Publication 225
Farmer's Tax Guide

For use in preparing 2002 Returns

Acknowledgment:

The valuable advice and assistance given us each year by the National Farm Income Tax Extension Committee is gratefully acknowledged.

Cancellation of Debt

This section explains the general rule for including canceled debt in income and the exceptions to the general rule.

General Rule

Generally, if your debt is canceled or forgiven, other than as a gift or bequest to you, you must include the canceled amount in gross income for tax purposes. Report the canceled amount on line 10 of Schedule F if you incurred the debt in your farming business. If the debt is a nonbusiness debt, report the canceled amount on line 21 of Form 1040.

Form 1099-C.   If a federal agency, financial institution, credit union, finance company, or credit card company cancels or forgives your debt of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of debt canceled is shown in box 2.

Exceptions

The following discussion covers some exceptions to the general rule for canceled debt.

Price reduced after purchase.   If you owe a debt to the seller for property you bought and the seller reduces the amount you owe, you generally do not have income from the reduction. Unless you are in bankruptcy or are insolvent, treat the amount of the reduction as a purchase price adjustment and reduce your basis in the property. The rules that apply to bankruptcy and insolvency are explained under Exclusions, later.

Deductible debt.   You do not realize income from a canceled debt to the extent the payment of the debt would have been a deductible expense.

Example.   You get accounting services for your farm on credit. Later, you have trouble paying your farm debts, but you are not bankrupt or insolvent. Your accountant forgives part of the amount you owe for the accounting services. How you treat the canceled debt depends on your method of accounting.

• Cash method - You do not include the canceled debt in income because payment of the debt would have been deductible as a business expense.
• Accrual method - You include the canceled debt in income because the expense was deductible when you incurred the debt.

Exclusions

Do not include canceled debt in income in the following situations.

1. The cancellation takes place in a bankruptcy case under title 11 of the U.S. Code.
2. The cancellation takes place when you are insolvent.
3. The canceled debt is a qualified farm debt.
4. The canceled debt is a qualified real property business debt (in the case of a taxpayer other than a C corporation). See chapter 5 in Publication 334.

If a canceled debt is excluded from income because it takes place in a bankruptcy case, the exclusions in situations (2), (3), and (4) do not apply. If it takes place when you are insolvent, the exclusions in situations (3) and (4) do not apply to the extent you are insolvent.

See Form 982, later, for information on how to claim an exclusion for a canceled debt.

Debt.   For this discussion, debt includes any debt for which you are liable or that attaches to property you hold.

Bankruptcy and Insolvency

You can exclude a canceled debt from income if you are bankrupt or to the extent you are insolvent.

Bankruptcy.   A bankruptcy case is a case under title 11 of the U.S. Code if you are under the jurisdiction of the court and the cancellation of the debt is granted by the court or is the result of a plan approved by the court.

Do not include debt canceled in a bankruptcy case in your income in the year it is canceled. Instead, you must use the amount canceled to reduce your tax benefits, explained later under Reduction of tax benefits.

Insolvency.   You are insolvent to the extent your liabilities are more than the fair market value of your assets immediately before the cancellation of debt.

You can exclude canceled debt from gross income up to the amount by which you are insolvent. If the canceled debt is more than this amount and the debt qualifies, you can apply the rules for qualified farm debt or qualified real property business debt to the difference. Otherwise, you include the difference in gross income. Use the amount excluded because of insolvency to reduce any tax benefits, as explained later under Reduction of tax benefits. You must reduce the tax benefits under the insolvency rules before applying the rules for qualified farm debt or for qualified real property business debt.

Example.   You had a $15,000 debt canceled outside of bankruptcy. Immediately before the cancellation, your liabilities totaled $80,000 and your assets totaled $75,000. Since your liabilities were more than your assets, you were insolvent to the extent of $5,000 ($80,000 - $75,000). You can exclude this amount from income. The remaining canceled debt ($10,000) may be subject to the qualified farm debt or qualified real property business debt rules. If not, you must include it in income.

Reduction of tax benefits.   If you exclude canceled debt from income in a bankruptcy case or during insolvency, you must use the excluded debt to reduce certain tax benefits.

Order of reduction.   You must use the excluded canceled debt to reduce the following tax benefits in the order listed unless you choose to reduce the basis of depreciable property first, as explained later.

