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1040e 1. 1040e Deducting Business Expenses Table of Contents What's New Introduction Topics - This chapter discusses: Useful Items - You may want to see: What Can I Deduct?Cost of Goods Sold Capital Expenses Capital versus Deductible Expenses Personal versus Business Expenses How Much Can I Deduct?Not-for-profit limits. 1040e At-risk limits. 1040e Passive activities. 1040e Net operating loss. 1040e When Can I Deduct an Expense?Economic performance. 1040e Not-for-Profit ActivitiesGross Income Limit on Deductions What's New Optional safe harbor method to determine the business use of a home deduction. 1040e Beginning in 2013, you can use the optional safe harbor method to determine the deduction for the business use of your home. 1040e See Optional safe harbor method under Business use of your home , later. 1040e Introduction This chapter covers the general rules for deducting business expenses. 1040e Business expenses are the costs of carrying on a trade or business, and they are usually deductible if the business is operated to make a profit. 1040e Topics - This chapter discusses: What you can deduct How much you can deduct When you can deduct Not-for-profit activities Useful Items - You may want to see: Publication 334 Tax Guide for Small Business 463 Travel, Entertainment, Gift, and Car Expenses 525 Taxable and Nontaxable Income 529 Miscellaneous Deductions 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts 538 Accounting Periods and Methods 542 Corporations 547 Casualties, Disasters, and Thefts 587 Business Use of Your Home 925 Passive Activity and At-Risk Rules 936 Home Mortgage Interest Deduction 946 How To Depreciate Property Form (and Instructions) Sch A (Form 1040) Itemized Deductions 5213 Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit See chapter 12 for information about getting publications and forms. 1040e What Can I Deduct? To be deductible, a business expense must be both ordinary and necessary. 1040e An ordinary expense is one that is common and accepted in your industry. 1040e A necessary expense is one that is helpful and appropriate for your trade or business. 1040e An expense does not have to be indispensable to be considered necessary. 1040e Even though an expense may be ordinary and necessary, you may not be allowed to deduct the expense in the year you paid or incurred it. 1040e In some cases you may not be allowed to deduct the expense at all. 1040e Therefore, it is important to distinguish usual business expenses from expenses that include the following. 1040e The expenses used to figure cost of goods sold, Capital expenses, and Personal expenses. 1040e Cost of Goods Sold If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. 1040e Some of your business expenses may be included in figuring cost of goods sold. 1040e Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. 1040e If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense. 1040e The following are types of expenses that go into figuring cost of goods sold. 1040e The cost of products or raw materials, including freight. 1040e Storage. 1040e Direct labor (including contributions to pension or annuity plans) for workers who produce the products. 1040e Factory overhead. 1040e Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. 1040e Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. 1040e This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million. 1040e For more information, see the following sources. 1040e Cost of goods sold—chapter 6 of Publication 334. 1040e Inventories—Publication 538. 1040e Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations. 1040e Capital Expenses You must capitalize, rather than deduct, some costs. 1040e These costs are a part of your investment in your business and are called “capital expenses. 1040e ” Capital expenses are considered assets in your business. 1040e In general, you capitalize three types of costs. 1040e Business start-up costs (See Tip below). 1040e Business assets. 1040e Improvements. 1040e You can elect to deduct or amortize certain business start-up costs. 1040e See chapters 7 and 8. 1040e Cost recovery. 1040e Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. 1040e These recovery methods allow you to deduct part of your cost each year. 1040e In this way, you are able to recover your capital expense. 1040e See Amortization (chapter 8) and Depletion (chapter 9) in this publication. 1040e A taxpayer can elect to deduct a portion of the costs of certain depreciable property as a section 179 deduction. 1040e A greater portion of these costs can be deducted if the property is qualified disaster assistance property. 1040e See Publication 946 for details. 1040e Going Into Business The costs of getting started in business, before you actually begin business operations, are capital expenses. 1040e These costs may include expenses for advertising, travel, or wages for training employees. 1040e If you go into business. 1040e When you go into business, treat all costs you had to get your business started as capital expenses. 1040e Usually you recover costs for a particular asset through depreciation. 1040e Generally, you cannot recover other costs until you sell the business or otherwise go out of business. 1040e However, you can choose to amortize certain costs for setting up your business. 1040e See Starting a Business in chapter 8 for more information on business start-up costs. 1040e If your attempt to go into business is unsuccessful. 1040e If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories. 1040e The costs you had before making a decision to acquire or begin a specific business. 1040e These costs are personal and nondeductible. 1040e They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility. 1040e The costs you had in your attempt to acquire or begin a specific business. 1040e These costs are capital expenses and you can deduct them as a capital loss. 1040e If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss. 1040e The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. 