Depreciation Demystified
Depreciation is the reduction in the value of business equipment over time, which impacts both taxes and financial statements. Kendall Kunelius and Rebecca Dube review depreciation with Sam Stoddard from Farm Credit East. They discuss special depreciation methods, building leases, and the importance of accurate record-keeping and financial management for farmers.
Guest Samantha Stoddard, Senior Loan Officer, Farm Credit East
Show notes:
Farm Credit East: https://www.farmcrediteast.com/
Samantha Stoddard: samantha.stoddard@farmcrediteast.com
Harvesting a Profit: https://www.farmcrediteast.com/en/FINANCING/Beginning-Farmer-Programs/Harvesting-a-Profit
Cornell Cooperative Extension: https://cals.cornell.edu/cornell-cooperative-extension
UNH Cooperative Extension: www.extension.unh.edu
Generation Next at Farm Credit East: https://www.farmcrediteast.com/en/FINANCING/Beginning-Farmer-Programs/GenerationNext
SCORE: https://www.score.org/
Women in Ag Newsletter signup - https://unhoutreach.tfaforms.net/217751?CID=701G0000001AiKCIA0
Kendall Kunelius – kendall.kunelius@unh.edu
Kendall Kunelius 0:09
Welcome to this episode of Shared Soil, a podcast dedicated to creating community, honoring challenges and encouraging personal and professional growth for all people in agriculture. My name is Kendall Kunelius, and I'm a field specialist in the area of agricultural business management.
Rebecca Dube 0:24
I'm Rebecca Dube, providing technology and administrative support to UNH Extension. Well, Kendall, today's episode is called Depreciation Demystified, and I am one of those people who need to be demystified on this topic! Taxes are not my forte, as I think would be the case for lots of our listeners as well.
Kendall Kunelius 0:46
Well, I think the good news about that is depreciation doesn't just relate to taxes. There's a lot more to dig into there than just thinking about pulling something off a tax or a tax write off sheet. There's also all of our financial considerations, like for our financial sheets, that kind of stuff. But we'll get into that. I'll put a, I'll put a pin in that. We'll get into it.
Rebecca Dube 1:05
Good. Well, I'm really glad that we have Samantha Stoddard from Farm Credit East with us today to talk about this mystifying topic. Sam, could you tell us a little bit about what you do and what Farm Credit East offers farmers?
Sam Stoddard 1:19
Certainly. Thank you for having me. Farm Credit East is a member-owned cooperative of farmers, fishermen and forestry professionals. And we work with those people to offer them loans, leases, and also financial services such as tax preparation, tax planning, record keeping and appraisal services, and even some consulting services, which can be for taxes, but it can be also for generational transfer or expansion plans.
Rebecca Dube 1:47
Well, that's a lot of great services that farmers won't necessarily have in their toolbox, but they can reach out to you to help them with it.
Sam Stoddard 1:54
Exactly. And we have a wide variety of professionals within our organization, so you may be my primary customer, or I may be your primary contact, but I don't know all the answers. I don't do taxes anymore, but I have been educated on how to do them, and I know a little bit about the topic of today's conversation - depreciation - because I have that tax experience. And then I also work with customers to help them understand the depreciation that they have, what is the functional life of equipment, and how that impacts their taxes and also their balance sheets.
Rebecca Dube 2:29
Oh, fantastic. Then, can you give us a working definition of what depreciation is? Why does it matter that we have an understanding of depreciation when it comes to making purchases in our daily lives?
