For most forestland owners, a timber sale is not a common occurrence. However, the occasional sale that does occur may involve thousands of dollars and can have a significant tax impact. The purpose of this article is to provide the forestland owner a general idea of how to deal with the federal tax issues associated with a timber sale. At the conclusion of this article, the reader will not be able to immediately fill out and file their own tax return for the timber sale proceeds. Rather the landowner will have a better understanding of the process, which will allow for more effective communication with his/her forester and accountant.
Prior to getting to the "nuts and bolts" of the article it is important for the forestland owner to understand that the information presented here primarily applies to the forestland owner who has an occasional timber harvest, but is not in the primary business of producing timber products. The reader will also note that the word "may" is used often in this article due to the fact that the tax code applying to timber sale proceeds is very complex, and there are always exceptions to the rule.
Due to the most recent changes in the tax rate for capital gains, it is often more beneficial for timber proceeds to be treated as a capital gain rather than as ordinary income. If the asset (timber) is held for minimum certain periods of time (long enough to be declared a long-term capital gain) the tax rate will be significantly less than the ordinary income tax rate or the short-term capital gain rate.
There are also additional benefits of treating timber proceeds as a capital gain. If the timber sale qualifies for capital gain treatment, the income is not subject to self-employment tax. Also, if a forestland owner has capital losses, these losses can be used to offset the capital gain. If the timber sale proceeds were declared as ordinary income, capital losses may be used to offset only $3,000 dollars of ordinary income.
When standing timber, or the right to cut standing timber, is sold the income may be treated as long-term capital gain if the timber has been owned for more than one year. This holding period requirement must also be met when disposing of timber acquired by gift. However, both the donor's and recipient's time of ownership is counted. For inherited timber, there is no required holding period in order to qualify for long-term capital gain status.
In order to determine the amount of the capital gain, a "basis" must be determined. The "basis" of an asset is the capital investment that one has in property that produces income. For most forestland owner's, the capital investment is the acquisition cost which would include commissions and fees, foresters and surveyors, and the purchase price.
The commissions and fees element and the foresters and surveyors element of the capital investment are usually quite evident. The purchase price, however, is dependent on how the property was acquired. If the property was acquired as a gift, the basis (purchase price) of the property is equal to the donor's basis plus tax. For example, if an individual held a property for 20 years and then gifted it to another person, the receiving parties basis is equal to what the donating parties basis was.
If the property was inherited, the basis (purchase price) is "stepped-up". Property acquired by inheritance has a basis equal to the fair market value on the date of death of the decedent or the alternative valuation date if an alternate date is chosen. The fair market value is usually greater than the basis to the decedent.
If the property is purchased, the purchase price is what was paid for the property. However, this purchase price must be allocated to all of the assets of the property. Forest property typically includes several assets. Separate accounts should be established for each type of asset in order to receive the proper tax treatment. For example, a typical property will have three capital accounts. The first would be depreciable items, the second bare land value, and the third would be timber value. Dealing with depreciable assets can become complex, and is beyond the scope of this article. The reader just needs to be aware that in some instances
depreciable assets should be looked at.
The allocation of original cost basis can be completed by determining each asset's proportionate share of total fair market value and then multiplying the total cost of acquisition by this share. For example, if a property is acquired that has buildings valued at $50,000 dollars, bare land at$10,000 dollars, and timber at $40,000 dollars, the fair market value of that property is $100,000 dollars. The building asset accounts for 50% of the total fair market value and the bare land and timber account for 10% and 40%respectively. If the property were purchased for $80,000 dollars, the building basis would be $40,000 dollars ($80,000 x 50%), the bare land basis would be $8,000 dollars ($80,000 x 10%), and the timber would be $32,000 dollars($80,000 x 40%).
The original cost basis allocated to marketable timber, using the above procedure, is available as a deduction from the timber sale receipts. If all the marketable timber is sold, the total revenue received is reduced by the cost basis in determining taxable gain. If only a part of the marketable timber is sold, then a proportionate part of the basis may be deducted from the amount received. This is done through the use of depletion units which will be discussed in further detail in a future NEFCo newsletter.
The introductory paragraph of this article encourages landowners to declare timber sale proceeds as a long-term capital gain. In order to do that, the long-term capital gain amount must be determined. Essentially, the long-term capital gain will equal the gross timber sale proceeds less the timber sale expenses and the depletion. The long-term capital gain can be declared a number of different ways and you will receive various opinions from different accountants as to which way to file. However, in most cases where a landowner files an IRS form 1040, the long-term capital gain can be declared on Schedule D. An attachment should be filed along with Schedule D showing how the "purchase price" and gain have been calculated.
There is also a specific tax form relating to forestry. This is Form T (Timber) - Forest Activities Schedules. Once again you will receive various opinions as to the need of filing this form. It is my understanding that this form should be submitted annually, however that the IRS has not enforced this requirement. Consultation with your accountant will provide you with more detailed guidance, but at a minimum I recommend that you complete this form, keep it up to date, and keep it on file.
Taxes on timber sale proceeds can be significant. However, proper planning can reduce the affects of taxes and allow the landowner the greatest financial return. Insuring that timber sale proceeds are accounted for as a long-term capital gain will, in most cases, be financially advantageous. However, in order to do this some pre-planning must be done. Communicating with a NEFCo forester and your accountant concerning a potential timber harvest will allow you to make a decision that is financially advantageous to you and in your best interest.