1040e You cannot take a deduction for these costs. 1040e You will recover the costs of these assets when you dispose of them. 1040e Business Assets There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. 1040e You must fully capitalize the cost of these assets, including freight and installation charges. 1040e Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. 1040e See Regulations section 1. 1040e 263A-2 for information on these rules. 1040e Improvements Improvements are generally major expenditures. 1040e Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements. 1040e The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. 1040e Beginning in 2014, you must capitalize as improvements costs that are for the betterment of a unit of property, restore the unit of property, or adapt the unit of property to a new or different use. 1040e Temporary regulations allow you to capitalize costs meeting the above criteria for tax years beginning after 2011. 1040e However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. 1040e Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition. 1040e Restoration plan. 1040e Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. 1040e This applies even if some of the work would by itself be classified as repairs. 1040e Capital versus Deductible Expenses To help you distinguish between capital and deductible expenses, different examples are given below. 1040e Motor vehicles. 1040e You usually capitalize the cost of a motor vehicle you use in your business. 1040e You can recover its cost through annual deductions for depreciation. 1040e There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. 1040e See Publication 463. 1040e Generally, repairs you make to your business vehicle are currently deductible. 1040e However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation. 1040e Roads and driveways. 1040e The cost of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. 1040e The cost of maintaining a private road on your business property is a deductible expense. 1040e Tools. 1040e Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor. 1040e Machinery parts. 1040e Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense. 1040e Heating equipment. 1040e The cost of changing from one heating system to another is a capital expense. 1040e Personal versus Business Expenses Generally, you cannot deduct personal, living, or family expenses. 1040e However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. 1040e You can deduct the business part. 1040e For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. 1040e The remaining 30% is personal interest and generally is not deductible. 1040e See chapter 4 for information on deducting interest and the allocation rules. 1040e Business use of your home. 1040e If you use part of your home for business, you may be able to deduct expenses for the business use of your home. 1040e These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. 1040e To qualify to claim expenses for the business use of your home, you must meet both of the following tests. 1040e The business part of your home must be used exclusively and regularly for your trade or business. 1040e The business part of your home must be: Your principal place of business, or A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or A separate structure (not attached to your home) used in connection with your trade or business. 1040e You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility. 1040e Your home office qualifies as your principal place of business if you meet the following requirements. 1040e You use the office exclusively and regularly for administrative or management activities of your trade or business. 1040e You have no other fixed location where you conduct substantial administrative or management activities of your trade or business. 1040e If you have more than one business location, determine your principal place of business based on the following factors. 1040e The relative importance of the activities performed at each location. 1040e If the relative importance factor does not determine your principal place of business, consider the time spent at each location. 1040e Optional safe harbor method. 1040e Beginning in 2013, individual taxpayers can use the optional safe harbor method to determine the amount of deductible expenses attributable to certain business use of a residence during the tax year. 1040e This method is an alternative to the calculation, allocation, and substantiation of actual expenses. 1040e The deduction under the optional method is limited to $1,500 per year based on $5 a square foot for up to 300 square feet. 1040e Under this method, you claim your allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A (Form 1040). 1040e You are not required to allocate these deductions between personal and business use, as is required under the regular method. 1040e If you use the optional method, you cannot depreciate the portion of your home used in a trade or business. 1040e Business expenses unrelated to the home, such as advertising, supplies, and wages paid to employees, are still fully deductible. 1040e All of the requirements discussed earlier under Business use of your home still apply. 1040e For more information on the deduction for business use of your home, including the optional safe harbor method, see Publication 587. 1040e If you were entitled to deduct depreciation on the part of your home used for business, you cannot exclude the part of the gain from the sale of your home that equals any depreciation you deducted (or could have deducted) for periods after May 6, 1997. 1040e Business use of your car. 1040e If you use your car exclusively in your business, you can deduct car expenses. 1040e If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. 1040e Generally, commuting expenses between your home and your business location, within the area of your tax home, are not deductible. 