Income from farming can vary substantially from year to year based on a number of factors including weather conditions, crop yields, and market prices. When your income is high in one year, you may be pushed into a higher tax bracket. By using income averaging you can apply part or all of that income to lower tax brackets in the three prior years when your income was lower. This averaging method may save you money on your overall taxes.
Who qualifies for farm income averaging?
For federal income tax purposes, you can be in the farming business either as an owner or tenant. Farming includes the cultivation, operation, or management of a stock, dairy, poultry, fish, fruit or truck farm, or a plantation, ranch, range, or orchard. You can use income averaging for any year you are engaged in a farming business. And it is not necessary that you were in the farming business in the three prior years in order to qualify. You can be in the farming business as an individual, a partner, or a shareholder in an S corporation. But a partnership or S corporation itself cannot use farm income averaging. If your filing status changed, for example if you are married filing jointly this year but were single in one of the prior years, you can still use income averaging.
How farm income averaging works
When you choose to use income averaging you first determine which farm income you want to have taxed at base year rates. This income is called “elected farm income”. The base years are the three prior years. Elected farm income cannot include gain on the sale of land, development rights, or grazing rights. You can include gains on the sale of other farm property in elected farm income if you used the property “regularly for a substantial period in a farming business”. If the income you designate as elected farm income includes both ordinary income and capital gains, you have to allocate an equal portion of both to each base year.
You do not have to include all your farming income in the income averaging calculation. How much you should include depends on your tax brackets for the current year and the three previous years. For example, you may want to include the amount of income that pushes you into a higher tax bracket for the current year.
The income averaging calculation is done on Schedule J. When you use income averaging you do not have to go back and file amended returns for the three prior years. The income averaging calculation on Schedule J takes into account the taxable income you reported in the three prior years and adjusts your tax for the current year. So, to complete Schedule J you need copies of your tax returns for the three prior years.
Your elected farm income can include amounts you report on different forms for the current year. For example, if you receive a salary or wages as a shareholder in an S corporation working on a farm, you could include the corresponding amount from line 7 of Form 1040. You could include all or part of the farm income you report on Schedule F. If you received farming-related rent income you could take that amount from Schedule E. If you had a gain on the sale of farming property (other than land and rights) that amount would come from Schedule D.
On Schedule J you deduct your elected farm income from your current year taxable income and add one-third of it to the taxable income for each of the three prior years. Then you recalculate your tax for the current year and each of the three prior years. If income averaging works to your benefit, this calculation should result in a lower tax for the current year than if you calculated your tax using the regular method (tax tables or tax rate schedule).
Effect of farm income averaging on other tax calculations
Subtracting your elected farm income and including it in the income averaging calculation on Schedule J does not affect other tax calculations for the current year. These other calculations include the self-employment tax and the alternative minimum tax. Income averaging does not change the classification of your capital gains as short-term or long-term, does not affect the limitations on itemized deductions or credits based on your adjusted gross income, and does not affect any net operating loss or net capital loss carryovers.
If your farm income is substantially higher one year compared to previous years, it may be to your advantage to go through the income averaging calculation and see whether it results in a lower overall tax. If you use tax software to prepare your return, this calculation might be taken into account. But you should review your return to be sure. If you determine that you could have saved money on taxes by income averaging in a previous year, you can file an amended return to claim a refund. The deadline for filing an amended return for a refund is three years from the date you filed the original return or two years from the date you paid the tax, whichever is later.
Income Averaging – Wisconsin Berry Growers Association
Income Averaging for Farmers – farmdoc – University of Illinois
Instructions for Schedule J – Internal Revenue Service
Publication 225 – Farmer’s Tax Guide – Internal Revenue Service
Schedule J – Income Averaging for Farmers and Fishermen – Internal Revenue Service