Sam Stoddard 2:41
Certainly. So depreciation is the value of the equipment, and it's useful for business only. So if you bought a personal car, yes, it has some depreciation. When you go to resell it, you'll understand that you're not going to get what you paid for it. But from a tax perspective, personal items are not depreciated. It's only has to do with your business items. So that's your tractors. It could be equipment that you use in a commercial kitchen or retail store. All of those things that you purchase for your business can be depreciated, and depreciation has the useful life of the equipment. So for software or computer systems, electronics of that nature, the useful life, the depreciation period, is usually short - three years - because if you've ever bought a cell phone after three years, they don't work as well anymore, and you have to get new ones. For tractors or balers or other types of equipment, the useful life is usually five to seven years. And with a depreciation a tax depreciation schedule, it allows you to write off part of that cost over what the IRS considers to be the useful life, life of the equipment. So that means that if you bought a tractor for $100,000 the useful life is usually seven years, and so you can take approximately 1/7 of the cost over a number of years, over seven years. Your question might be, why would you want to depreciate over seven years versus expensing it over one? And the tax code is great because it allows you to do both, or let me rephrase that. It allows you to do one or the other. So if you have a loan on a piece of equipment, and the loan is seven years and the depreciation schedule is seven years, you may want to depreciate it over that full seven year period, so that when you are paying, making your loan payment, you're paying principal and interest. Interest you can expense, principal, you don't. So if you depreciate it over the same period as your loan, your depreciation deduction is usually similar to the loan principal payment. So at the end of the seven years, you have no loan and you have no depreciation left. There's also what we call special depreciation. It's two types of special depreciation. One is called Special Depreciation, and that allows you to deduct either 30% or 50% of the cost upfront. So that is useful if you made a down payment, but then want to depreciate the remainder over the period of your loan. And then there is another depreciation called Section 179 Depreciation. And that one is very flexible. It allows you to depreciate initially, or expense initially, any amount of the cost of the equipment, from zero to 100%, up to certain really high levels, and you can use that to immediately decrease your taxable income. Now, some people have an aversion to paying taxes, and so they want to depreciate everything upfront, all at once. And that can be useful, but then when you get to the next year, you don't have any depreciation, and you have to pay your taxes on all of your income after expenses, and so depreciation is useful to allow you to figure out how to manage your taxes this year versus next year and the year after.
Kendall Kunelius 6:14
So that, okay, wait, I just had like a million questions pop up in my brain about everything you just said. Okay, I'm gonna slow down and think how I'm gonna start this. So yeah, the 179, what this really makes me think of is a beginner farmer, somebody just getting into farming, versus someone who's been in farming for like, 10 plus years, right? We're kind of playing that intentionality around the long game, versus growth, versus our income projections. And for me, all this boils down to is record keeping. How good am I at keeping my expenses, my receipts? Well, one of the things I see the most from my work as an ag business person, I don't see farmers separating their personal and business expenses. A lot of the times it goes on the same card, because farmers don't necessarily pay themselves a paycheck. They kind of just, I don't want to use the word shrink, but like in technical terms, I think this is where shrink applies. If you're harvesting 50 chickens, and 10 of those go into your freezer, because that was your plan is, you know, to sell 40, keep 50. That is technically shrink, but it, I think, still applies to a farmer purchasing things off the business, because they are really using it for the business, but it is also a personal expense. So I think sometimes the record keeping piece gets murky. And I also wonder how, how you might suggest to a farmer a good record keeping system, which then also informs how they would choose to depreciate something based on paying a lot of taxes versus paying nothing. And I know that's a huge question to ask. I'm so sorry, but I'm just like, kind of want to get us down into this mindset that's just like, Hmm, you know, really being strategic around the idea of depreciation.
Sam Stoddard 7:50
Certainly. And I will try to answer both of those questions in a straightforward manner.
Kendall Kunelius 7:54
Thank you, because it was not a straightforward question!
Sam Stoddard 7:57
So we'll start with the record keeping portion of it. So a lot of our customers use QuickBooks or QuickBooks Online, but you can also do that with an Excel spreadsheet, if that is your preferred, or a paper ledger. It doesn't matter how you keep the records. What matters about your record keeping is that a you keep them, you keep them up to date, and they are accessible. If you are giving your records to someone else to do your taxes, they would prefer in some sort of electronic form, which can be QuickBooks Online, or it can be an Excel spreadsheet, as opposed to your shoebox or a paper ledger. And the reason for that is you can not manipulate but you can change things. You can search for items to figure out, okay, what is truly an expense, what is a personal expense that I need to discount and then find the things that you bought so that you can figure out your depreciation. So if you're have one set of books for both personal and your business, and my parents grew up with one set of books, so I understand how that works. A lot of smaller farmers and old time farmers, people who have been farming for a really long time, have one set of books. And so what you need to do is make sure that when you categorize your expenses, you are clear on what is business and what is personal. So your grocery store is probably going to be personal, but the John Deere repair shop is going to be mostly business. And so you need to make sure you understand, are there any items which can be personal and business, and so keep a really close track of those particular items. But things that you buy at the clothing store, unless it's specific farm-related equipment, like specialized boots, steel-toed boots, or overalls, coveralls, most likely they'll be personal. But there are some that will be business, and so you need to make sure you capture what is truly business and truly personal, if you have a combined checkbook, okay? And then for the example that Kendall mentioned about, you grew 50 chickens, and 10 of them went into your freezer, and 10 of them went into the store. So for that, the IRS person would say, Well, you had your total cost - 20%, 10 of the chickens went into your freezer. So that's personal, so you should reduce your expenses by that percentage that went into your freezer.