1040e You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. 1040e Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. 1040e Beginning in 2013, the standard mileage rate is 56. 1040e 5 cents per mile. 1040e If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate. 1040e For more information on car expenses and the rules for using the standard mileage rate, see Publication 463. 1040e How Much Can I Deduct? Generally, you can deduct the full amount of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense. 1040e Recovery of amount deducted (tax benefit rule). 1040e If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. 1040e If you have a recovery in a later year, include the recovered amount in income in that year. 1040e However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income. 1040e For more information on recoveries and the tax benefit rule, see Publication 525. 1040e Payments in kind. 1040e If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. 1040e You cannot deduct the cost of your own labor. 1040e Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. 1040e If these costs are included in the cost of goods sold, do not deduct them again as a business expense. 1040e Limits on losses. 1040e If your deductions for an investment or business activity are more than the income it brings in, you have a loss. 1040e There may be limits on how much of the loss you can deduct. 1040e Not-for-profit limits. 1040e If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. 1040e See Not-for-Profit Activities , later. 1040e At-risk limits. 1040e Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. 1040e You are at risk in any activity for the following. 1040e The money and adjusted basis of property you contribute to the activity. 1040e Amounts you borrow for use in the activity if: You are personally liable for repayment, or You pledge property (other than property used in the activity) as security for the loan. 1040e For more information, see Publication 925. 1040e Passive activities. 1040e Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. 1040e In general, deductions for losses from passive activities only offset income from passive activities. 1040e You cannot use any excess deductions to offset other income. 1040e In addition, passive activity credits can only offset the tax on net passive income. 1040e Any excess loss or credits are carried over to later years. 1040e Suspended passive losses are fully deductible in the year you completely dispose of the activity. 1040e For more information, see Publication 925. 1040e Net operating loss. 1040e If your deductions are more than your income for the year, you may have a “net operating loss. 1040e ” You can use a net operating loss to lower your taxes in other years. 1040e See Publication 536 for more information. 1040e See Publication 542 for information about net operating losses of corporations. 1040e When Can I Deduct an Expense? When you can deduct an expense depends on your accounting method. 1040e An accounting method is a set of rules used to determine when and how income and expenses are reported. 1040e The two basic methods are the cash method and the accrual method. 1040e Whichever method you choose must clearly reflect income. 1040e For more information on accounting methods, see Publication 538. 1040e Cash method. 1040e Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them. 1040e Accrual method. 1040e Under an accrual method of accounting, you generally deduct business expenses when both of the following apply. 1040e The all-events test has been met. 1040e The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. 1040e Economic performance has occurred. 1040e Economic performance. 1040e You generally cannot deduct or capitalize a business expense until economic performance occurs. 1040e If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. 1040e If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. 1040e Example. 1040e Your tax year is the calendar year. 1040e In December 2013, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. 1040e You paid it by check in January 2014. 1040e If you use the accrual method of accounting, deduct the $600 on your tax return for 2013 because all events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic performance occurred in that year. 1040e If you use the cash method of accounting, deduct the expense on your 2014 return. 1040e Prepayment. 1040e You generally cannot deduct expenses in advance, even if you pay them in advance. 1040e This rule applies to both the cash and accrual methods. 1040e It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. 1040e Example. 1040e In 2013, you sign a 10-year lease and immediately pay your rent for the first 3 years. 1040e Even though you paid the rent for 2013, 2014, and 2015, you can only deduct the rent for 2013 on your 2013 tax return. 1040e You can deduct the rent for 2014 and 2015 on your tax returns for those years. 1040e Contested liability. 1040e Under the cash method, you can deduct a contested liability only in the year you pay the liability. 1040e Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U. 1040e S. 1040e possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. 1040e However, to take the deduction in the year of payment or transfer, you must meet certain conditions. 1040e See Regulations section 1. 1040e 461-2. 1040e Related person. 1040e Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. 1040e However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. 1040e Your deduction is allowed when the amount is includible in income by the related cash method payee. 1040e See Related Persons in Publication 538. 1040e Not-for-Profit Activities If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. 1040e Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit. 1040e The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. 1040e It does not apply to corporations other than S corporations. 