Rental of Jointly Owned Farmland 



It may be possible for a farmer to pay rent to a co- 

 owner spouse on land used for farming. The purpose is to 

 reduce the income subject to self-employment tax. The farm 

 income is reduced by the amount of the rent payment and 

 the spouse reports the rental income on Schedule E where 

 it does not attract self-employment tax. Note: it may not 

 always be advantageous to reduce self-employment taxes 

 since social security benefits may also be reduced. 



The view of the IRS is that a deduction for rental ex- 

 pense is allowable only if the arrangement between spouses 

 is a bona fide landlord-tenant relationship. This would 

 require, among other acts, that the spouse owner avoid 

 material participation in the farm business (for definition, 

 see later section), that he or she issue Form 1099 for all 

 rent payments, that a formal written lease be executed, that 

 rents be at market rate and be paid regularly, and thus the 

 receipts be kept in a separate account. If the landlord spouse 

 is the sole owner, mortgage interest and property taxes 

 should be paid from a separate account. The spouse opera- 

 tor can be a co-owner (see the case of Cox vs Commis- 

 sioner described below) but a better situation would be pre- 

 sented if the operator was strictly a non-owner tenant. 

 Transactions between family members are likely to at- 

 tract close scrutiny by the IRS. Where the spouses are 

 co-owners, the IRS is most likely to disallow the rental 

 deduction, despite the Tax Court ruling in the Cox case. 



In the Cox case, the husband, an attorney, rented space 

 in a building owned by himself and his wife as tenants by 

 the entirety. They reported rent of $18,000 on Schedule E 

 and mortgage interest deductions on the same form. The 

 husband reported deductible rental expenses on his Sched- 

 ule C. Because tenancy by the entirety is a separate le- 

 gal entity (the marital community) the Tax Court allowed 

 the wife to report one half of the $18,000 as income and 

 the attorney to deduct $9,000 rental expense. He cannot 

 deduct the other one-half because of his equity interest in it 

 (I.R.C. § 1 62(a) allows a deduction for all ordinary and nec- 

 essary expenses incurred to carry out a trade or business 

 including "(3) rentals or other payments required to be made 

 as a condition to the continued use or possession, for pur- 

 poses of the trade or business, of properly to which the 

 taxpayer has not taken or is not taking title or in which 

 he has no equity"). [Sherman and Maxinc M. Cox vs Com- 

 missioner, 66 TCM, July 22, 19931 



Form 4835 or Schedule F? 



Landowners who pay a share of the expenses of the 

 farm or who receive a part of the crop as rental payment 

 hut who do not materially participate in the business of 

 farming must file Form 4835. A landowner in the business 

 of farming files Schedule F and is subject to self-employ- 

 ment tax. A taxpayer filing Form 4835 who received con- 



servation reserve payments would generally not pay self- 

 employment tax on them. The same taxpayer would gener- 

 ally be subject to passive activity rules that limit the deduc- 

 tion of losses. [I.R.C. § 1402(a)(1)] 



Confused about Material Participation Rules? 



There are two sets of material participation rules. A 

 taxpayer who is materially participating for the purposes 

 of self-employment tax may or may not be materially par- 

 ticipating for the purposes of passive activity loss rules. 

 The reverse is true: a taxpayer who materially participates 

 for the purposes of passive activity loss rules may not be 

 materially participating for the purposes of self-employ- 

 ment tax. 



The Farmer's Tax Guide (IRS Publication 225) lists 

 the tests of material participation of a farm-landlord to de- 

 termine whether or not self-employment tax must be paid. 

 You are materially participating if you have an arrange- 

 ment with your tenant and you meet one of the following 

 tests: 



Test No. 1. You do any three of the following: (1) pay or 

 stand good (e.g., sign for materials bought on 

 credit) for at least half the direct costs of pro- 

 ducing the crop; (2) furnish at least half the 

 tools, equipment, and livestock used in pro- 

 ducing the crop; (3) consult with your tenant; 

 and (4) inspect the production activities peri- 

 odically. 

 Test No. 2. You regularly and frequently make, or take 

 an important part in making of. management 

 decisions substantially contributing to or af- 

 fecting the success of the enterprise. 

 Test No. 3. You work 100 hours or more spread over a 

 period of 5 weeks or more in activities con- 

 nected with crop production. (Note: these 

 numbers do not appear in either the tax code 

 or the regulations.) 

 Test No. 4. You do things which, considered in their to- 

 tal effect, show that you are materially and 

 significantly involved in the production of the 

 farm commodities. 

 If you pass the test for material participation you file Sched- 

 ule F and arc subject to self-employment tax on the in- 

 come. [I.R.C. §1402. Treas. Reg. §1402(a)-4(6) gives six 

 examples] 



Material participation for the purposes of passive ac- 

 tivity loss rules can be met by passing one of the following 

 seven conditions: 



( 1 ) The individual participates in the activity for more than 

 500 hours during the tax year; 



(2) The individual's participation in the activity for the 

 taxable year constitutes substantially all of the partici- 

 pation in such activity of all individuals (including in- 

 dividuals who are not owners of interests in the activ- 



22 



Fruit Notes, Winter, 1995 



