If you own a farm or work for a farming business, there are specific requirements in the Internal Revenue Code that spell out how you must report farming income and expenses. Those expenses include interest.
This article is the fourth in a series on the deductible business expenses associated with farming. The previous articles on deductible expenses covered Prepaid Farm Supplies, Prepaid Livestock Feed, and Hired Labor.
You can deduct as an expense the interest you pay on mortgages and other obligations you incur as a result of your farm or farming business. The type of accounting method you use affects how you determine deductible interest.
Under the Cash Method of accounting, you can deduct interest paid during the tax year. You cannot deduct interest paid using funds borrowed, advanced, or otherwise provided by the original lender using a loan. In such cases, you can deduct interest paid on the new loan.
In addition, you cannot deduct prepaid interest, that is, interest paid before the year in which it is due. You can only deduct interest paid in advance in the tax year when it is due.
Under the Accrual Method of accounting, you can deduct only interest accrued during the tax year. You cannot deduct interest paid to another person who uses the cash method of accounting until both of the following have occurred:
- the payment is made to the other person
- the payment is includable in the gross income of that person
Allocation of Interest
If you use the proceeds from a loan for more than one purpose, you must allocate the interest on the loan based on the use. You should allocate interest into the following categories:
- Investment interest
- Passive activity interest
- Personal interest
- Portfolio interest
- Trade or business interest
Typically, you allocate interest in the same manner as the allocation of the loan proceeds. You allocate loan proceeds by tracking the specific disbursements at the time of use.
For secured loans, the allocation of the loan proceeds and the related interest is not affected by the type or use of the property used to secure the loan.
For example, if you use farming property to secure a loan and then use the loan proceeds to purchase a car for personal use, you must allocate the interest for personal use. In this example, the interest is not deductible, because the proceeds were used to purchase a personal item. The fact the loan was secured by farming property does not make the interest deductible.
For a secured loan where the property is your home, you typically do not need to allocate the loan proceeds and interest, because the interest is deductible qualified home mortgage interest.
The time period over which a loan is allocated for a particular use begins on the date the proceeds are used and ends on the earliest of the following dates:
- The date you repay the loan
- The date you reallocate the loan for another use
Proceeds not Disbursed to Borrower
In cases where the lender disburses the loan proceeds directly to a third party rather than to the borrower, the allocation of the loan proceeds and interest is still based on the use of the funds.
Who can give me further help on my income taxes?
You can work with a tax attorney to get help with your income taxes, whether it is answering questions or helping preparing and file your tax return. By completing the form below or calling the telephone number at the top of this site, you can meet with a tax attorney who specializes in your area of need, whether it is related to farming income and expenses or other matters.
Your first consultation with a tax attorney is free of charge, and all discussions with an attorney are protected by attorney-client privilege. Therefore, you have every reason to get in touch with a tax attorney today to get the help you need.
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Mark has been a contributor to legal web sites related to bankruptcy, tax, and criminal law since 2011. He has an Accounting degree from Texas A&M University.