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.

Ordinary or Capital
Gain or Loss

You must classify your gains and losses as either ordinary or capital (and your capital gains or losses as either short-term or long-term). You must do this to figure your net capital gain or loss.

Your net capital gains may be taxed at a lower tax rate than ordinary income. See Capital Gain Tax Rates, later. Your deduction for a net capital loss may be limited. See Treatment of Capital Losses, later.

Capital gain or loss.   Generally, you will have a capital gain or loss if you sell or exchange a capital asset. You may also have a capital gain if your section 1231 transactions result in a net gain.

Section 1231 transactions.   Section 1231 transactions are sales and exchanges of property held longer than 1 year and either used in a trade or business or held for the production of rents or royalties. They also include certain involuntary conversions of business or investment property, including capital assets. See Section 1231 Gains and Losses in chapter 11 for more information.

Capital Assets

Almost everything you own and use for personal purposes or investment is a capital asset.

The following items are examples of capital assets.

• A home owned and occupied by you and your family.
• Household furnishings.
• A car used for pleasure. If your car is used both for pleasure and for farm business, it is partly a capital asset and partly a noncapital asset, defined later.
• Stocks and bonds. However, there are special rules for gains and losses on qualified small business stock. For more information on this subject, see Losses on Section 1244 (Small Business) Stock in chapter 4 of Publication 550.

Personal-use property.   Property held for personal use is a capital asset. Gain from a sale or exchange of that property is a capital gain and is taxable. Loss from the sale or exchange of that property is not deductible. You can deduct a loss relating to personal-use property only if it results from a casualty or theft. For information about casualties and thefts, see chapter 13.

Long and Short Term

Where you report a capital gain or loss depends on how long you own the asset before you sell or exchange it. The time you own an asset before disposing of it is the holding period.

If you hold a capital asset 1 year or less, the gain or loss resulting from its disposition is short term. Report it in Part I of Schedule D. If you hold a capital asset longer than 1 year, the gain or loss resulting from its disposition is long term. Report it in Part II of Schedule D.

Holding period.   To figure if you held property longer than 1 year, start counting on the day after the day you acquired the property. The day you disposed of the property is part of your holding period.

Example.   If you bought an asset on June 19, 2001, you should start counting on June 20, 2001. If you sold the asset on June 19, 2002, your holding period is not longer than 1 year, but if you sold it on June 20, 2002, your holding period is longer than 1 year.

Inherited property.   If you inherit property, you are considered to have held the property longer than 1 year, regardless of how long you actually held it. This rule does not apply to livestock used in a farm business. See Holding period under Livestock, later.

Nonbusiness bad debt.   A nonbusiness bad debt is a short-term capital loss. See chapter 4 of Publication 550.

Nontaxable exchange.   If you acquire an asset in exchange for another asset and your basis for the new asset is figured, in whole or in part, by using your basis in the old property, the holding period of the new property includes the holding period of the old property. That is, it begins on the same day as your holding period for the old property.

Gift.   If you receive a gift of property and your basis in it is figured using the donor's basis, your holding period includes the donor's holding period.

Real property.   To figure how long you held real property, start counting on the day after you received title to it or, if earlier, on the day after you took possession of it and assumed the burdens and privileges of ownership.

However, taking possession of real property under an option agreement is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. The holding period of the seller cannot end before that time.

Figuring Net Gain or Loss

The totals for short-term capital gains and losses and the totals for long-term capital gains and losses must be figured separately.

Net short-term capital gain or loss.   Combine your short-term capital gains and losses. Do this by adding all your short-term capital gains. Then add all your short-term capital losses. Subtract the lesser total from the other. The result is your net short-term capital gain or loss.

Net long-term capital gain or loss.   Follow the same steps to combine your long-term capital gains and losses. The result is your net long-term capital gain or loss.

Net gain.   If the total of your capital gains is more than the total of your capital losses, the difference is taxable. However, part of your gain (but not more than your net capital gain) may be taxed at a lower rate than the rate of tax on your ordinary income. See Capital Gain Tax Rates, later.

Net loss.   If the total of your capital losses is more than the total of your capital gains, the difference is deductible. But there are limits on how much loss you can deduct and when you can deduct it. See Treatment of Capital Losses, next.

Treatment of Capital Losses

If your capital losses are more than your capital gains, you must claim the difference even if you do not have ordinary income to offset it. The yearly limit on the capital loss you can deduct is $3,000 ($1,500 if you are married and file a separate return). If your other income is low, you may not be able to use the full $3,000. The part of the $3,000 you cannot use becomes part of your capital loss carryover.

Capital loss carryover.   Generally, you have a capital loss carryover if either of the following situations applies to you.