1040e In determining whether you are carrying on an activity for profit, several factors are taken into account. 1040e No one factor alone is decisive. 1040e Among the factors to consider are whether: You carry on the activity in a businesslike manner, The time and effort you put into the activity indicate you intend to make it profitable, You depend on the income for your livelihood, Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business), You change your methods of operation in an attempt to improve profitability, You (or your advisors) have the knowledge needed to carry on the activity as a successful business, You were successful in making a profit in similar activities in the past, The activity makes a profit in some years, and You can expect to make a future profit from the appreciation of the assets used in the activity. 1040e Presumption of profit. 1040e An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. 1040e Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. 1040e The activity must be substantially the same for each year within this period. 1040e You have a profit when the gross income from an activity exceeds the deductions. 1040e If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death. 1040e If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. 1040e This means the limits discussed here will not apply. 1040e You can take all your business deductions from the activity, even for the years that you have a loss. 1040e You can rely on this presumption unless the IRS later shows it to be invalid. 1040e Using the presumption later. 1040e If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test. 1040e You can elect to do this by filing Form 5213. 1040e Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity. 1040e The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. 1040e Accordingly, it will not restrict your deductions. 1040e Rather, you will gain time to earn a profit in the required number of years. 1040e If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. 1040e If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period. 1040e Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. 1040e The period is extended only for deductions of the activity and any related deductions that might be affected. 1040e You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity. 1040e Gross Income Gross income from a not-for-profit activity includes the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from the activity. 1040e Gross income from the activity also includes capital gains and rents received for the use of property which is held in connection with the activity. 1040e You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. 1040e However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting. 1040e Limit on Deductions If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. 1040e If you are an individual, these deductions may be taken only if you itemize. 1040e These deductions may be taken on Schedule A (Form 1040). 1040e Category 1. 1040e Deductions you can take for personal as well as for business activities are allowed in full. 1040e For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. 1040e Deduct them on the appropriate lines of Schedule A (Form 1040). 1040e For tax years beginning after December 31, 2008, you can deduct a casualty loss on property you own for personal use only to the extent it is more than $500 and exceeds 10% of your adjusted gross income (AGI). 1040e The 10% AGI limitation does not apply to net disaster losses resulting from federally declared disasters in 2008 and 2009, and individuals are allowed to claim the net disaster losses even if they do not itemize their deductions. 1040e The reduction amount returns to $100 for tax years beginning after December 31, 2009. 1040e See Publication 547 for more information on casualty losses. 1040e For the limits that apply to home mortgage interest, see Publication 936. 1040e Category 2. 1040e Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. 1040e Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category. 1040e Category 3. 1040e Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. 1040e Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. 1040e Where more than one asset is involved, allocate depreciation and these other deductions proportionally. 1040e Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). 1040e They are subject to the 2%-of-adjusted-gross-income limit. 1040e See Publication 529 for information on this limit. 1040e Example. 1040e Adriana is engaged in a not-for-profit activity. 1040e The income and expenses of the activity are as follows. 1040e Gross income $3,200 Subtract: Real estate taxes $700 Home mortgage interest 900 Insurance 400 Utilities 700 Maintenance 200 Depreciation on an automobile 600 Depreciation on a machine 200 3,700 Loss $(500) Adriana must limit her deductions to $3,200, the gross income she earned from the activity. 1040e The limit is reached in category (3), as follows. 1040e Limit on deduction $3,200 Category 1: Taxes and interest $1,600 Category 2: Insurance, utilities, and maintenance 1,300 2,900 Available for Category 3 $ 300 The $800 of depreciation is allocated between the automobile and machine as follows. 1040e $600 $800 x $300 = $225 depreciation for the automobile $200 $800 x $300 = $75 depreciation for the machine The basis of each asset is reduced accordingly. 1040e Adriana includes the $3,200 of gross income on line 21 (other income) of Form 1040. 1040e The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). 1040e Adriana deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit. 1040e Partnerships and S corporations. 1040e If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. 1040e They are reflected in the individual shareholder's or partner's distributive shares. 1040e More than one activity. 1040e If you have several undertakings, each may be a separate activity or several undertakings may be combined. 1040e The following are the most significant facts and circumstances in making this determination. 1040e The degree of organizational and economic interrelationship of various undertakings. 1040e The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting. 1040e The similarity of the undertakings. 1040e The IRS will generally accept your characterization if it is supported by facts and circumstances. 1040e If you are carrying on two or more different activities, keep the deductions and income from each one separate. 1040e Figure separately whether each is a not-for-profit activity. 1040e Then figure the limit on deductions and losses separately for each activity that is not for profit. 1040e Prev Up Next Home More Online Publications
