There are two big topics that you will only really find on a farm tax return. Financial losses and inventory are treated differently for farm businesses than for other businesses.
Farms have a couple of unique accounting and tax guidelines. Today I will cover the differences between restricted and unrestricted losses as well as mandatory and optional inventory. Some other day we’ll talk about how farms are the only businesses allowed to report using cash basis accounting.
A loss is when your revenue is lower than your expenses. Losses happen but besides the cost, they also present an opportunity for some individuals to use a business loss to offset other income. To reduce the chances of a loss being abused, the CRA has restricted and unrestricted losses. If you are running a farm business and working off-farm at the same time, there is a chance that the restricted loss rules will apply to you in the event that your farm business had a loss in the given tax year.
If you only have your farm business, you can report the loss as is and there are no further considerations for you from a tax perspective. However, if you have more than one source of income, the restricted loss situation might occur.
If your primary source of income is neither from farming nor from a combination of farming and some other source of income, you can only deduct a portion of your farm loss for the year. This means that if your farm is not large enough to be considered an active farming operation, and most of your income comes from a T4, you will need to restrict the loss. This only applies to partnerships and sole proprietorships.
The maximum amount you can deduct as a loss is $17,500. This would require $32,500 in actual farm losses to receive the maximum deduction as allowed farm losses are the full first $2,500 and 50% of the next $30,000. For net farm losses greater than $32,500, the deductible portion of the farm losses will be capped at $17,500.
The portion of the loss that you cannot deduct becomes a restricted farm loss (RFL). You can carry an RFL incurred in tax years ending after 2005, back 3 years and forward up to 20 years. However, the amount you can deduct in any year cannot be more than your net farming income for that year.
The RFLs that you incurred in your farming operation can apply part of these RFLs against any capital gain you may have when you sell your farmland. There are limitations to this and detailed calculation.
In short, you can not use an RFL to create a loss in any situation, only to reduce your net income or capital gain from selling farmland.
There are a number of ways that you might end up being required to report a restricted loss:
- Your gross annual farm revenue is less than $7,000
- You are the off-farm working half of a farming couple
- Your T4 is the majority of your income
- The farm is not large enough to be considered commercial (as in its a hobby farm)
- Your loss seems excessive to the size of your operation
Overall, it’s best to seek the advice of your accountant if you are not sure if you might have to restrict the loss. Failing to report a restricted loss and then getting a review can lead to more than one year getting readjusted. The purpose of the restricted loss is to prevent people from using a farm loss as a way to reduce their taxes considerably.
Inventory is all of the supplies and animals you have on hand at your year-end. If you are using the cash method to report your financials, you will probably have to do a mandatory inventory adjustment on your tax return if you are reporting a loss. This applies to sole proprietorships, partnerships and corporations. On December 31st, you should make an inventory count of everything you have on hand.
If a farm is in a loss, buying inventory related items (fertilizer, chemicals, feed and livestock) shortly before year-end is going to have a net-zero effect as the mandatory inventory applies in a loss situation.
Mandatory inventory adjustments (MIA) are required when a year results in a net loss instead of income. If this occurs, you’re required to add the value of your purchased inventory still on hand at year-end to your income at fair market value. You’ll need to add the lesser of the value of purchased inventory or the amount of the loss to the income.
You will have to calculate the mandatory inventory when both of these conditions are met:
- There is a loss from the farming business in the year as calculated with the cash method before optional inventory adjustments, and;
- There is inventory owned in connection with the farming business at the end of the year that had been purchased by the farmer (as in purchased supplies and livestock on hand).
The amount of the mandatory inventory adjustment is the lesser of the loss described in point 1 and the value of the inventory in point 2. The mandatory inventory adjustment has to be deducted in the following year. Generally, inventory for purposes of the mandatory inventory adjustment will be valued at the lesser of the total amount paid by the farmer to acquire the inventory and its fair market value.
Optional inventory adjustments (OIA) can be used to increase your net income to take advantage of non-refundable tax credits and further reduce any losses. You can also use it to increase income in one year if you know you will have much higher income the next as the adjustment gets deducted in the following year. This can be useful if you have a lot of inventory on hand right before year-end that you plan to sell right after. The OIA does not have to be purchased inventory. The maximum OIA is the difference between the fair market value and the mandatory inventory adjustment.
If your farm business ends up having a loss in a tax year, you need to carefully consider your sources of income. You might have to report a restricted loss. You should always track your inventory as you might have to make an adjustment at year-end.
Please remember, all of this is just guidelines and it is always best to consult an accountant if you are unsure when it comes to taxes. Happy Tax Season!