Kendall Kunelius 10:19
Interesting. Yeah, maybe that's a good lead in to our next question, which we kind of just, we did kind of float around, but in terms of taxes, specifically, how does that depreciation come into play when you are a beginner farmer? So we work with a lot of beginner farmers and somebody who's really looking at, let's say they're getting into beef cattle, trying to, like, make a good example scenario here. So they're getting into beef cattle, and this means that they need a tractor to move their round bales and bulk feed around. But tractors are not cheap, right? That's a very large expense, and it's not necessarily risky, because tractors do tend to retain their value, but it's still a big amount of debt to be taking on, especially when you know your product, your income - your return on that is not going to be really coming in for two years by the time those cattle are grown out, unless you buy older cattle. So let's just say we're taking on a big debt load to begin with, and we're not expecting a return on that for at least two years. How would that depreciation make sense to work around for a very beginner farmer?
Sam Stoddard 11:21
So when you are in the beginning stages of farming, you are probably not generating a profit, or certainly not a large profit, unless you're very lucky and get in exactly at the right time. So you would want to, you would want to move as many of your expenses forward into other tax years. So what that means for a depreciation schedule is you would buy something this year. You buy your tractor this year. You bought it used, so maybe you paid $20,000 for it. And then you would want to take as little a depreciation this year, because you're not making a profit this year anyway, or it's very small. And of course, we have a progressive or graduated income tax, which means that your initial amount of profit is taxed at a low tax rate, and then the next segment is taxed at a little bit higher tax rate. So when you're in the beginning stages of your business, you are in these lower tax rates. So you want to push your depreciation forward in hopes that it's better, you'll have more profit and thus be at a higher tax bracket later. So in the beginning stages, you probably would not want to do Special or Section 179 Depreciation. You would want to do regular depreciation. So you take your little bit this year, and you can look forward in future years of having depreciation to reduce your expenses and reduce your taxable income.
Kendall Kunelius 12:43
I want to return to our record keeping, the hill that we will die on, kind of thing. This is our soap box, for lack of a better term. So when I think of record keeping, I also think of financial sheets. And I think of the big three, our cash flow statement, our income or our profit and loss statement, and then, of course, our balance sheet. And the more I really dig into these as useful tools, the more I realize that I think it's kind of like a, I want to say, a titrated build up to really getting a healthy, holistic farm book or a portfolio. And I think one of the first things I would tell people to start with is your cash flow statement. You've got to know those numbers. But I feel like the balance sheet is one of those things that comes in, and it's a tool that's really only useful when you need it, and only certain times of the year. It's like a blood test, right? Your blood test is only good for the day that you took those numbers on. Same thing for that balance sheet. If you have a balance sheet that you pulled one day and then over the night, let's say, God forbid, you lost 10 of your breeding stock cattle. In that moment you lost those cattle, that balance sheet has changed, so you really have to kind of plan when you're going to pull it and the reason why you would pull it. So my question here for you is, which financial sheets does depreciation really impact? Where are we going to look for that, and then maybe any of your recommendations on how would a farmer really start to get to know a balance sheet? And I say that because I'm kind of leaking the answer where I think this depreciation is going, but yeah, just kind of talk us through your thoughts on that.