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1040e 9. 1040e Dispositions of Property Used in Farming Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Section 1231 Gains and LossesNonrecaptured section 1231 losses. 1040e Depreciation RecaptureSection 1245 Property Section 1250 Property Installment Sale Other Dispositions Other GainsExceptions. 1040e Amount to report as ordinary income. 1040e Applicable percentage. 1040e Amount to report as ordinary income. 1040e Applicable percentage. 1040e Introduction When you dispose of property used in your farm business, your taxable gain or loss is usually treated as ordinary income (which is taxed at the same rates as wages and interest income) or capital gain (which is generally taxed at lower rates) under the rules for section 1231 transactions. 1040e When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. 1040e Any gain remaining after applying the depreciation recapture rules is a section 1231 gain, which may be taxed as a capital gain. 1040e Gains and losses from property used in farming are reported on Form 4797, Sales of Business Property. 1040e Table 9-1 contains examples of items reported on Form 4797 and refers to the part of that form on which they first should be reported. 1040e Topics - This chapter discusses: Section 1231 gains and losses Depreciation recapture Other gains Useful Items - You may want to see: Publication 544 Sales and Other Dispositions of Assets Form (and Instructions) 4797 Sales of Business Property See chapter 16 for information about getting publications and forms. 1040e Section 1231 Gains and Losses Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions (explained below). 1040e Their treatment as ordinary or capital gains depends on whether you have a net gain or a net loss from all of your section 1231 transactions in the tax year. 1040e Table 9-1. 1040e Where to First Report Certain Items on Form 4797 Type of property Held 1 year or less Held more than 1 year 1 Depreciable trade or business property: a Sold or exchanged at a gain Part II Part III (1245, 1250) b Sold or exchanged at a loss Part II Part I 2 Farmland held less than 10 years for which soil, water, or land clearing expenses were deducted: a Sold at a gain Part II Part III (1252) b Sold at a loss Part II Part I 3 All other farmland Part II Part I 4 Disposition of cost-sharing payment property described in section 126 Part II Part III (1255) 5 Cattle and horses used in a trade or business for draft, breeding, dairy, or sporting purposes: Held less than 24 mos. 1040e Held 24 mos. 1040e or more a Sold at a gain Part II Part III (1245) b Sold at a loss Part II Part I c Raised cattle and horses sold at a gain Part II Part I 6 Livestock other than cattle and horses used in a trade or business for draft, breeding, dairy, or sporting purposes: Held less than 12 mos. 1040e Held 12 mos. 1040e or more a Sold at a gain Part II Part III (1245) b Sold at a loss Part II Part I c Raised livestock sold at a gain Part II Part I If you have a gain from a section 1231 transaction, first determine whether any of the gain is ordinary income under the depreciation recapture rules (explained later). 1040e Do not take that gain into account as section 1231 gain. 1040e Section 1231 transactions. 1040e Gain or loss on the following transactions is subject to section 1231 treatment. 1040e Sale or exchange of cattle and horses. 1040e The cattle and horses must be held for draft, breeding, dairy, or sporting purposes and held for 24 months or longer. 1040e Sale or exchange of other livestock. 1040e This livestock must be held for draft, breeding, dairy, or sporting purposes and held for 12 months or longer. 1040e Other livestock includes hogs, mules, sheep, goats, donkeys, and other fur-bearing animals. 1040e Other livestock does not include poultry. 1040e Sale or exchange of depreciable personal property. 1040e This property must be used in your business and held longer than 1 year. 1040e Generally, property held for the production of rents or royalties is considered to be used in a trade or business. 1040e Examples of depreciable personal property include farm machinery and trucks. 1040e It also includes amortizable section 197 intangibles. 1040e Sale or exchange of real estate. 1040e This property must be used in your business and held longer than 1 year. 1040e Examples are your farm or ranch (including barns and sheds). 1040e Sale or exchange of unharvested crops. 1040e The crop and land must be sold, exchanged, or involuntarily converted at the same time and to the same person, and the land must have been held longer than 1 year. 1040e You cannot keep any right or option to reacquire the land directly or indirectly (other than a right customarily incident to a mortgage or other security transaction). 1040e Growing crops sold with a leasehold on the land, even if sold to the same person in a single transaction, are not included. 1040e Distributive share of partnership gains and losses. 1040e Your distributive share must be from the sale or exchange of property listed above and held longer than 1 year (or for the required period for certain livestock). 1040e Cutting or disposal of timber. 1040e Special rules apply if you owned the timber longer than 1 year and elect to treat timber cutting as a sale or exchange, or you enter into a cutting contract, as described in chapter 8 under Timber . 