1. Net operating loss (NOL). Reduce any NOL for the tax year of the debt cancellation, and then any NOL carryover to that year. Reduce the NOL or NOL carryover one dollar for each dollar of excluded canceled debt.
2. General business credit carryover. Reduce the credit carryover to or from the tax year of the debt cancellation. Reduce the carryover 331/3 cents for each dollar of excluded canceled debt.
3. Minimum tax credit. Reduce the minimum tax credit available at the beginning of the tax year following the tax year of the debt cancellation. Reduce the credit 331/3 cents for each dollar of excluded canceled debt.
4. Capital loss. Reduce any net capital loss for the tax year of the debt cancellation, and then any capital loss carryover to that year. Reduce the capital loss or loss carryover one dollar for each dollar of excluded canceled debt.
5. Basis. Reduce the basis of the property you hold at the beginning of the tax year following the tax year of the debt cancellation in the following order.
   1. Real property (except inventory) used in your trade or business or held for investment that secured the canceled debt.
   2. Personal property (except inventory and accounts and notes receivable) used in your trade or business or held for investment that secured the canceled debt.
   3. Other property (except inventory and accounts and notes receivable) used in your trade or business or held for investment.
   4. Inventory and accounts and notes receivable.
   5. Other property.

   Reduce the basis one dollar for each dollar of excluded canceled debt. However, the reduction cannot be more than the total bases of property and the amount of money you hold immediately after the debt cancellation minus your total liabilities immediately after the cancellation.

   For allocation rules that apply to basis reductions for multiple canceled debts, see section 1.1017-1(b)(2) of the regulations. Also see Choosing to reduce the basis of depreciable property first, later.

6. Passive activity loss and credit carryovers. Reduce the passive activity loss and credit carryovers from the tax year of the debt cancellation. Reduce the loss carryover one dollar for each dollar of excluded canceled debt. Reduce the credit carryover 331/3 cents for each dollar of excluded canceled debt.
7. Foreign and possession tax credits. Reduce the credit carryover to or from the tax year of the debt cancellation. Reduce the carryover 331/3 cents for each dollar of excluded canceled debt.

How to make tax benefit reductions.   Always make the required reductions in tax benefits after figuring your tax for the year of the debt cancellation. In making the reductions in (1) and (4) above, first reduce the loss for the tax year of the debt cancellation. Then reduce any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. In making the reductions in (2) and (7) above, reduce the credit carryovers to the tax year of the debt cancellation in the order in which they are taken into account for that year.

Choosing to reduce the basis of depreciable property first.   You can choose to apply any portion of the excluded canceled debt first to reduce the basis of depreciable property you hold at the beginning of the tax year following the tax year of the debt cancellation, in the following order.

1. Depreciable real property used in your trade or business or held for investment that secured the canceled debt.
2. Depreciable personal property used in your trade or business or held for investment that secured the canceled debt.
3. Other depreciable property used in your trade or business or held for investment.
4. Real property held as inventory if you choose to treat it as depreciable property on Form 982.

The amount you apply cannot be more than the total adjusted bases of all the depreciable property. Depreciable property for this purpose means any property subject to depreciation, but only if a reduction of basis will reduce the depreciation or amortization otherwise allowable for the period immediately following the basis reduction.

You make this reduction before reducing the other tax benefits listed earlier. If the excluded canceled debt is more than the basis reduction you can make under this choice, use the difference to reduce the other tax benefits. In figuring the limit on the basis reduction in (5), Basis, use the remaining adjusted bases of your property after making this choice.

See Form 982, later, for information on how to make this choice. If you make this choice, you can revoke it only with the consent of the IRS.

Recapture of basis reductions.   If you reduce the basis of property under these provisions and later sell or otherwise dispose of the property at a gain, the part of the gain due to this basis reduction is taxable as ordinary income under the depreciation recapture provisions. Treat any property that is not section 1245 or section 1250 property as section 1245 property. For section 1250 property, determine the straight-line depreciation adjustments as though there were no basis reduction for debt cancellation. Sections 1245 and 1250 property and the recapture of gain as ordinary income are explained in chapter 11.

More information.   For more information on debt cancellation in bankruptcy proceedings or during insolvency, see Publication 908.

Qualified Farm Debt

You can exclude from income a canceled debt that is qualified farm debt owed to a qualified person. This exclusion applies only if you were solvent when the debt was canceled or, if you were insolvent, only to the extent the canceled debt is more than the amount by which you were insolvent. This exclusion does not apply to a canceled debt excluded from income because it takes place in a bankruptcy case.

Your debt is qualified farm debt if both the following requirements are met.

• You incurred it directly in operating a farming business.
• At least 50% of your total gross receipts for the 3 tax years preceding the year of debt cancellation were from your farming business.