Sam Stoddard 14:14
As far as your equipment is concerned, there's two things that you want to think about, and you may have heard these terms before. There is your book value and your market value, and so depreciation will show up as an expense on your tax return. The form is form - it's called Schedule 4562, and that is where your depreciation numbers are listed on your tax return, but they ultimately show up on your balance sheet. So when you purchase equipment, you will add the cost of that equipment to your machinery and equipment. Sometimes people will specifically list their the thing they bought on their machinery and equipment, and sometimes they'll just list it as I bought machinery, and so it increases that machinery and equipment line. And then you have your depreciation, and there'll be a line under - in the same section in your intermediate or fixed assets of accumulated depreciation. And that lists all of the depreciation that you have taken over the past several years as long as you have been in business. And what's important about that is, if you bought something seven or 10 years ago, you will have a machinery value of $20,000 because that's what you paid for it, and you'll have an accumulated depreciation line that is also $20,000 because you've depreciated all of it over the past 10 years. So your net is zero. But the thing, the tractor, is worth more than zero if you were to sell it on the open market, and that is its market value. So when you go to get a loan and they ask for your balance sheet, some people will just print off their QuickBooks balance sheet. But then we will want to understand what is the market value of your equipment, because that's a lot different, and that can make you go from a zero net worth, if you just have one tractor, and you fully depreciated it, to something more. Maybe that tractor is now worth $10,000 or $15,000, so you have net worth. Your tax balance sheet will say you have a zero net worth. Your actual net worth, your market value will say you have a $15,000 net worth.
Kendall Kunelius 16:23
And so for the people like me who love a good visual of this, I loved using your resource, Harvesting a Profit, in the ag biz management class I taught. I thought it had excellent examples. And I want to put in kind of a shameless plug in this for that Harvesting a Profit resource, because it just worked so beautifully for that class, and I think it's great for folks. So maybe we could take a quick second to say, if you want to see a visual of a balance sheet, where can people find that resource?
Sam Stoddard 16:51
I know that YouTube and Google can offer you great initial resources for what a balance sheet looks like, and many Cooperative Extension programs, both in New Hampshire. Cornell Cooperative Extension also has a lot of resources for farmers. Cornell is a major player in the farm education sector. And so that would be some good initial options. Is to figure out what is a balance sheet, what's it supposed to look like, is to go online and look at various Cooperative Extension programs. Sometimes they will offer QuickBooks training. Such trainings are usually in the winter, when most farmers have more time. So now, if you're thinking about doing that, now's a good time to start looking for that. To understand all right, what can I find, what can I afford, what can I make the time for? Farm Credit actually has a program we're offering this winter, and it's called Generation Next, and it is being offered in online and in person, depending on where you are and where the classes are offered. The in person classes rotate around our area. We service customers in New York, New Jersey, and all of New England, and so we move around that area where we're offering the training. It's designed to help the next generation of managers, which doesn't necessarily need to be the farmers kids. It can be trusted managers who want to take over the business, or somebody they want to bring in to do that. And it helps them talk about production economics. So how do you farm? It talks about marketing and record keeping items and a little bit about human resources and retirement. So you can get all aspects of the business. And if people are interested in that, they should contact their local Farm Credit office and ask about Generation Next, and we can provide them with the information.
Rebecca Dube 18:39
Wow, what an amazing resource.
Kendall Kunelius 18:41
Yeah, I think one of the cool aspects that I'm hearing from that is group learning, co-learning. I wanted to share a quick story and like a little sample, if folks want to take advantage of this. From when I was teaching ag business management, I thought long and hard, like, how am I going to talk about a balance sheet? What actually makes sense to give people to think about your assets and liabilities, because sometimes not everyone is really good with Excel, not everyone has a numbers brain. Sometimes black and white can be hard. And one thing that I think farmers in particular love is that they love their animals. They love their crops. They like that it is the heart and soul of their business, right? Farmers love their tractors. They really like their employees. You know, whatever it is. I actually did an activity where I had the students make a pictorial balance sheet on the whiteboard. So