1040e Condemnation. 1040e The condemned property (defined in chapter 11) must have been held longer than 1 year. 1040e It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. 1040e It cannot be property held for personal use. 1040e Casualty or theft. 1040e The casualty or theft must have affected business property, property held for the production of rents or royalties, or investment property (such as notes and bonds). 1040e You must have held the property longer than 1 year. 1040e However, if your casualty or theft losses are more than your casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation. 1040e Section 1231 does not apply to personal casualty gains and losses. 1040e See chapter 11 for information on how to treat those gains and losses. 1040e If the property is not held for the required holding period, the transaction is not subject to section 1231 treatment, and any gain or loss is ordinary income reported in Part II of Form 4797. 1040e See Table 9-1. 1040e Property for sale to customers. 1040e A sale, exchange, or involuntary conversion of property held mainly for sale to customers is not a section 1231 transaction. 1040e If you will get back all, or nearly all, of your investment in the property by selling it rather than by using it up in your business, it is property held mainly for sale to customers. 1040e Treatment as ordinary or capital. 1040e To determine the treatment of section 1231 gains and losses, combine all of your section 1231 gains and losses for the year. 1040e If you have a net section 1231 loss, it is an ordinary loss. 1040e If you have a net section 1231 gain, it is ordinary income up to your nonrecaptured section 1231 losses from previous years, explained next. 1040e The rest, if any, is long-term capital gain. 1040e Nonrecaptured section 1231 losses. 1040e Your nonrecaptured section 1231 losses are your net section 1231 losses for the previous 5 years that have not been applied against a net section 1231 gain by treating the gain as ordinary income. 1040e These losses are applied against your net section 1231 gain beginning with the earliest loss in the 5-year period. 1040e Example. 1040e In 2013, Ben has a $2,000 net section 1231 gain. 1040e To figure how much he has to report as ordinary income and long-term capital gain, he must first determine his section 1231 gains and losses from the previous 5-year period. 1040e From 2008 through 2012 he had the following section 1231 gains and losses. 1040e Year Amount 2008 -0- 2009 -0- 2010 ($2,500) 2011 -0- 2012 $1,800 Ben uses this information to figure how to report his net section 1231 gain for 2013 as shown below. 1040e 1) Net section 1231 gain (2013) $2,000 2) Net section 1231 loss (2010) ($2,500) 3) Net section 1231 gain (2012) 1,800 4) Remaining net section 1231 loss from prior 5 years ($700) 5) Gain treated as ordinary income $700 6) Gain treated as long-term capital gain $1,300 His remaining net section 1231 loss from 2010 is completely recaptured in 2013. 1040e Depreciation Recapture If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if it is otherwise nontaxable) as ordinary income. 1040e To figure any gain that must be reported as ordinary income, you must keep permanent records of the facts necessary to figure the depreciation or amortization allowed or allowable on your property. 1040e For more information, see chapter 3 of Publication 544. 1040e Section 1245 Property A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable. 1040e Any recognized gain that is more than the part that is ordinary income is a section 1231 gain. 1040e See Treatment as ordinary or capital under Section 1231 Gains and Losses , earlier. 1040e Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and that is any of the following types of property. 1040e Personal property (either tangible or intangible). 1040e Other tangible property (except buildings and their structural components) used as any of the following. 1040e See Buildings and structural components below. 1040e An integral part of manufacturing, production, or extraction, or of furnishing certain services. 1040e A research facility in any of the activities in (a). 1040e A facility in any of the activities in (a) above, for the bulk storage of fungible commodities (discussed later). 1040e That part of real property (not included in (2)) with an adjusted basis reduced by (but not limited to) the following. 1040e Amortization of certified pollution control facilities. 1040e The section 179 expense deduction. 1040e Deduction for clean-fuel vehicles and certain refueling property. 1040e Expenditures to remove architectural and transportation barriers to the handicapped and elderly. 1040e Certain reforestation expenditures (as described under Reforestation Costs in chapter 7. 1040e Single purpose agricultural (livestock) or horticultural structures. 1040e Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum. 1040e Buildings and structural components. 1040e Section 1245 property does not include buildings and structural components. 1040e The term building includes a house, barn, warehouse, or garage. 1040e The term structural component includes walls, floors, windows, doors, central air conditioning systems, light fixtures, etc. 1040e Do not treat a structure that is essentially machinery or equipment as a building or structural component. 1040e Also, do not treat a structure that houses property used as an integral part of an activity as a building or structural component if the structure's use is so closely related to the property's use that the structure can be expected to be replaced when the property it initially houses is replaced. 1040e The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot be used economically for other purposes indicates it is closely related to the use of the property it houses. 1040e Structures such as oil and gas storage tanks, grain storage bins, and silos are not treated as buildings, but as section 1245 property. 