The production of commercial timber species in the United States by non-industrial forest landowners is subject to the income tax laws of the federal and state governments. Forest landowners should develop an understanding of basic timber tax principles in order to claim deductions and pay tax appropriately. Many forest landowners pay more tax than necessary on timber harvested due to a lack of tax education and poor record keeping. Others often fail to claim appropriate deductions on legitimate expenses of timber production.
Principles of Timber Taxation in the United States
There are five basic principles of timber taxation. Each is important and can affect the profitability of the timber investment or business. The principles concern categories of ownership, timber as a capital asset, reforestation expense, operating expense, and tax treatment of losses. A brief review of the principles can be helpful in establishing a framework for further study. The general rules of federal income taxation of timber are described below. States usually accept these federal income tax procedures and use them as the basis for the relevant state tax, although states also may have separate yield taxes and severance taxes on timber income, as well as a variety of forest land property taxes.
Categories of Ownership
Forest landowners fall into three basic categories: Hobby or personal use, investor, and business owner, including farmers. The category depends largely on profit motive and level of activity. Category chosen affects profitability, tax reporting, and exposure to passive loss rules.
Hobby or Personal Use.--Hobby or personal use owners have no profit motive for timber production. These owners may not deduct timber management expenses except in the years in which they have income from the hobby. Any timber sold or loss is treated as a capital gain or loss.
Investors.--Investors treat their forest as an investment. They are less active in management than a business owner and timber does not make a significant part of income. They have fewer timber sales than one every few years and many have much fewer timber sales. Older landowners may never expect a timber sale, due to the long term nature of timber investment. Instead, these investors are “banking on the stump” or investing in the capital appreciation and growth of their timber as a way to increase the value of their property. Deductions are taken as miscellaneous itemized deductions unless the standard deduction is taken. In that case, deductions may be capitalized into the timber basis—or investment value of the timber. Timber sales are capital gains or losses and reported on Schedule D.
Business.--Business owners treat their timber production as a business or farm. These owners are more active in business than investors and are more likely to produce income from their forest. Business owners report their expenses as business expenses on the proper business form. Individuals report their deductions on Schedule C of the 1040 or on Schedule F, if he or she is a farmer. Other business forms may be used for corporations, s-corps, LLCs and partnerships. Business owners are subject to the passive loss rules, which limit the ability of the passive owner to deduct expenses except in years in which there is passive income.
Timber as a Capital Asset
Standing timber is a capital asset, as is the underlying land. When sold, it is treated as a long-term or short term capital gain or loss. Capital gains are not subject to self-employment tax. Long-term capital gains are subject to the long term capital gains rates, which are the lowest tax rates available.
Because timber is a capital asset, it is necessary to establish and maintain a timber basis account to properly recover capital investment. The basis of timber is the book value of investment in timber. When timber is sold, the profit is based on the sales price less sales expenses and less basis. The profit is figured by using Form T: Forest Activities Schedule and then transferred to the appropriate tax form. Not every forest has a basis, particularly if the timber has been harvested since purchase and allowed to naturally regenerate or if regeneration costs were recovered via the special provisions within the tax code. Basis consists of the value of the asset and volume of the asset—acres for premerchantible timber, tons, cords, thousand board feet (MBF), cunits, or other measure for merchantable timber.
The initial basis of a capital asset depends on how the asset was acquired. Inherited property receives a “step-up” in basis to fair market value at the death of the decedent as determined by an appraisal. Gifted property receives a “carry-over” basis as the basis carries over from the giver to the recipient. If gift taxes are paid on the gift, this affects the value of the property’s basis. The basis of purchased assets is the total acquisition cost—the price paid for the property plus associated costs of acquisition.
Initial basis must be divided between the various assets which make up the total asset. If land and timber are purchased, inherited, or gifted, each has its own basis. For purchased assets, the total acquisition costs are divided between the various assets according to the proportion each contributes to fair market value. For inherited property, the assets are assessed independently.
