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b. Treat farm losses like real estate losses under the passive loss rules

Present Law

Present law, as amended by the 1986 Act, provides that deductions from passive trade or business activities, to the extent they exceed income from all such passive activities (exclusive of portfolio income), generally may not be deducted against other income. Suspended losses are carried forward and treated as deductions from passive activities in the next year. Suspended losses are allowed in full when the taxpayer disposes of his entire interest in the activity to an unrelated party in a transaction in which all realized gain or loss is recognized. The provision applies to individuals, estates, trusts, and personal service corporations. A special rule limits the use of passive activity losses and credits against portfolio income in the case of closely held corporations.

An activity generally is treated as passive if the taxpayer does not materially participate in it, i.e. the taxpayer is not involved in the operations of the activity on a basis which is regular, continuous, and substantial. Retired farmers and surviving spouses of farmers generally are treated as continuing to materially participate after retirement or death, as the case may be.

Rental activities are defined as passive activities, without regard to material participation. A special rule provides that up to $25,000 of losses and (deduction equivalent) credits from a rental real estate activity (generally, one in which the taxpayer actively participates) are allowed against other income for the year. The $25,000 amount is phased out between $100,000 and $150,000 of adjusted gross income.

Possible Proposal

Losses from farming activities could be treated in the same manner as losses from rental activities. Thus, farm losses would be treated as losses from passive activities for purposes of the passive loss rule and could not offset income from other activities prior to the time the farming activity is disposed of. An exception similar to the allowance of up to $25,000 of losses from certain rental real estate activities could allow individuals who materially participate (within the meaning of the passive loss rule) in the farming activity to offset up to $25,000 of non-farm income, with a phase-out of the $25,000 amount between $100,000 and $150,000 adjusted gross income.

Arguments for the proposal

Pros and Cons

1. Until a taxpayer disposes of his or her interest in a farming activity, the losses may not represent economic losses (because of the use of the cash method of accounting or other tax preferences) and should not be allowed to offset other income.

2. High-income taxpayers often offset non-farm business income with farming losses and thereby avoid paying substantial income tax.

3. The ability of high income individuals to use immediately farm tax losses to offset other income may give time an unfair advantage in competing with real farmers and distort the farm economy. The allowance of up to $25,000 of losses against nonfarm income will be sufficient for the person whose main livelihood is farming.

Arguments against the proposal

1. Farming is a risky business in which many individuals lose money and those losses should be allowed to offset other income prior to disposing of the farm.

2. Unlike rental activities, farming is a labor-intensive business in which services of the taxpayer are likely to be a material income producing factor. Thus, the rationale for treating rental activities generally as passive should not apply to farming.

3. Farming operations should not be discouraged by tax law limitations.

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c. Increase cost recovery period for single-purpose agricultural structures

Present Law

For purposes of ACRS and the alternative depreciation system, single-purpose agricultural and horticultural structures (described in ADR class 01.3) are assigned an ADR midpoint life of 15 years. As a result of assigning a 15-year midpoint, the cost of this property is recovered over seven years under ACRS.

Possible Proposal

Under ACRS, the cost of single-purpose agricultural and horticultural structures (except greenhouses and mushroom houses) could be recovered over 15 years.

Argument for the proposal

Under the ADR system, farm buildings were assigned an ADR midpoint of 25 years. Under the general rules, the cost of property with an ADR midpoint of 25 years is recovered over 20 years. Providing a special, accelerated recovery period for such structures encourages tax-shelter motivated investment in the farming sector. Such investment hinders, rather than assists, family farming activities.

Argument against the proposal

The high-risk nature of many of the farming activities (e.g., chicken farming) in which single-purpose agricultural structures are used necessitates continuation of preferential subsidies.

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8. Financial Institutions

a. Repeal tax-exempt status of credit unions

Present Law

Credit unions are exempt from Federal income tax under present law. This exemption applies regardless of whether, or to what extent, income of the credit union is distributed as dividends. Both State and Federally chartered credit unions are exempt from tax.

Possible Proposal

Under the President's 1985 tax reform proposal, the tax exemption would have been repealed for credit unions having assets of $5 million or more.

Credit unions could be taxed in a manner similar to thrift institutions (e.g., savings and loans and mutual savings banks). Retained earnings of a taxable credit union (i.e., earnings not distributed as dividends to members) would be subject to tax at the credit union level, while dividends would (as under present law) be taxable upon receipt by individual members. Alternatively, a specified amount of credit union income could be exempt from tax.

Arguments for the proposal

Pros and Cons

1. Credit unions, especially larger credit unions, offer services similar to those provided by other financial institutions. Allowing them to be tax-exempt provides an unfair competitive advantage.

2. The Tax Reform Act of 1986 significantly reduced the tax advantages enjoyed by other financial institutions, thereby making credit unions have an even larger competitive advantage.

Arguments against the proposal

1. Credit unions are distinguished from other financial institutions, because they are more directly controlled by their members, and generally are limited to making consumer loans.

2. Tax exemption enables credit unions to act in the interest of their members, rather than seeking higher returns in other, possibly riskier ventures.

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