The Farm CPA
Paul is now part of the fourth generation in America that is involved in farming and hopes the next generation will be involved also. Through his blog he provides analysis and insight to farmer tax questions.
Question on What is a Hedge?
Jun 22, 2011
We had a reader ask the following question:
“On taxing options, you state that hedges apply to crops that you raise or feed. However, you say if you raise wheat but have no livestock an option would not be a hedge. I am confused. “
The tax definition of hedging is when a farmer has made a transaction to minimize or eliminate the risk of price action going against them. For example, a wheat farmer may purchase a contract on the futures market to sell short their wheat at $7 per bushel. This contract has locked in the price that the farmer will receive (subject to basis adjustments). By entering into this contract, if the price of wheat goes up a $1 at the elevator, the farmer will get cash of $8 per bushel but lose $1 on the futures contract for a net of $7. This is what the IRS calls a hedge.
Conversely, if a farmer only raises livestock and purchases a long contract to buy corn at $5 per bushel, they have hedged their feed costs by locking in corn at $5 per bushel (again subject to basis adjustments).
However, if a wheat farmer with no livestock operation, buys a long contract or a call option to purchase wheat at $7 per bushel, the IRS views this as not being a hedge, but rather speculation on where the price of wheat is headed. In this case, the gain or loss on the sale of this contract is considered 60% long-term and 40% short-term. If the farmer has a gain, this may work in their favor since 60% of the gain is taxed at a maximum 15% federal rate, however, if the farmer has a loss and no other capital gains, this loss is limited to $3,000 per year until it is fully used up.
This is why it is extremely important for a farmer to know what is a hedge and what is not for tax purposes and how it can affect them.