Question on What is a Hedge?

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.