Many more farmers are using futures contracts to hedge their crops these days than 20 or 30 years ago. Hedging income and losses are treated as ordinary income or loss as part of the farming operation. What many farmers do not know is that if they are using futures to speculate in other commodities or crops that these transactions are considered speculation and the income tax treatment is very different. If a farmer is speculating, then these losses are treated as capital gains and losses.
I will give you an example from when I was in college. I had a very good friend that was speculating in the commodity market. During year #1, he enjoyed a very profitable year and lets assume he made $300,000. All of these gains were short-term and at that time, the top rate was 50%. Therefore, his tax bill from his speculation that year was $150,000. During year 2, he lost the $300,000 he made in year 1 and then lost another $300,000. When he filed his tax return for year 2, he deduction, the net loss of $600,000 on the return, but the capital loss rules limit you to only claiming a net capital loss each year of $3,000. Therefore, he got a credit of $1,500 for year 2. Adding the two amounts together resulted in net tax due of $148,500.
If he had all of the transactions in one year, he would have gotten a net refund of $1,500. As you can see, if your capital gain income occurs earlier than your losses, the tax laws provide a large penalty to taking advantage of any future capital losses. You can use $3,000 each year or use your capital losses to offset other capital gains.
In your farm operation, make sure to note what is actually hedging and what might be speculation and subject to the rules above.