Qualified person.   This is a person who is actively and regularly engaged in the business of lending money. A qualified person includes any federal, state, or local government, or any of their agencies or subdivisions. The USDA is a qualified person. A qualified person does not include any of the following.

• A person related to you.
• A person from whom you got the property (or a person related to this person).
• A person who receives a fee from your investment in the property (or a person related to this person).

For the definition of a related person, see Related persons under At-Risk Amounts in Publication 925.

Exclusion limit.   The amount of canceled qualified farm debt you can exclude from income is limited. It cannot be more than the sum of your adjusted tax benefits and the total adjusted bases of the qualified property you hold at the beginning of the tax year following the tax year of the debt cancellation. Figure this limit after taking into account any reduction of tax benefits because of debt canceled during insolvency.

If the canceled debt is more than this limit, you must include the difference in gross income.

Adjusted tax benefits.   Adjusted tax benefits means the sum of the following items.

1. Any net operating loss (NOL) for the tax year of the debt cancellation and any NOL carryover to that year.
2. Any general business credit carryover to or from the year of the debt cancellation, multiplied by 3.
3. Any minimum tax credit available at the beginning of the tax year following the tax year of the debt cancellation, multiplied by 3.
4. Any net capital loss for the tax year of the debt cancellation and any capital loss carryover to that year.
5. Any passive activity loss and credit carryovers from the tax year of the debt cancellation. Any credit carryover is multiplied by 3.
6. Any foreign and possession tax credit carryovers to or from the tax year of the debt cancellation, multiplied by 3.

Qualified property.   This is any property you use or hold for use in your trade or business or for the production of income.

Reduction of tax benefits.   If you exclude canceled debt from income under the qualified farm debt rules, you must use the excluded debt to reduce tax benefits. (If you also excluded canceled debt under the insolvency rules, you reduce the amount of the tax benefits remaining after reduction for the exclusion allowed under those rules.) You generally must follow the reduction rules previously explained under Bankruptcy and Insolvency. However, do not follow the rules in item (5), Basis. Instead, follow the special rules explained next.

Special rules for reducing the basis of property.   You must use special rules to reduce the basis of property for excluded canceled qualified farm debt. Under these special rules, you only reduce the basis of qualified property (defined earlier). Reduce it in the following order.

1. Depreciable qualified property. You may choose on Form 982 to treat real property held as inventory as depreciable property.
2. Land that is qualified property and is used or held for use in your farming business.
3. Other qualified property.

Form 982

Use Form 982 to show the amounts of canceled debt excluded from income and the reduction of tax benefits in the order listed on the form. Also use it if you are choosing to apply the excluded canceled debt to reduce the basis of depreciable property before reducing tax benefits. You make this choice by showing the amount you choose to apply on line 5 of the form.

When to file.   You must file Form 982 with your timely filed income tax return (including extensions) for the tax year in which the cancellation of debt occurred. If you timely filed your return for the year without choosing to apply the excluded canceled debt to reduce the basis of depreciable property first, you can still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). For more information, see When to file in the Form 982 instructions.

Income From Other Sources

This section discusses other types of income you may receive.

Barter income.   If you are paid for your work in farm products, other property, or services, you must report as income the fair market value of what you receive. The same rule applies if you trade farm products for other farm products, property, or someone else's labor. This is called barter income. For example, if you help a neighbor build a barn and receive a cow for your work, you must report the fair market value of the cow as ordinary income. Your basis for property you receive in a barter transaction is usually the fair market value that you include in income. If you pay someone with property, see Property for services under Labor Hired in chapter 5.

Below-market loans.   A below-market loan is a loan on which either no interest is charged or interest is charged at a rate below the applicable federal rate. If you make a below-market loan, you may have to report income from the loan in addition to any stated interest you receive from the borrower. See chapter 1 of Publication 550 for more information on below-market loans.

Commodity futures and options.   See Hedging (Commodity Futures) in chapter 10 for information on gains and losses from commodity futures and options transactions.

Custom hire (machine work).   Pay you receive for contract work or custom work that you or your hired help perform off your farm for others, or for the use of your property or machines, is income to you whether or not income tax was withheld. This rule applies whether you receive the pay in cash, services, or merchandise. Report this income on line 9, Part I, of Schedule F.

Easements and rights-of-way.   Income you receive for granting easements or rights-of-way on your farm or ranch for flooding land, laying pipelines, constructing electric or telephone lines, etc., may result in income, a reduction in the basis of all or part of your farm land, or both.

