Knowing how our income tax laws apply to your forest investment can help you to maximize the return on that investment by minimizing the income taxes you need to pay. Following are a few notes to help you get started. This discussion is by no means complete, so additional research may be warranted. You may want to visit the timber tax web site, www.timbertax.org for further discussion.
Holding Timber Property
There are three ways you can hold timber property, either as a hobby, an investment, or as a business. The latter two are differentiated from a hobby by the presence of a profit motive. To claim your forest management activity as an investment or as a business, you must be able to show, over the course of your participation in the activity, that you will generate more income than you will incur expenses.
From a tax standpoint, the most advantageous way to report your forest management activity is as a business. Assuming you are classified as “materially participating” all expenses of the activity will be deductible against any and all other income. A further discussion of material participation follows later in the text.
If you classify your activity as an investment, those expenses will still be deductible but only if you itemize your expenses (file Schedule A). In addition, investment expenses are classified as “miscellaneous itemized deductions”, a category that serves to possibly diminish the value of your deductions. Only the expenses in this category that exceed a floor, calculated by multiplying your adjusted gross income by 2%, will be deductible. If you do not ordinarily itemize, you can possibly make an election to capitalize those expenses and deduct them against a future sale of timber.
If you report your forest management activity as a hobby, you will only be able to deduct expenses up to the amount of income generated. This calculation is made on a year-by-year basis so the receipt of income this year will have no bearing on your ability to deduct management expenses next year. As with an investment, you deduct hobby expenses, other than property taxes, as an itemized deduction subject to the 2% floor.
As indicated, reporting your forestry activity as a business is the most tax favored. Be prepared, however, to defend the premise that you have a profit motive, especially if it will be some time before harvesting operations commence. Many continuous years of losses on a business schedule tend to attract the attention of the Internal Revenue Service and may result in an audit of your return. To defend against such an audit, be certain that your management plan clearly states your objective to “grow commercial forest products at a profit”. The management plan should also clearly identify the cost of various planned management activities and annual recurring expenses as well as anticipated revenues from the sale of timber. To prove a profit motive, the anticipated revenues will need to exceed the total anticipated costs. You should also do this if holding your timber property as an investment.
You may also be asked to prove that you are a “material participant” in your business activity. This is usually not a problem for most small forest landowners. In general, if you and your spouse participate in the business for a combined 500 hours per year, or you perform all the work that needs to be done in a particular year, you are a material participant.
In general, any work you do in connection with your Tree Farm will qualify as participation in the activity, as long as it is customarily something the owner of a Tree Farm would do. Examples include the establishment of property boundaries, insect and disease control, timber stand improvement, tree planting, erosion control practices, and timber harvesting.
From a practical standpoint, if your timber holdings generate fairly regular and continuous transactions, you may wish to consider treating your operation as a business. If you own a small number of acres that produce only occasional transactions, you may want to consider treating the operation as an investment. If you don't want to be concerned with proving a profit motive, go the hobby route.
When selling timber, you may have basis you can deduct against the sale proceeds. Basis is nothing more than your cost in the asset you are selling. As an example, if you purchase a share of stock for $20 and sell it sometime later for $25, you are only taxed on $5; the difference between the sale proceeds and your basis.
Determining your basis in timber, however, is not near as easy as it is for a share of stock (though that can also get complicated due to stock dividends, splits, and the like). When you purchased your property, you not only acquired timber but land as well. There may also have been buildings or other improvements that were a part of the purchase agreement. Since each of those assets are treated differently, from a taxation standpoint, we need to allocate our purchase price among them.
To do this allocation, we need to determine the fair market value of each asset (timber, land, improvements, etc) as of the date the property was acquired. The purchase price, including closing costs and other costs of purchase, will then be allocated based on those fair market values. The proportion of purchase price allocated to each asset will be determined by comparing the asset’s fair market value, at the date of purchase, to the total fair market value. The total fair market value is calculated simply by summing the fair market value of each asset, again determined at the date of purchase.
