your business as a hobby, it may be a good idea to hire a certified public accountant and a business advisor. These professionals can help you create a strategy that ensures that your activity falls within the IRS definition of a trade or business, so that you can obtain the corresponding tax benefits.
What Can I Do if the IRS Labels My Business as a Hobby?
If the IRS considers your activity to be a hobby, but you feel that it is actually carried on with a profit motive, you must be able to demonstrate that the activity was carried out in a business-like manner. To do this, you should keep detailed records and documents that help you demonstrate that you are carrying out an activity for profit.
You should also be able to demonstrate your experience doing the activity and document how much time you spend on it. If you carry on other activities that are generating losses, you should abandon them. Abandoning other activities after they have been shown to be unsuccessful can help you show a profit motive with the current activity.