1040e Facility for bulk storage of fungible commodities. 1040e This is a facility used mainly for the bulk storage of fungible commodities. 1040e Bulk storage means storage of a commodity in a large mass before it is used. 1040e For example, if a facility is used to store oranges that have been sorted and boxed, it is not used for bulk storage. 1040e To be fungible, a commodity must be such that one part may be used in place of another. 1040e Gain Treated as Ordinary Income The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts. 1040e The depreciation (which includes any section 179 deduction claimed) and amortization allowed or allowable on the property. 1040e The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property). 1040e For any other disposition of section 1245 property, ordinary income is the lesser of (1) above or the amount by which its fair market value (FMV) is more than its adjusted basis. 1040e For details, see chapter 3 of Publication 544. 1040e Use Part III of Form 4797 to figure the ordinary income part of the gain. 1040e Depreciation claimed on other property or claimed by other taxpayers. 1040e Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts. 1040e Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion. 1040e For details on exchanges of property that are not taxable, see Like-Kind Exchanges in chapter 8. 1040e Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift and part of the transfer is a sale or exchange). 1040e Example. 1040e Jeff Free paid $120,000 for a tractor in 2012. 1040e On February 23, 2013, he traded it for a chopper and paid an additional $30,000. 1040e To figure his depreciation deduction on the chopper for the current year, Jeff continues to use the basis of the tractor as he would have before the trade. 1040e Jeff can also depreciate the additional $30,000 for the chopper. 1040e Depreciation and amortization. 1040e Depreciation and amortization deductions that must be recaptured as ordinary income include (but are not limited to) the following items. 1040e See Depreciation Recapture in chapter 3 of Publication 544 for more details. 1040e Ordinary depreciation deductions. 1040e Section 179 deduction (see chapter 7). 1040e Any special depreciation allowance. 1040e Amortization deductions for all the following costs. 1040e Acquiring a lease. 1040e Lessee improvements. 1040e Pollution control facilities. 1040e Reforestation expenses. 1040e Section 197 intangibles. 1040e Qualified disaster expenses. 1040e Franchises, trademarks, and trade names acquired before August 11, 1993. 1040e Example. 1040e You file your returns on a calendar year basis. 1040e In February 2011, you bought and placed in service for 100% use in your farming business a light-duty truck (5-year property) that cost $10,000. 1040e You used the half-year convention and your MACRS deductions for the truck were $1,500 in 2011 and $2,550 in 2012. 1040e You did not claim the section 179 expense deduction for the truck. 1040e You sold it in May 2013 for $7,000. 1040e The MACRS deduction in 2013, the year of sale, is $893 (½ of $1,785). 1040e Figure the gain treated as ordinary income as follows. 1040e 1) Amount realized $7,000 2) Cost (February 2011) $10,000 3) Depreciation allowed or allowable (MACRS deductions: $1,500 + $2,550 + $893) 4,943 4) Adjusted basis (subtract line 3 from line 2) $5,057 5) Gain realized (subtract line 4 from line 1) 1,943 6) Gain treated as ordinary income (lesser of line 3 or line 5) $1,943 Depreciation allowed or allowable. 1040e You generally use the greater of the depreciation allowed or allowable when figuring the part of gain to report as ordinary income. 1040e If, in prior years, you have consistently taken proper deductions under one method, the amount allowed for your prior years will not be increased even though a greater amount would have been allowed under another proper method. 1040e If you did not take any deduction at all for depreciation, your adjustments to basis for depreciation allowable are figured by using the straight line method. 1040e This treatment applies only when figuring what part of the gain is treated as ordinary income under the rules for section 1245 depreciation recapture. 1040e Disposition of plants and animals. 1040e If you elect not to use the uniform capitalization rules (see chapter 6), you must treat any plant you produce as section 1245 property. 1040e If you have a gain on the property's disposition, you must recapture the pre-productive expenses you would have capitalized if you had not made the election by treating the gain, up to the amount of these expenses, as ordinary income. 1040e For section 1231 transactions, show these expenses as depreciation on Form 4797, Part III, line 22. 1040e For plant sales that are reported on Schedule F (1040), Profit or Loss From Farming, this recapture rule does not change the reporting of income because the gain is already ordinary income. 1040e You can use the farm-price method or the unit-livestock-price method discussed in chapter 2 to figure these expenses. 1040e Example. 1040e Janet Maple sold her apple orchard in 2013 for $80,000. 1040e Her adjusted basis at the time of sale was $60,000. 1040e She bought the orchard in 2006, but the trees did not produce a crop until 2009. 1040e Her pre-productive expenses were $6,000. 1040e She elected not to use the uniform capitalization rules. 1040e Janet must treat $6,000 of the gain as ordinary income. 1040e Section 1250 Property Section 1250 property includes all real property subject to an allowance for depreciation that is not and never has been section 1245 property. 1040e It includes buildings and structural components that are not section 1245 property (discussed earlier). 1040e It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. 1040e A fee simple interest in land is not section 1250 property because, like land, it is not depreciable. 