How to Use Farm Income Averaging on Your Tax Return
Manage income volatility by applying a portion of a high-income year to the three prior tax years, which can result in a lower current tax liability.
Farm income averaging is a tax management strategy for individuals in the agricultural sector to smooth out income fluctuations. A profitable year can push a farmer into a higher tax bracket, resulting in a large tax bill. This method allows a portion of the current year’s high income to be spread over the three preceding, less profitable years, which can lower the overall tax liability for the current year.
Determining Eligibility
To use farm income averaging, an individual’s activities must qualify as a “farming business.” This definition centers on the cultivation of land or the raising of agricultural commodities and requires direct involvement in the production process. Qualifying activities include operating a plantation, ranch, or orchard, as well as raising livestock or producing crops, fruits, or nuts.
Certain activities, while related to agriculture, do not meet the definition for this purpose. For instance, providing services like contract harvesting, where you are paid to harvest a crop grown by someone else, is not a qualifying activity. Income from veterinary services does not count, and neither does a business that primarily buys and resells plants or animals raised by another entity.
The income being averaged must be from the qualifying farming business, including proceeds from the sale of crops, livestock, or business assets. Income from land leased to a tenant farmer also qualifies if payments are based on a share of the tenant’s production, not a fixed cash rent. This arrangement must be established before the tenant begins their farming operations.
Information Needed for the Calculation
The calculation involves two concepts: “elected farm income” (EFI) and the “base years.” The base years are the three tax years immediately preceding the current one. The EFI is the amount of your current year’s farm income that you choose to average; you are not required to average all of it. This amount cannot exceed your total taxable income for the current year.
You will need your completed tax returns for the three base years to identify the taxable income for each. You also need your current year’s completed return to determine your total taxable income and total farm income. This information is used for the calculation on IRS Schedule J, “Income Averaging for Farmers and Fishermen.”
On Schedule J, you will input the taxable income from the three base years, your current year’s taxable income, and your chosen EFI. The form then guides you through distributing one-third of your EFI to each of the three base years.
You will recalculate the tax for each base year with the newly increased taxable income. The sum of the recalculated taxes for the base years, plus the tax on your current year’s income (minus the EFI), is your total tax liability. This process shows if using Schedule J results in a lower tax than your standard calculation.
Making the Election on Your Tax Return
To formally make the election, the completed Schedule J must be attached to your primary tax form, such as Form 1040 or Form 1040-SR. This attachment officially informs the IRS of your choice to use this tax provision.
The result of the Schedule J calculation directly impacts the final tax you owe. The total tax figure computed on the form is transferred to the appropriate line on your Form 1040. This replaces the tax amount you would have otherwise calculated without income averaging.
The election can be revoked by filing an amended tax return for the year the election was made. You must use Form 1040-X, “Amended U.S. Individual Income Tax Return,” to recalculate your tax without using Schedule J. A statement explaining the reason for the change must be attached.