I printed out a bunch of pictures, and I gave them little slips too that said, like $10,000 in cash or a construction loan for $280,000 and they had to draw on the whiteboard the structure of a balance sheet. And then they just used tape and then the pictures, and they taped what is a liability, what's an asset. And then we reordered them when we got to the point of short, medium, long term types of things. That is a fun activity for you to do with your family. Take pictures of your own assets. Take pictures of your chicken- I mean, I could do this with my chickens!. I just love pictures of my chickens anyways. But you know, if you walk around your farm and you really start to translate the visual thing, the physical thing, into the number that's on that page, that really helps you understand and stay motivated to keep those records, and you kind of understand why it's important. And if you're tracking the visual look of a thing over time, whether it's your breeding stock, cattle, whether it's your apple trees, are you improving those over time? That's a longevity type of crop. Even your tractor. What about that piece of equipment needs maintaining that you're seeing change from year to year? I think that if there's any way that you can take something that seems like a big thing, like Rebecca in your intro, you're talking about the taxes, right? They kind of seem like this big, onerous thing, or creating a financial sheet, like a balance sheet. Find a way that it's a little more digestible for you, and that keeps it a little more approachable for if you, as a farmer have trouble getting into the business aspect of things,
Sam Stoddard 20:55
Certainly that's a great way to talk about your balance sheet. At Farm Credit, we like to get balance sheets from our customers once a year, usually around January 1. That's helpful, because if a lot of our customers are in the greenhouse industry, or they might be having the turkey industry, and you know, January 1 is usually a time when they have more money and less things, because their greenhouses are empty, their turkey barns are empty. Hopefully their bank accounts are more full. When I talk to customers initially about their balance sheet, I talk about it in terms of what do you own versus what do you owe. And I've had people come to me and they list their car loan because they recently bought a car. So their car loan is $40,000 but then they didn't list their car. And I asked them about that, what does this car loan for? And they said, Well, I owe so much on it, there's really no equity in it. And I understand that, but now you have $40,000 of debt with no asset to balance it. And it's called a balance sheet because you want to if you have a loan, you should have a thing for it. The only thing that really doesn't work that way are student loans, because you have the loan of what you spent to get your education, but the education is hard to collateralize. I can't take that out of my head and give it to you and then you have that education. It doesn't work that way. So student loans are a little bit different. But car loans, equipment loans, home mortgage, real estate mortgages, they all have collateral. They all have the thing that was purchased with them, and so your balance sheet, well, this thing that you bought versus how much you borrowed to pay for it.
Rebecca Dube 22:33
Ah, wow. Thank you, Sam, that is a lot of amazing information. Can you tell me, are there any resources that you find the most helpful when it comes to understanding depreciation or any other financial term?
Sam Stoddard 22:46
Yeah, I think I would refer a lot of people to a Cooperative Extension or looking online for specific terms that you're looking for. If you are looking for a little bit deeper understanding of how financials work and what things you need to think of if you've been asked to generate a business plan and you're trying to do some projections, one thing that you can look for are SCORE mentors. We work with SCORE mentors, and we often refer some of our customers to a SCORE mentor. SCORE stands for the Service Core Of Retired Executives, and so they are people who have successfully transitioned out of whatever business they are, and now they want to give back to the community. So they are out there in the field, and they want to talk to you, figure out what it is that you want to do and what you need from a business perspective. Do you need to understand your marketing plan? Do you need to understand your business plan? How do they interrelate? When does it make sense for you to look for financing, to look for a partner to incorporate? What are the different things you can incorporate as LLC, a limited liability corporation, an S corp, which is a small corporation, a C Corp, which is a larger corporation? They can help you figure out what makes sense for your business and where you want to go. So that is a great resource, a Service Corps of Retired Executives or SCORE one of the SCORE mentors that we work with in particular is Alan lamb. He's based out of Maine, but he used to work with Farm Credit, so he's very well versed in what Farm Credit or what another lender would want to understand about your business.
Rebecca Dube 24:21
Wow, that's fantastic. Is there any other topics that you want to discuss with us in regards to depreciation?