1040e Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable. 1040e To determine the additional depreciation on section 1250 property, see Depreciation Recapture in chapter 3 of Publication 544. 1040e You will not have additional depreciation if any of the following apply to the property disposed of. 1040e You figured depreciation for the property using the straight line method or any other method that does not result in depreciation that is more than the amount figured by the straight line method and you have held the property longer than 1 year. 1040e You chose the alternate ACRS (straight line) method for the property, which was a type of 15-, 18-, or 19-year real property covered by the section 1250 rules. 1040e The property was nonresidential real property placed in service after 1986 (or after July 31, 1986, if the choice to use MACRS was made) and you held it longer than 1 year. 1040e These properties are depreciated using the straight line method. 1040e Installment Sale If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. 1040e This applies even if no payments are received in that year. 1040e If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. 1040e For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale. 1040e If you dispose of more than one asset in a single transaction, you must separately figure the gain on each asset so that it may be properly reported. 1040e To do this, allocate the selling price and the payments you receive in the year of sale to each asset. 1040e Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain. 1040e For more information on installment sales, see chapter 10. 1040e Other Dispositions Chapter 3 of Publication 544 discusses the tax treatment of the following transfers of depreciable property. 1040e By gift. 1040e At death. 1040e In like-kind exchanges. 1040e In involuntary conversions. 1040e Publication 544 also explains how to handle a single transaction involving multiple properties. 1040e Other Gains This section discusses gain on the disposition of farmland for which you were allowed either of the following. 1040e Deductions for soil and water conservation expenditures (section 1252 property). 1040e Exclusions from income for certain cost sharing payments (section 1255 property). 1040e Section 1252 property. 1040e If you disposed of farmland you held more than 1 year and less than 10 years at a gain and you were allowed deductions for soil and water conservation expenses for the land, as discussed in chapter 5, you must treat part of the gain as ordinary income and treat the balance as section 1231 gain. 1040e Exceptions. 1040e Do not treat gain on the following transactions as gain on section 1252 property. 1040e Disposition of farmland by gift. 1040e Transfer of farm property at death (except for income in respect of a decedent). 1040e For more information, see Regulations section 1. 1040e 1252-2. 1040e Amount to report as ordinary income. 1040e You report as ordinary income the lesser of the following amounts. 1040e Your gain (determined by subtracting the adjusted basis from the amount realized from a sale, exchange, or involuntary conversion, or the FMV for all other dispositions). 1040e The total deductions allowed for soil and water conservation expenses multiplied by the applicable percentage, discussed next. 1040e Applicable percentage. 1040e The applicable percentage is based on the length of time you held the land. 1040e If you dispose of your farmland within 5 years after the date you acquired it, the percentage is 100%. 1040e If you dispose of the land within the 6th through 9th year after you acquired it, the applicable percentage is reduced by 20% a year for each year or part of a year you hold the land after the 5th year. 1040e If you dispose of the land 10 or more years after you acquired it, the percentage is 0%, and the entire gain is a section 1231 gain. 1040e Example. 1040e You acquired farmland on January 19, 2005. 1040e On October 3, 2013, you sold the land at a $30,000 gain. 1040e Between January 1 and October 3, 2013, you incur soil and water conservation expenditures of $15,000 for the land that are fully deductible in 2013. 1040e The applicable percentage is 40% since you sold the land within the 8th year after you acquired it. 1040e You treat $6,000 (40% of $15,000) of the $30,000 gain as ordinary income and the $24,000 balance as a section 1231 gain. 1040e Section 1255 property. 1040e If you receive certain cost-sharing payments on property and you exclude those payments from income (as discussed in chapter 3), you may have to treat part of any gain as ordinary income and treat the balance as a section 1231 gain. 1040e If you chose not to exclude these payments, you will not have to recognize ordinary income under this provision. 1040e Amount to report as ordinary income. 1040e You report as ordinary income the lesser of the following amounts. 1040e The applicable percentage of the total excluded cost-sharing payments. 1040e The gain on the disposition of the property. 1040e You do not report ordinary income under this rule to the extent the gain is recognized as ordinary income under sections 1231 through 1254, 1256, and 1257. 1040e However, if applicable, gain reported under this rule must be reported regardless of any contrary provisions (including nonrecognition provisions) under any other section. 1040e Applicable percentage. 1040e The applicable percentage of the excluded cost-sharing payments to be reported as ordinary income is based on the length of time you hold the property after receiving the payments. 1040e If the property is held less than 10 years after you receive the payments, the percentage is 100%. 1040e After 10 years, the percentage is reduced by 10% a year, or part of a year, until the rate is 0%. 1040e Form 4797, Part III. 1040e Use Form 4797, Part III, to figure the ordinary income part of a gain from the sale, exchange, or involuntary conversion of section 1252 property and section 1255 property. 1040e Prev Up Next Home More Online Publications