• Your net loss on line 17 of Schedule D is more than the yearly limit.
• The amount shown on line 39, Form 1040 (your taxable income without your deduction for exemptions), is less than zero.

If either of these situations applies to you for 2002, complete the Capital Loss Carryover Worksheet in the instructions to Schedule D (Form 1040) to figure the amount you can carry over to 2003.

Capital Gain Tax Rates

The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower rates are called the maximum capital gain rates.

The term net capital gain means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss.

You will need to use Part IV of Schedule D (Form 1040), and the Schedule D Tax Worksheet in certain cases, to figure your tax using the capital gain rates if both the following are true.

• Both lines 16 and 17 of Schedule D are gains.
• Your taxable income on Form 1040, line 41, is more than zero.

The maximum capital gain rate can be 8%, 10%, 20%, 25%, or 28%. See Table 10-1.

The maximum capital gain rate does not apply if it is higher than your regular tax rate.

Using the capital gain rates.   The part of a net capital gain subject to each rate is determined by first netting long-term capital gains with long-term capital losses in the following tax rate groups.

1. A 28% group, consisting of all the following gains and losses.
   1. Collectibles gains and losses.
   2. The part of the gain on qualified small business stock equal to the section 1202 exclusion.
   3. Any long-term capital loss carryover.
2. A 25% group, consisting of unrecaptured section 1250 gain.
3. A 20% group, consisting of gains and losses not in the 28% or 25% group.

If any group has a net loss, the following rules apply.

• A net loss from the 28% group reduces any gain from the 25% group, and then any net gain from the 20% group.
• A net loss from the 20% group reduces any net gain from the 28% group, and then any gain from the 25% group.

If you have a net short-term capital loss, it reduces any net gain from the 28% group, then any gain from the 25% group, and finally any net gain from the 20% group.

The resulting net gain (if any) from each group is subject to the tax rate for that group. (The 10% rate applies to a net gain from the 20% group to the extent that, if there were no capital gain rates, the net capital gain would be taxed at the 10% or 15% regular tax rate.)

Collectibles gain or loss.   This is gain or loss from the sale or exchange of a work of art, rug, antique, metal, gem, stamp, coin, or alcoholic beverage held longer than 1 year. Collectibles gain includes gain from the sale of an interest in a partnership, S corporation, or trust attributable to an increase in value of the collectibles whether you sold them or not.

Gain on qualified small business stock.   If you realized a gain from qualified small business stock you held longer than 5 years, you exclude up to one-half your gain from your income. The taxable part of your gain equal to your section 1202 exclusion is a 28% rate gain. See Sales of Small Business Stock in chapter 1 of Publication 544.

Unrecaptured section 1250 gain.   This is the part of any long-term capital gain on section 1250 property (real property) due to straight-line depreciation minus any net loss in the 28% group. Unrecaptured section 1250 gain cannot be more than the net section 1231 gain or include any gain that is otherwise treated as ordinary income. Use the worksheet in the Schedule D instructions to figure your unrecaptured section 1250 gain. For more information about section 1250 property and net section 1231 gain, see chapter 3 of Publication 544.

Qualified 5-Year Gain

The 10% capital gain tax rate is lowered to 8% for qualified 5-year gain. Qualified 5-year gain is long-term capital gain from the sale of property you held longer than 5 years that would otherwise be subject to the 10% or 20% capital gain rate.

Beginning in 2006, the 20% capital gain rate will be lowered to 18% for qualified 5-year gain from property with a holding period that begins after 2000.

Net capital gain from disposition of investment property.   If you choose to include any part of a net capital gain from a disposition of investment property in investment income for figuring your investment interest deduction, you must reduce the net capital gain eligible for the capital gain tax rates by the same amount. You make this choice on Form 4952, Investment Interest Expense Deduction. For information on making this choice, see the instructions to Form 4952. For information on the investment interest deduction, see chapter 3 in Publication 550.

Noncapital Assets

Noncapital assets include property such as inventory and depreciable property used in a trade or business. A list of properties that are not capital assets is provided in the Schedule D instructions.

Property held for sale in the ordinary course of your farm business.   Property you hold mainly for sale to customers, such as livestock, poultry, livestock products, and crops, is a noncapital asset. Gain or loss from sales or other dispositions of this property is reported on Schedule F (not on Schedule D or Form 4797). The treatment of this property is discussed in chapter 4.

Land and depreciable properties.   Noncapital assets include land and depreciable property you use in farming. They also include livestock held for draft, breeding, dairy, or sporting purposes. However, your gains and losses from sales and exchanges of your farm land and depreciable properties must be considered together with certain other transactions to determine whether the gains and losses are treated as capital or ordinary gains and losses. The sales of these business assets are reported on Form 4797. See chapter 11 for more information.