There is a simpler procedure, known as the residual method, for allocating basis. Though simpler, this method does not usually result in as much basis being allocated to the timber as with the method previously described. To use this method, simply subtract the land fair market value, as of the date of purchase, from the purchase price. The remainder, assuming you purchased only land and timber, is allocated to the timber.
The allocation you make to the timber can all be kept in one account, for bookkeeping purposes, or can be divided into several accounts based on species, size, or other parameters. Just keep in mind that your initial decision as to number of accounts could be binding on into the future. Balance your decision based on the expected timing for recovery of your basis with the added accounting complexity that many different accounts will generate.
For each account established, you will calculate what is known as a “depletion unit”. The depletion unit is nothing more than the total basis in the account divided by the total volume of timber that is contained in the account. The timber volume can be expressed in cords, MBF, cunits or other units. This depletion unit will change from year to year due to growth and other factors.
To determine how much basis you can claim on a timber sale, multiply the volume of timber sold by the depletion unit. A Form T can be attached to your return if you are claiming basis to show how you arrived at the numbers claimed. You can also notify the Internal Revenue Service of the allocation of your purchase price using this form.
You may also acquire property in a manner other than by purchase. For instance, you could receive property through an inheritance or as a gift. Your basis will be calculated differently depending on how you acquired the property.
If you’ve held your property over the long-term holding period, currently one year, you may qualify for a lower tax rate. Wisconsin also provides a benefit in this case as well.
How you sell your timber (unless cutting it yourself) no longer has an impact on its qualification for the lower capital gains rates. Selling timber lump sum or as a scaled sale (economic interest retained) are now treated the same regardless of the number of sales you've had.
Treatment of Management Expenses
Any expenses you incur that are “ordinary and necessary”, in the production of income, are allowed to be deducted. You may also be required to prove that the expense was reasonable both in amount and in relation to its purpose.
An ordinary expense is one that is customary or usual in that particular line of business. As an example, a chainsaw would be an ordinary expense in tree farming. A mink “cutting” jacket would not.
A necessary expense is one that is appropriate and helpful to the business. Generally, the courts will accept your judgment as to whether a certain expenditure was appropriate and helpful.
The courts, though, have ruled on occasion that spending $20,000 on a private airplane was not a reasonable expense when you could have flown by private carrier for substantially less.
Examples of deductible expenses for a typical forest owner include travel, depreciation on equipment and structures, supplies, dues (such as your membership in woodland owner organizations), property taxes and interest, fees for professional services, road and firebreak maintenance, and control of damaging agents such as fire, insects, or disease.
Deduct expenses on the forms that are appropriate to how you treat the activity. For example, if you are treating the activity as a business, the expenses will be listed on your business schedule.
Reforestation Tax Incentives
You are now allowed to expense up to $10,000 of reforestation expenses, per qualified timber property, on a yearly basis. You don't need to treat the activity as a business to qualify for this deduction. You don't need to itemize either, as the amount can be deducted in the “Adjustments” section on the front page of your return, Form 1040.
Amounts in excess of $10,000 can be amortized over a seven-year period.
Eligible costs include all out of pocket costs incurred in the planting of the trees. These costs include the cost of site preparation, seed or seedlings, labor (not your own - sorry) and tool costs, among others.
The timber property being planted must consist of at least one acre, be located in the United States, and contain trees in “significant commercial quantities”. The purpose of the planting must be to grow timber for eventual production of commercial timber products. The planting of shelterbelts, ornamental trees, or Christmas trees are specifically excluded.
Any catch? Not really. Since the government is giving you such a good tax break, they just expect that you will maintain the trees for the purpose you planted them -- to produce commercial forest products. That’s a reasonable expectation. If you have a change of heart and sell the property or replace the planting with a building and parking lot, you may have to pay some of the benefit back. Recapture provisions extend ten years past the year you incurred the reforestation expenditures.