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DEEPYIELDTAX STRATEGIES

Farm Income Averaging (Schedule J): Who Can Use It and How It Works

Short answer: Farm income averaging lets an individual with income from a farming business elect to figure the year's income tax on Schedule J (Form 1040) by averaging all or part of that farm income over the previous 3 years, called the base years. Individuals, partners in a partnership and shareholders in an S corporation who are engaged in a farming business can use it. The partnership, the S corporation, corporations, estates and trusts can't. Whether it changes anything depends on your income history, so ask your CPA to figure the tax both ways.

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1. Who can use Schedule J?

Publication 225 says you can use income averaging for any year in which you were engaged in a farming business as an individual, a partner in a partnership, or a shareholder in an S corporation. A few details from the IRS:

  • Employees: services performed as an employee are disregarded in deciding whether you're engaged in a farming business. If you're a shareholder of an S corporation engaged in farming, you may treat compensation from the corporation that's attributable to the farming business as farm income.
  • Entities: corporations, partnerships, S corporations, estates and trusts can't use income averaging.
  • Base years: you don't need to have been engaged in a farming business in any base year.
  • Filing status: you can still average farm income even if your filing status isn't the same as in the base years. Publication 225's example is a married couple filing jointly who filed as single in all of the base years.

2. What counts as a farming business?

The Schedule J instructions define a farming business as the trade or business of cultivating land or raising or harvesting any agricultural or horticultural commodity. That includes operating a nursery or sod farm, raising or harvesting trees bearing fruits, nuts or other crops, and raising, shearing, feeding, caring for, training and managing animals. It doesn't include contract harvesting of a commodity grown or raised by someone else, or merely buying or reselling plants or animals grown or raised by someone else.

Landowners who lease: leasing land to a tenant engaged in a farming business counts only in one case. The lease payments must be based on a share of the tenant's production (not a fixed amount), and they must be set under a written agreement entered into before the tenant begins significant activities on the land. (Schedule J also covers fishing businesses; this page sticks to farming.)

3. What income can you elect to average?

Your elected farm income is the amount of taxable income from farming that you choose to include on Schedule J, line 2a. The IRS rules:

  • It includes all income, gains, losses and deductions attributable to your farming business.
  • It can include gain or loss on farm property other than land that was used regularly in the farming business for a substantial period. Whether that's the case depends on all the facts and circumstances.
  • If you liquidate the farming business, gains or losses on property sold within a reasonable time after operations stop can count. Publication 225 says a period of 1 year after stopping operations is a reasonable time.
  • It doesn't include gain or loss from the sale or other disposition of land, or from the sale of development rights, grazing rights and other similar rights.
  • It can't be more than your taxable income, and any part that comes from a net capital gain from farming can't be more than your total net capital gain.
  • You don't have to include all of your farm income. The instructions say the amount to include depends on how it affects your tax bracket for the current year and the prior 3 years.
  • Other income: elected farm income comes only from your farming business, and it can't be more than your taxable income. If you also have a high-paying career or another business, that income isn't elected farm income, but it does affect your tax brackets in this year and the base years, and those brackets decide whether averaging changes anything.

The instructions list forms where farm income may be reported, including Schedule F, Form 4835, Schedule E (Part II), Form 4797, Schedule D, Form 8949 and Schedule C.

4. How the base years work

Publication 225 describes the mechanics: you subtract your elected farm income from this year's taxable income and add one-third of it to the taxable income of each base year to determine the tax rate to use. Some details:

  • If the elected amount includes both ordinary income and capital gains, you use the tax rates from each base year on an equal portion of each type.
  • If a base year's taxable income was zero because deductions were more than income, you may have negative taxable income for that year to combine with your elected farm income.
  • If you used Schedule J in one of the base years, the Schedule J instructions take that year's starting figure from the earlier Schedule J instead of the original return.
  • Spreading the income to the base years doesn't change other tax figures, such as your self-employment tax, how section 1231 transactions net out, or any net operating loss or capital loss carryover.
  • Income averaging applies to the regular tax. It isn't used when figuring the alternative minimum tax on Form 6251.

5. When can the election be made or changed?

Publication 225 says you use income averaging by filing Schedule J with your timely filed return for the year, including extensions. You can also use it on a late return, or use, change or cancel it on an amended return, if the time for filing a claim for refund hasn't expired for that election year. Publication 225 adds that you generally must file the claim within 3 years from the date you filed the original return or 2 years from the date you paid the tax, whichever is later. Your CPA can tell you which years are still open.

6. Records to have ready

  • Copies of your original or amended returns for the 3 base years. The Schedule J instructions say Form 4506 requests copies (there's a fee) and Form 4506-T requests a free transcript.
  • Any Schedule J you filed for one of the base years.
  • This year's farm schedules and forms, such as Schedule F, Form 4835 or Form 4797.
  • A copy of this year's return. The instructions say to keep it for income averaging in the next 3 years.

Where DeepYield fits

DeepYield is a second set of eyes, not a replacement for your CPA. A free two-year look-back is a review of your last two years of tax returns, done for you, then a 30-minute call to walk through what we found. For anyone with farm income, including alongside a career or another business, that review includes whether Schedule J was considered in a year with farm income and how the elected amount was figured. We go looking for what's missing, and what we find can go to your CPA too. Sometimes the review ends with nothing to change.

Related: Year-End Tax Planning for Farmers and Ranchers · Tax Planning for High-Income Earners

Request your free two-year look-back →

Frequently asked questions

Who can use farm income averaging?

Publication 225 says you can use income averaging for any year in which you were engaged in a farming business as an individual, a partner in a partnership, or a shareholder in an S corporation. You don't need to have been farming in any of the 3 base years.

Can a farm partnership, S corporation or trust file Schedule J?

No. Publication 225 says corporations, partnerships, S corporations, estates and trusts can't use income averaging. Partners and S corporation shareholders who are engaged in the farming business can use it on their own individual returns.

Does a gain on selling farmland count as elected farm income?

No. Elected farm income doesn't include gain or loss from the sale or other disposition of land, or from the sale of development rights, grazing rights and other similar rights. A gain or loss on other farm property can count if the property was used regularly in the farming business for a substantial period, which depends on the facts.

Does cash rent from farmland count?

Only in some cases. The Schedule J instructions say leasing land to a tenant engaged in a farming business counts only in one case. The lease payments must be based on a share of the tenant's production (not a fixed amount), and they must be set under a written agreement entered into before the tenant begins significant activities on the land.

Can I use Schedule J on an amended return?

Publication 225 says you can use income averaging on a late return, or use, change or cancel it on an amended return, if the time for filing a claim for refund hasn't expired for that election year. Your CPA can tell you whether that window is still open for a given year.

Does income averaging change my self-employment tax?

No. Publication 225 says the allocation of elected farm income to the base years doesn't affect other tax determinations, and it lists the amount of your self-employment tax among the items figured before that allocation.

Is farm income averaging worth running?

Whether it changes anything depends on your income history in the current year and the 3 base years, so ask your CPA to figure the tax both ways.

Sources

Results depend on your specific facts. No outcome is guaranteed. This is general information, not tax advice; advice is provided only under a signed engagement.

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