Timber Tax Issues – Part One

Overview

Another aspect of agricultural taxation involves the timber industry.  Most of the time we tend to think of tax issues for grain farmers, but there are also tax issues for producers that raise fruits and vegetables.  In addition, livestock producers have some tax issues that are unique to them.  But, there are certain areas of the country where the timber industry is significant, with taxpayers involved in the industry having unique tax issues of their own. 

In the first of two blog posts involving timber tax issues, today’s post looks at the tax issues for timber producers and timber investors.

Timber Sellers in the Trade or Business of Timber Farming

A timber seller is either an investor or is engaged in the timber business.  For an investor, resulting gain or loss is capital in nature.  However, if the seller is in the trade or business of timber farming, the tax treatment of the sale depends on the amount of timber sold and how the taxpayer chooses to treat the sale.

For taxpayers that are engaged in the trade of business of timber farming, the income resulting from the sale of cut timber, whether cut personally or cut via contract by another party, the income on sale is ordinary gain or loss unless the taxpayer elects to treat the cutting as a sale under I.R.C. §631(a).  That’s because the sales are generally treated as occurring in the ordinary course of the taxpayer’s business.  If the election is made, the difference between the standing timber’s fair market value (as of the first day of the tax year) and basis is I.R.C. §1231 gain or loss that is netted with other I.R.C. §1231 gains or losses for the year.  The difference between the net proceeds and the standing timber’s fair market value is ordinary in nature. Form T is required; this form tracks the taxpayer’s depletion in the timber.

To qualify for the election, standing timber must be cut by the owner or someone who has held a contract right to cut the timber for more than a year.  The holding period must include the first day of the tax year in which timber is cut.   The election statement must be attached to the return and the gain or loss is reported as of the first day of the tax year on Form 4797 and on Schedule F

If the taxpayer sells standing timber, the gain or loss is I.R.C. §1231 gain or loss (reported on Form 4797 along with a subtraction for the costs of sale and basis in the timber) that is netted with taxpayer’s other I.R.C. §1231 gains or losses for the year.  I.R.C. §631(b). Net proceeds from annual sales of timber products (e.g., firewood, pine straw) and from sale of timber products after cutting (e.g., tree stumps) is ordinary income or loss.

Investors as Timber Sellers

For investors, lump-sum sales of standing timber are treated as a capital gain or loss under I.R.C. §1231.  For land that is inherited with standing timber, the holding period is deemed to be long-term irrespective of how long either the taxpayer or the decedent held the land. I.R.C. §1223(9).  The timber’s basis is its fair market value as of the date of the decedent’s death (or I.R.C.§2032 date).

Timber Expenses

The tax treatment of timber-related expenses depends on the type of expense and the tax status of the timber activity.  I.R.C. §263A(c)(5) provides exception from uniform capitalization rules for timber and ornamental trees, other than Christmas trees (an evergreen tree that is more than six years old when it is severed from its roots).

Management and operating expenses.  Ordinary and necessary expenses associated with the daily operation and management of timber property are currently deductible in accordance with IRC §162, even if no income is produced from the property, if the timber activity is engaged in for profit and the expenses are directly related to the property’s income potential.  If the timberland is investment property, management and operating expenses are deductible in accordance with I.R.C. §212.

Expenses that are associated with the sale or other disposition of timber are deducted from the sale proceeds.

Carrying charges.  Carrying charges (taxes, interest and other expenses that are related to the development and operation of timber properties) may be treated as deductible expenses or, by election, may be capitalized.  Investors can also make the election.  The election is made by attaching a statement to the original return for the tax year for which the election is desired to apply.  The statement should explain that the taxpayer is electing to capitalize carrying charges and include sufficient information with respect to the activity that the charges relate to.  If carrying charges are not deducted in a particular year, it is not assumed that an election to capitalize the costs has been made.

If the election to capitalize is made, the carrying charges are allocated to the capital accounts to which the charges apply.  Non-commercial thinning and timber stand improvement costs are allocated in full to the timber accounts associated with the timber involved.

Holding costs.  Annual property taxes, mortgage interest, insurance premiums and similar costs can be expensed or capitalized as the taxpayer chooses during any year in which timberland is “unimproved and unproductive.”  Unimproved real property is generally defined as land without buildings, structures or any other improvements that contribute significantly to its value.  Timberland is unproductive in any year in which it produces no income from any source (such as hunting lease income, timber sales, or sale of forest products from cut timber).  The election to capitalize carrying charges characterized as holding costs cannot be made in any year that the taxpayer receives income from the timberland.

Development costs.  Expenses for developing real property (such as non-commercial thinning and timber stand improvements) constitute carrying charges and must be treated consistently from year-to-year.  It is immaterial whether the property is improved or unimproved, productive or unproductive.

Management costs.  Management costs are deductible by individual taxpayers who hold timber activities as an investment as a miscellaneous itemized deduction on Schedule A.  Property taxes (and other taxes attributable to timber operations) are deductible by investors as an itemized deduction (not subject to 2% of AGI floor).  The interest deduction is limited to investment income.  Fertilizer expenses are deductible under I.R.C. §194.

Reforestation expenses.  Under I.R.C. §194(b), qualifying taxpayers can deduct up to $10,000 of reforestation expenses annually per individual tract of timberland.  But, each reforestation project must be separately tracked and be shown on Form T.  Cost–share payments may be available for expenses associated with reforestation activities.  Cost-share expenses are excludible in accordance with a formula set forth in I.R.C. §126.  But, unless a taxpayer is in a high tax bracket, the taxpayer may be better off to include cost-share expenses in income so as to claim the reforestation deduction (or amortization deduction) on total qualified reforestation expenses.

Non-deductible expenses.   Non-deductible expenses for “qualified timber property” can be amortized over 84 months using the half-year convention.  I.R.C.§194(a).  For this purpose, “qualified timber property” is a woodlot or other site located in the U.S. that will contain trees in significant commercial quantities and is held by the taxpayer for the planting, cultivating, caring for and cutting of trees for sale or use in the commercial production of timber products.  “Commercial production” means that the timber is grown for eventual sale to commercial timber processors or for use in the taxpayer’s trade or business.  In addition, the tract (whether owned or leased) being reforested must be at least one acre in size, and the tract must contain sufficient trees to be adequately stocked for purposes of commercial timber production.  Thus, trees grown for personal use do not qualify.  The same is true for Christmas trees irrespective of whether the trees are grown for personal use or for commercial purposes.

Conclusion

Timber tax issues are, obviously, very important to timber producers.  In Part Two on Friday, I will examine timber-related casualty loss issues and like-kind exchanges involving timber.