Once the initial basis is determined, it is adjusted as needed. Non-deducted expenses may be capitalized into the basis account yearly. If all expense is deducted, there is no monetary addition to the basis account unless additional timber is purchased. When a timber sale is made, the part of the basis which applies to that timber sale is “depleted” from the basis account in order to determine net taxable gain. If the basis is not used in a timely fashion, it is lost. Once all the original timber is harvested, the basis account is zeroed out until further non-deducted expense is incurred.
Other capital assets such as equipment are depreciated according to IRS rules. The IRS Publication 946: How to Depreciate Property should be consulted for the current rules on depreciation of equipment, buildings, culverts, etc.
The basis of a newly established forest is the cost of establishment. Ordinarily, these costs are capitalized or recorded into the timber basis account and recovered when the timber is sold or if a loss is taken. The American Jobs Creation Act of 2004 allows deduction of up to $10,000 of qualified reforestation costs for each qualified timber property each year. Any remaining costs are to be amortized and deducted over eight tax years. Trusts are ineligible for the initial deduction and regulations to allow amortization have not yet been written.
Necessary and ordinary operating expenses are deductible for those landowners growing timber for profit. Expenses must meet the industry standard—that is, the expense is a reasonable one incurred by industrial forest owners. Landowners may deduct such expenses as boundary line maintenance, road maintenance, hazard reduction burning, competition control via herbicide application, fertilization, etc. Expenses relating to management are also deductible: travel costs, record-keeping costs, training and education, for example. Records must be kept in order to claim these deductions.
Timber is subject to natural events which may result in significant or total physical loss. Many landowners are dismayed to find that when their timber is destroyed, they are unable to deduct the loss of potential income. Like any other capital asset, losses are limited to the loss in fair market value or the basis, whichever is less. Since many landowners do not have a basis or have a limited basis in their timber, their losses are not deductible.
Claiming loss deductions is quite complicated. Losses from different events are treated differently. For instance, losses from the southern pine beetle are not considered casualty losses for forests, although they may be claimed as noncasualty business losses, if there is an appropriate basis in the timber.
The primary national resource for timber tax information is the Timber Tax Website, hosted by Purdue University. The Cooperative Extension Service at state land grant universities are good sources of information. Many have short courses or workshops to educate landowners, forest professionals, and tax preparers about timber taxation. The IRS website, http://www.irs.gov, has many publications that are of interest to forest landowners. None, however, is solely focused on timber. The US Forest Service has several professionals who provide timber tax training and materials. Periodically, the Service produces an agriculture handbook entitled, Forest Landowners’ Guide to the Federal Income Tax. The current volume is out-of-date, due to many changes in the law.
Anonymous. 2005. Timber casualty loss audit techniques guide. [ http://www.irs.gov].
Anonymous. 2008. How to depreciate property. IRS Pub 946. [ http://www.irs.gov]
Gaddis D.A. and S.G. Dicke. 2006. Frequently asked questions about timber casualty losses. [ http://www.msucares.com/forestry/topics/timber_loss_faqs.pdf].
Gaddis D.A. and S.G. Dicke. 2007. Timber tax overview. MSU-ES Pub 2307. [ http://www.msucares.com].
Gaddis D.A. and S.G. Dicke. 2007. Paying for a new forest without cost share funding. MSU-ES Pub 2420. [ http://www.msucares.com].
Haney, Jr. H.L., W.L. Hoover, W.C. Siegel, J.L. Greene. 2007. Agriculture Handbook 718: Forest Landowners’ Guide to the Federal Income Tax. USDA Forest Service. [ http://www.timbertax.org].
Haney, Jr. H.L., W.C. Siegel, and L. Bishop. 2005. Federal income tax on timber: A key to your most frequently asked questions. USDA Forest Service. R8-TP-34. [ http://www.timbertax.org].
Hamilton R. And G. van der Hoeven. 2006. Federal income tax for the timber grower. [ http://www.ces.ncsu.edu/forestry/economicspubs.htm].
Hoover, W.L. 2007. Handling fire losses and reforestation expense of trusts. Tree Farmer Magazine 24:4. [ http://www.timbertax.org].
Posted 24 June 2008