We got a question from a reader today asking if you they are required to report a deduction on their income tax return. I would normally post a copy of the question here, but the details associated with this question makes that impractical.
In brief, the farmer originally reported $2,000 of interest expense as interest income by mistake and when they got the return back from the CPA and reviewed it, they caught the error and prepared an amended tax return to correct the error. However, when they got the amended tax return back from the CPA, they expected their gross income to decrease by $4,000 and it only went down by $2,000 since the interest expense was reported on form 4835, farm rental income. They had net passive losses, so the actual interest expense of $2,000 does not get deducted in the current year, but gets carried forward.
They had an interesting question regarding are you required to report this expense on their return. Generally, you are required to report all income and expenses associated with your farm operation. However, you have some lee-way in whether you have to deduct the expense. In some cases, such as repairs, taxes, interest, etc., you can elect to capitalize these items and either amortize or depreciate over a longer period. In other cases, you can make an argument that part of the expense is of a personal nature and not deduct that portion. Also, by capitalizing repairs, this gives you the option to take Section 179 expense of whatever amount you want to maximize your refund.
You are probably asking why would you not want to deduct an expense. There are several times when you would not want to:
- Lets say you have a couple of kids and your income for this year is not very high. By capitalizing certain items and depreciating them, you would be able to go from not getting any earned income tax credit to perhaps getting $5,000 or more just by setting these items up on the depreciation schedule.
- You may want to take advantage of the 15% or other low income tax brackets by getting your income up to that level, so your income for the next year would not go over that level.
Here is a quick example of how this works. Say we have a farmer who has net farm income of $35,000 before deducting a large repair of $35,000. If they deducted the repair in full, they would owe no tax, however, they would get no refund back either. If they capitalize the repair and elect to take Section 179 expense of lets say $7,500, they will still not owe any tax, however, they now get an earned income tax credit of $5,000 as a tax refund.
You must be careful to not simply ignore the expense on the return since the IRS, on audit, can report the expense and reduce your tax refund if you were trying to manipulate the earned income tax credit.