* Net farm income down 3 pct from 2011's record
* Production costs up 8 pct, feed rises 18 pct
* Big increase expected in insurance payments
* Farm equity to top 2011 record as assets rise
By Charles Abbott
WASHINGTON, Nov 27 (Reuters) - U.S. farm income will drop by 3 percent this year, the result of surging production costs aggravated by crop losses that stemmed from the worst drought in half a century, the government said on Tuesday.
Even so, income would be close to the record high set in 2011, the Agriculture Department said. In a quarterly forecast, it said production costs would rise by 8 percent this year, outpacing a gain in crop and livestock income.
Feed costs are up 18 percent this year, the USDA said. Feed would account for 40 percent of the overall increase in costs.
"Despite gains in almost all sources of farm income, larger increases in farm expenditures, especially for purchased feed, have more than wiped out those price-led gains to farm income," it said.
The largest increases in farm income would come from insurance indemnities, the USDA said.
So far, crop insurers have paid $6.3 billion on losses this year. Some analysts say the drought in the Farm Belt will drive indemnities to $20 billion, nearly double the record set last year.
The USDA will make its first estimate of farm income in 2013 in February, at the same time it closes the books on 2012.
The new year "could be another in a string of unusually high income years," said analyst Mark McMinimy of Guggenheim Securities. Crop prices should remain high at the same time yields rebound from drought, he said. Bigger crops would give a break to livestock producers squeezed by high feed costs.
High farm income gives producers the cash to update their equipment and pay for seed, fertilizer and pesticides. Their outlays buoy businesses ranging from Deere and AGCO to Monsanto, Syngenta, Potash Corp and Dow AgroSciences.
The 8 percent rise in production costs this year would follow a 9 percent surge in 2011. The USDA said the string of large year-to-year increases in production costs dated to 2002.
Sharply higher market prices -- corn up by $1 a bushel and soybeans up by $2 a bushel -- will more than offset the drought-shortened harvest, meaning larger receipts for growers. The corn crop is down 13 percent and soybeans down 4 percent from 2011. Livestock production, except for hogs and milk, would rise in value.
Farm real estate -- land and buildings -- was forecast to rise by 7.6 percent in value nationwide this year, despite widespread drought. As a result, farm equity is forecast to set a record, at $2.27 trillion, up 7 percent from the previous mark set in 2011.
Higher equity will mean lower debt-to-asset and debt-to-equity ratios, said the USDA. The debt-to-asset ratio, now 10.7 percent, would drop to 10.5 percent.
"These declines reflect the farm sector's improving solvency position," it said.
While farm real estate debt was forecast to hold steady, non-real estate debt would climb by 10 percent from 2011 as farmers buy equipment and expand their working capital.
"During 2012, farmers have continued to invest substantially in equipment, structures and land improvements," the USDA said.
The USDA forecast net farm income of $114 billion this year. It pegged net cash farm income at $132.8 billion, down 1.4 percent. Net farm income is a gauge of farm sector wealth. Net cash farm income is a measure of solvency, or the ability to pay bills.
Sixty percent of the continental United States is under moderate to exceptional drought, with the worst conditions in the wheat-growing U.S. Plains that stretch from North Dakota and Montana into Texas.
Persistent dry weather imperiled the winter wheat crop, now in its worst condition ever for late November. The crop will be harvested next spring. Dry soil in the Corn Belt has prompted concern about the prospects for corn and soybeans in 2013.
Agriculture Secretary Tom Vilsack cited the uncertain outlook in a statement that saluted the resiliency of the farm sector in this year's drought and the support provided by the government, which heavily subsidizes the privately run crop insurance system.