What Is Considered a Passive Activity Loss By the Internal Revenue Service?
Updated: Jul 2, 2020
This post originally appeared in the Lancaster Farming on April 1, 2016.
This should not be construed as legal or tax advice.
Since this is tax season, I’m focusing today on when a landlord with a crop-share lease can deduct losses from the farming operation. The Internal Revenue Code limits a taxpayer’s ability to deduct losses from certain passive activities unless the taxpayer materially participates in the operation. In Leland v. Commissioner of Internal Revenue, the U.S. Tax Court dealt with a cash-share landlord deducting losses from his taxes. The Internal Revenue Service (IRS) had found losses deducted on the landlord’s taxes to be passive losses in two tax years.
Let’s look at the facts of the case. The landlord lived in Mississippi and owned farmland in Texas which was crop-share leased to a local farmer. Landlord routinely traveled to Texas to perform maintenance work on the farmland. Landlord worked to maintain roads on the farm by brush hogging and discing the roads, spraying trees near roads, and planting wheat on the roads to maintain them. Wild hogs were also a problem on the farm, and landlord routinely spent time controlling the wild hog population. Lastly, the landlord also worked to maintain farm equipment and the small travel trailer he stayed in when visiting the farm.
The landlord, in this case, did not keep records of his time spent on the farms for the two tax years but was able to reference his calendar and credit card receipts to develop the records for the tax court. According to those records, he estimated he spent between 200 to 350 hours on farm-related activities in the two tax years (2009 and 2010), compared to the approximate 30 hours per year in 2009 and 2010.
How does the IRS determine material participation? According to IRS regulations, material participation in a farm operation is determined when a taxpayer can meet one of seven options the IRS has developed as a test. If the taxpayer is materially participating, then the taxpayer can deduct losses from the operation on his/her taxes. If the taxpayer does not meet any of the seven options in the material participation test, then the activity is considered passive, and the taxpayer cannot deduct these expenses.
In Leland, the landlord felt he had met the requirement showing he had participated more than 100 hours during the tax year, and that participation was not less than any other individual’s participation in the operation. In applying this test, the Tax Court found that the landlord had fully satisfied the test and had not materially participated less than the tenant had in the operation. The records provided by the landlord to prove this material participation in the operation were also reasonable. The landlord had utilized his work calendar to show dates he had traveled to Texas to work on the farm and produced receipts to show the work performed while on the farm. The Tax Court allowed the deductions for the landlord for the two tax years.
Why care about this Tax Court decision? Material participation cases are often heavily influenced by the facts. For those landlords out there with crop-share leases, your accountant will need to take into account these provisions to determine if you are materially participating in the operation. You will also need to make sure you have developed records verifying you have completed the participation you are claiming. Developing records will potentially allow you to deduct losses from the operation on your taxes, but this will depend on the advice of your tax professional.