Sam Stoddard 24:30
Sure, one of the things that many people don't understand is how a building lease can affect your depreciation and your transitional plans. Many people think, oh, I want to build this thin. I need a loan for, and I'll pay off the loan in a certain amount of time. If you have strong cash flow and can afford to pay off that building loan in a shorter amount of time - And by shorter I mean 10 years, as opposed to 20 years for a building. You can get a building lease for that. There are many advantages to a building lease, and some of those advantages also apply to an equipment lease, but we're going to talk about building leases right now. So if you spend $100,000 on a very small building - I did a building lease for two million so there's definitely a lot of room in a building lease that you can use. So in this one particular example, they wanted to build a barn for some livestock, and the business took it as a building lease. So they leased the cost of it, which meant that the business had to make the payments on the lease, which was considered rent for a five-year period. At the end of that five-year period, they could buy the building from Farm Credit Leasing, because Farm Credit Leasing was the owner of that building. And so then you buy it at a predetermined amount, which is usually 15 to 20 to 25% of the overall cost of the building. So when you put that on your taxes, the initial 75% of those building payments were rental payments, as opposed to depreciation. And then when you buy the building, you can have the business buy the building, or if you are in a partnership, and you have an older partner and a younger partner, and the younger partner can buy the building for that 10 to 25% of the total cost. He then gets to depreciate it. But what makes it better, more interesting for everybody, is when he goes to buy the entire property from the older partner. He already owns that building, and that building is not worth the 10% that he paid for. It's worth 100% of whatever it's worth today. So it may be worth 10% of the total cost. When Farm Credit East looks at financing a buyout of this nature, we'll want to know well, what is your equity in the property? Well, he already owns, say, one building, which could be 10% of that purchase price. And so that is a great way to help bring in younger partners. Helps them build equity in the building. Ah, another advantage to the leasing is if you didn't have a younger partner buying it in and you were just going to outright sell it. When you depreciate an object, a tractor or a building, it reduces your taxable income. Now the IRS is giving you that advantage while you're in business to reduce your taxes, but when you sell it, they want to get their share. At that time, you have a thing called depreciation recapture. And so if you bought it for 20, depreciated it all. And so now you have it's worth zero, and then you sell it. Maybe you sell it for 10, maybe you sell it for $20,000 what you pay for. Maybe you sell it for $30,000 because it's appreciated in value. Whatever amount you depreciated- so if you bought it for 20 and depreciated all 20- when you sell it for 10,000 up to 20,000 you have to recapture as ordinary taxable income the amount you depreciated. If you sold it for 30, you would recapture 20,000 and then have capital gain on the difference between what you bought it for and what you sold it for. So that extra is a capital gain, but the up to 20 is an ordinary income taxed at your ordinary tax rate. With a building lease, you rented 75% of that, so there's no recapture, because it was rent. You only recapture what you depreciated with a building lease, you only depreciated 10 to 25% of it. So that is a secondary tax strategy. It works well if you have the right situation and the right cash flow to do it.
Kendall Kunelius 28:55
So that makes me think a lot of our New England farms, especially. So land is the only asset that doesn't depreciate. And I think it's important to think about the premium that's put on farmland, ag land now, especially in New Hampshire, since we're what like 82-83% forested, and that just the remainder is what's open. And there is some forest land that is ag land, but for the sake of this conversation, thinking about connecting people who are just getting into farming with folks who are getting out of farming, that's a really interesting thought. You know, if there's a barn, an existing barn on the property, and many barns are very old, maybe not well maintained, and we need to build a new building in order to safely house our cattle, or dry our onions and garlic, whatever have you, or even a farm stand. What an interesting way to approach a succession plan, like a transition plan, that also takes into account some of the pretty common conditions that we're seeing here in the area that we live.
Sam Stoddard 29:50
We have worked on building leases, as I mentioned, from 100,000 to over 2 million, and really works well for businesses that have pretty good cash flow, because with a building lease, you are paying for it over a shorter amount of time. If you were doing an equipment lease, an equipment loan, we would do seven years with an equipment lease. We like that to be no more than five because it is a rental of the equipment. And with our leasing programs, we fully expect that you were going to buy it at the end. So it was not like a car lease, where you have a certain mileage requirement, and after three years, you trade it in for the new model. We expect eventually that at the end of the lease you're going to buy it. So therefore, we don't have any mileage requirements on our trucks, for instance.
Kendall Kunelius 30:42
Interesting. You know, the one thing we haven't touched on yet is the designation of a hobby farm versus a commercial farm. And you know, the 2022 Ag Census, the ag statistics point to the fact that roughly two thirds of what we call farms (in air quotes) in New Hampshire gross $10,000 or less. And in my brain, I kind of reason through that, and I say, okay, you know, we're a smaller state. Fair. We only have so much land, only so much production agriculture can happen. You're probably not hiring someone if you're grossing $10,000 a year, that's probably just a large market garden. Maybe that's someone that goes to farmers markets a couple weekends a month, but you're not a large scale production farm. So you know, how do we parse out this idea between that $10,000 of income, is that really farm revenue, or is that a hobby revenue? How do I figure out, where do I fit? You know, that term farm is a little bit loose in some ways!