Hedging
(Commodity Futures)

Hedging transactions are transactions that you enter into in the normal course of business primarily to manage the risk of interest rate or price changes or currency fluctuations with respect to borrowings, ordinary property, or ordinary obligations. (Ordinary property or obligations are those that cannot produce capital gain or loss if sold or exchanged.)

A commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity at a future date for a fixed price. The holder of an option on a futures contract has the right (but not the obligation) for a specified period of time to enter into a futures contract to buy or sell at a particular price. A forward contract is generally similar to a futures contract except that the terms are not standardized and the contract is not exchange traded.

Businesses may enter into commodity futures contracts or forward contracts and may acquire options on commodity futures contracts as either of the following.

• Hedging transactions.
• Transactions that are not hedging transactions.

Futures transactions with exchange-traded commodity futures contracts that are not hedging transactions generally result in capital gain or loss and are generally subject to the mark-to-market rules discussed in Publication 550. There is a limit on the amount of capital losses you can deduct each year. Hedging transactions are not subject to the mark-to-market rules.

If, as a farmer-producer, to protect yourself from the risk of unfavorable price fluctuations, you enter into commodity forward contracts, futures contracts, or options on futures contracts and the contracts cover an amount of the commodity within your range of production, the transactions are generally considered hedging transactions. They can take place at any time you have the commodity under production, have it on hand for sale, or reasonably expect to have it on hand.

The gain or loss on the termination of these hedges is generally ordinary gain or loss. Farmers who file their income tax returns on the cash method report any profit or loss on the hedging transaction on line 10 of Schedule F.

Gain or loss on transactions that hedge supplies of a type regularly used or consumed in the ordinary course of its trade or business may be ordinary.

If you have numerous transactions in the commodity futures market during the year, you must be able to show which transactions are hedging transactions. Clearly identify a hedging transaction on your books and records before the end of the day you entered into the transaction. It may be helpful to have separate brokerage accounts for your hedging and speculation transactions.

The identification must not only be on, and retained as part of, your books and records but must specify both the hedging transaction and the item, items, or aggregate risk that is being hedged. Although the identification of the hedging transaction must be made before the end of the day it was entered into, you have 35 days after entering into the transaction to identify the hedged item, items, or risk.

For more information on the tax treatment of futures and options contracts, see Commodity Futures and Section 1256 Contracts Marked to Market in Publication 550.

Accounting methods for hedging transactions.   Hedging transactions must be accounted for under special rules unless the transaction is subject to mark-to-market accounting under section 475 of the Internal Revenue Code or you use an accounting method other than the following methods.

1. Cash method.
2. Farm-price method.
3. Unit-livestock-price method.

Under these rules, the accounting method you use for a hedging transaction must clearly reflect income. This means that your accounting method must reasonably match the timing of income, deduction, gain, or loss from a hedging transaction with the timing of income, deduction, gain, or loss from the item or items being hedged. There are requirements and limits on the method you can use for certain hedging transactions. See section 1.446-4(e) of the regulations for those requirements and limits.

Once you adopt a method, you must apply it consistently and must have IRS approval before changing it.

Your books and records must describe the accounting method used for each type of hedging transaction. They must also contain any additional identification necessary to verify the application of the accounting method you used for the transaction. You must make the additional identification no more than 35 days after entering into the hedging transaction.

Example of a hedging transaction.   You file your income tax returns on the cash method. On July 2, 2002, you anticipate a yield of 50,000 bushels of corn this crop year. The present December futures price is $2.75 a bushel, but there are indications that by harvest time the price will drop. To protect yourself against a drop in the sales price of your corn inventory, you enter into the following hedging transaction. You sell 10 December futures contracts of 5,000 bushels each for a total of 50,000 bushels of corn at $2.75 a bushel.

The price did not drop as anticipated but rose to $3 a bushel. In November, you sell your crop at a local elevator for $3 a bushel. You also close out your futures position by buying 10 December contracts for $3 a bushel. You paid a broker's commission of $700 ($70 per contract) for the complete in and out position in the futures market.

The result is that the price of corn rose 25 cents a bushel and the actual selling price is $3 a bushel. Your loss on the hedge is 25 cents a bushel. In effect, the net selling price of your corn is $2.75 a bushel.

Report the results of your futures transactions and your sale of corn separately on Schedule F.

The loss on your futures transactions is $13,200, figured as follows.

The proceeds from your corn sale at the local elevator are $150,000 (50,000 bu. × $3). Report it on line 4, Part I of Schedule F.

Assume you were right and the price went down 25 cents a bushel. In effect, you would still net $2.75 a bushel, figured as follows.

The proceeds from the sale of your corn at the local elevator, $125,000, are reported on line 4, Part I of Schedule F.

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