Example.   You granted a right-of-way for a gas pipeline through your property for $10,000. Only a specific part of your farm land was affected. You reserved the right to continue farming the surface land after the pipe was laid. Treat the payment for the right-of-way in one of the following ways.

1. If the payment is less than the basis properly allocated to the part of your land affected by the right-of-way, reduce the basis by $10,000.
2. If the payment is more than the basis of the affected part of your land, reduce the basis to zero and the rest is gain from a sale. The gain is reported on Form 4797 and is treated as section 1231 gain if you held the land for more than 1 year. See chapter 11.

If construction of the line damaged growing crops and you later receive a settlement of $250 for this damage, the $250 is income and is included on line 10 of Schedule F. It does not affect the basis of your land.

Fuel tax credit and refund.   Include any credit or refund of federal excise taxes on fuels in your gross income if you included the cost of the fuel as an expense deduction that reduced your income tax. See chapter 18 for more information about fuel tax credits and refunds.

Illegal federal irrigation subsidy.   The federal government, operating through the Bureau of Reclamation, has made irrigation water from certain reclamation and irrigation projects available for agricultural purposes. The excess of the amount required to be paid for water from these projects over the amount you actually paid is an illegal subsidy.

For example, if the amount required to be paid is full cost and you paid less than full cost, the difference is an illegal subsidy and you must include it in income. Report this on line 10 of Schedule F. You cannot take a deduction for the amount you must include in income.

For more information on reclamation and irrigation projects, contact your local Bureau of Reclamation.

Prizes.   Report prizes you win on farm livestock or products at contests, exhibitions, fairs, etc., on Schedule F as Other income. If you receive a prize in cash, include the full amount in income. If you receive a prize in produce or other property, include the fair market value of the property. For prizes of $600 or more, you should receive a Form 1099-MISC, Miscellaneous Income.

See chapter 15 for information about prizes related to 4-H Club or FFA projects. See Publication 525 for information about other prizes.

Property sold, destroyed, stolen, or condemned.   You may have an ordinary or capital gain if property you own is sold or exchanged, stolen, destroyed by fire, flood, or other casualty, or condemned by a public authority. In some situations, you can postpone the tax on the gain to a later year. See chapters 10 through 13.

Recapture of certain depreciation.   If you took a section 179 deduction for property used in your farming business and at any time during the property's recovery period you do not use it more than 50% in your business, you must include part of the deduction in income. See chapter 8 for information on the section 179 deduction and when to recapture that deduction.

In addition, if the percentage of business use of listed property (see chapter 8) falls to 50% or less in any tax year during the recovery period, you must include in income any excess depreciation you took on the property.

Both of these amounts are farm income. Use Part IV of Form 4797 to figure how much to include in income.

Refund or reimbursement.   You generally must include in income a reimbursement, refund, or recovery of an item for which you took a deduction in an earlier year. Include it for the tax year you receive it. However, if any part of the earlier deduction did not decrease your income tax, you do not have to include that part of the reimbursement, refund, or recovery.

Example.   A tenant farmer purchased fertilizer for $1,000 in April 2001. He deducted $1,000 on his 2001 Schedule F and the entire deduction reduced his tax. The landowner reimbursed him $500 of the cost of the fertilizer in February 2002. The tenant farmer must include $500 in income on his 2002 tax return because the entire deduction decreased his 2001 tax.

Sale of soil and other natural deposits.   If you remove and sell topsoil, loam, fill dirt, sand, gravel, or other natural deposits from your property, the proceeds are ordinary income. A reasonable allowance for depletion of the natural deposit sold may be claimed as a deduction. See Depletion in chapter 8.

Sod.   Report proceeds from the sale of sod on Schedule F. A deduction for cost depletion is allowed, but only for the topsoil removed with the sod.

Granting the right to remove deposits.   If you enter into a legal relationship granting someone else the right to excavate and remove natural deposits from your property, you must determine whether the transaction is a sale or another type of transaction (for example, a lease).

If you receive a specified sum or an amount fixed without regard to the quantity produced and sold from the deposit and you retain no economic interest in the deposit, your transaction is a sale. You are considered to retain an economic interest if, under the terms of the legal relationship, you depend on the income derived from extraction of the deposit for a return of your capital investment in the deposit.

Your income from the deposit is capital gain if the transaction is a sale. Otherwise, it is ordinary income subject to an allowance for depletion. See chapter 8 for information on depletion and chapter 10 for the tax treatment of capital gains.

Timber sales.   Timber sales, including sales of logs, firewood, and pulpwood, are discussed in chapter 10.

- Continue -