Sam Stoddard 31:39
It certainly is. The IRS considers it an actual farm if your intent is to generate a profit, and you did indeed generate a profit in two of the last five years. If you were just growing it because you really like tomatoes, and then you sell a few on your lawn, that's a hobby. And you have to take the hobby; you have to claim that income as income. It's your hobby farm. The hobby farm rules apply to businesses who don't intend to generate profits, or certainly are not generating profits. So if you are running a farm and you spend $20,000 a year on your feed and your seeds and your fertilizer, and you sell the product every year for about $10,000 each and every year, you're losing $10,000. That is considered a hobby farm because your intention is not to generate income, not to be profitable. You have in startup operations two or three years of losses, and that's understandable. You are a startup operation. You have to intend to make a profit, and then by years four and five, you have to be generating some sort of profit, otherwise it doesn't look like a real business in the eyes of the IRS. You're just losing money to offset some other income, and that is not what a farm, a Schedule F, is intended to do.
Kendall Kunelius 32:09
And a couple things I want to clarify. So we used the term revenue and we used the term profit, two very different things. Revenue is usually defined as all of the monies coming into the business. It's everything that you've collected throughout the tax year, whether it's the $5 tomato at the end of the driveway or you're selling whole chickens for $30 a piece. That's revenue. But profit is everything you make after you've covered your expenses. So for example, if that chicken; you're selling it for $30 and it costs you $10 to raise, $20 would be your profit on that chicken. We're using two terms that indicate money coming in rather than expense going out, but they're two different pieces of the stream of what we're talking about here. So revenue versus profit.
Sam Stoddard 33:54
That's exactly right. Some people think that they must be doing well, they had so much gross sales. But then I want to ask people, so what did you realize? What do you have left over in the checkbook? I remember going to a tax training class with someone who, as we had talked about earlier in the podcast, who had one checkbook for their business and their personal. And so this person would take their checkbook, figure out what was definitely business expenses, and the rest was personal profit, and because the records were not clearly defined. If something was maybe business, maybe personal, it was all personal because the records were not kept well. So that is another way of thinking about it. If you want to keep track of your hobby and determine if - Is it a real farm that is supposed to generate not only revenue, but net income? You want to make sure you keep your records very carefully so you can separate out what is personal, what is business, and make sure that your farm income and expenses are just your farm income and expenses.
Kendall Kunelius 34:59
Hmm, cool. Okay. I don't know about you guys, but I am totally excited to go take a look at all of my little costs. So I have, I don't even think I'd call it a hobby, because I don't really sell my eggs, but, you know, I keep track of my expenses for my little flocks of chickens and that kind of thing. And it is, to me, it is fun to dig in to see where I could be a little more efficient. Or, if I chose to sell eggs, what would I sell them for, in theory, per dozen, that kind of thing. I'm maybe one of those weird people that I just love business. I love digging into these numbers. And I think knowledge is power. So I would be curious, Sam, how would you encourage farmers to to approach business from a little bit more of an enjoyable standpoint? How would you, what's the- I don't want to say, like, what's the slippery slope that gets people into this kind of thing, but what do you find enjoyable about talking business?
Sam Stoddard 35:49
I like it when I can explain a concept to someone and then you see the light go off in their head and be like, Oh, that makes sense! I never thought of it in that way. And so a lot of farmers do it because they love their animals or they love being out in the field, and the bookkeeping part of it isn't what they like to do. Let's face it, it's not always what I like to do, but we want people to be able to have enough knowledge about their books so they can see what is generating profit, and what isn't. So if you have chickens, you do have chickens, you have your chicken feed. You have to have a building to house them so the wild animals don't get them, and they generate some eggs. And if you are trying to generate a profit, you want to keep track of exactly how much feed is going in there, how many shavings, what your electricity cost is for that thing. So then you can determine, does it make sense to expand production, or do you want to decrease production? Because it's not worth it to you to have 20 chickens, when 10 chickens does your family exactly what they need., And the extra 10 chickens worth of eggs, you're not selling them. You're not selling them at cost. You're not making a profit on them. So having good books allows you to determine, am I making a profit on this? Is it worth expanding? Should I decrease? Should I expand it to another area? This year was really important for people to understand their books, because at the beginning of the year there was a lot of rain, so if you had early spring crops, like asparagus or strawberries, are very popular in this area. We had a lot of rain, so the strawberry crop wasn't great for a lot of people because they got moldy or there wasn't enough sun for them to develop. People didn't want to go out and pick in the rain, so the strawberry income was kind of low for a lot of people. So then you have to look out for the rest of the year, and think about, what can I do to increase my income for the rest of the year? And so I know some farmers who grew more vegetables, more turns of vegetables, because they knew they had to make up for the bad spring. So then we had the rest of the year, which was very dry, and all of New Hampshire is in a drought, and there's no burning, and there's just no water inside, no rain inside. So if you planted a lot of vegetables, then you have to make sure that you also have some irrigation involved, otherwise the vegetables aren't going to grow. So this year is a very difficult year for planning, but it's important to understand where you are in the year so you can determine what changes you need to make for the rest of the year. You need to understand your input. So if you decided at the beginning of the year that you're going to sell your eggs for $10 a dozen, because that means all of your books balance, and then halfway through the year your chicken feed price is doubled, well then you have to adjust what you're selling your eggs for, because if you still sell them for $10 you're going to lose money. So do you increase them to $20 or to 15 or to 12? You have to understand, have a really good idea of what your expenses are, so you can determine what the new price will be, so you can continue to make profit.
Kendall Kunelius 38:55
And thinking of capturing costs, Rebecca, I actually have a question for you. You used to teach Excel, and in fact, you've actually taught an Excel class for me, for one of my classes, for our equipment and facilities class. For farmers who want to capture this kind of data, where would you point them to take Excel classes? Or, you know, what would you recommend for them to learn how to use technology?
Rebecca Dube 39:20
Well, you know, there's so many resources available for things like Excel. You can certainly look online. There's all sorts of tutorials. That's where I started with Excel when I started with it, but there's lots of organizations around that give beginner classes in Excel that get you familiar with how it works. It's a very powerful tool that can do lots of things for you, but it also has a lot of simplicity. It's very easy to work with. Now I'm also a supporter of things like QuickBooks as a wonderful program, and there's also classes that will teach you how to use that. So you find the program that works best for you, or maybe the one that you have access to that you can afford, and look around for resources on how to learn it. And they're definitely out there.
Kendall Kunelius 40:04
Perfect. That's really what I was looking for. Yeah, it's just like a quick, a quick little like, if we're gonna talk about capturing those costs, I wanted people to figure out, too, where they're going for that. Sam, is there anything else? I mean, we could go on!
Sam Stoddard 40:18
Yeah, I think it just about covers the main points that we wanted to talk about with depreciation. It's a tool to figure out how profitable you're going to be in any given year. It's a tool to help facilitate generational transfer, and it's a tool to figure out where your equipment needs will be in the future. I was talking with a customer recently, and they finally put together a 10-year capital expense budget, and so they understand each year they're going to have to replace a thing. Could be a trailer, could be a tractor, could be some piece of equipment for hanging or for the timber industry. They know each year what they are going to be replacing, so they can plan to look for that particular piece of equipment on sale or in a good deal. And that helps them determine where they are, because you don't want to be surprised. The weather is enough surprise, so you don't want to be surprised with extra repair costs in a given year, or you have something that has a 10 year warranty and you forget to sell it in year nine. So your 10 rolls around, the warranty rolls off, and then something happens to it that's very expensive to repair. You want to make sure you're aware of those things so you can replace equipment as needed, and have a budget to do that, and depreciation helps you figure that out.
Rebecca Dube 41:43
Wow. Thank you. Samantha, that's a lot of amazing information. You really - I think this is a really meaty episode, don't you, Kendall? We've got a lot of really informative information that you may not have known in everyday life. And I say to everyone, Farm Credit is a fantastic resource to reach out to to get more information about this and to have someone help you with all of these various aspects of your business. So thank you, Sam for joining us.
Sam Stoddard 42:13
Thank you, it was a pleasure to speak with you, and I hope we have other occasions to talk about farming in New Hampshire.
Rebecca Dube 42:19
Well. Thank you, and we'll be talking with all of you again soon in the next episode of Shared Soil.
Kendall Kunelius 42:31
Shared Soil is a production of University of New Hampshire Cooperative Extension, an equal opportunity educator and employer. Views expressed on this podcast are not necessarily those of the university, its trustees or its volunteers. Inclusion or exclusion of commercial products in this podcast does not imply endorsement. The University of New Hampshire, US Department of Agriculture and New Hampshire counties cooperate to provide extension programming in the Granite State, learn more@extension.unh.edu.
Transcribed by https://otter.ai
Author(s)
