For forest landowners who have or are contemplating the sale of their timber it is never too early to begin planning for the inevitable deadline with Uncle Sam. For many forest landowners, the end of the tax year can be particularly disconcerting because of the tax considerations for how to treat the sale of timber.
Proceeds (gain) from the sale of your standing timber are fully taxable. However, the proceeds from your timber sale can be reduced by deducting (subtracting) certain costs associated with the sale as well as the original cost of acquiring the property.
Costs of sale can include retaining the services of a consulting forester to inventorying your timber, estimating a value, marking the trees, marketing the timber, and administering the sale. Other costs of sale that you might incur include paying a lawyer to draft a timber sale contract and transportation costs associated with checking on the timber sale operation yourself.
The original cost of the property is based on the manner in which you acquired the property. The Internal Revenue Code (IRC) recognizes four methods for acquiring real property. You might inherit it, purchase it, receive it as a gift or exchange it for something else.
The taxable basis for property that has been inherited is, in most cases, the fair market value of the property on the date of death.
For property you have purchased, the basis in the property is the cost basis. This includes the amount you pay in cash, debt obligations, other property or services; recording fees, legal fees, abstract fees; transfer taxes; owner's title insurance; and any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs and sales commissions.
Property you acquire through a gift will most likely have a basis equal to the adjusted basis of the person who gave you the property, as long as that adjusted basis is not greater than the property's fair market value on the date of the transfer. The adjusted basis is the original cost plus any improvements and minus any deductions from that original cost. There are some exceptions to this rule, and the IRS allows you to add any gift tax that you might pay to that adjusted basis.
Basis in exchanged property gets even more complicated. The Internal Revenue Service (IRS) recognizes two kinds of exchanges: taxable exchanges and nontaxable exchanges. For taxable exchanges of property, or exchanges where property is traded for other property that is not similar in use to the property exchanged, the basis is the fair market value on the date of exchange. For nontaxable exchanges, such as like-kind exchanges, the basis in the property received is usually the same as the basis in the property exchanged.
When you acquire a tract of forestland, there may be several assets on the land, such as fences, bridges, ponds, plantations, buildings, and merchantable timber. These assets are referred to as real capital assets. Most forest landowners just pay for the tract and do not know that they can separate or allocate the costs to acquire the property to each asset. That means that you can literally deduct the amount you spent to purchase the timber asset from the proceeds of any future timber sale. This is important because anytime you can subtract something from the sale proceeds, you effectively reduce your tax bill.
So, how do you do it? First of all, at the time you acquire the tract, you need to establish the original cost basis in this timber asset.
Determining the original cost basis in the timber asset is a process of calculating the proportionate amount of the original basis in the property as a whole that is allocated to the timber asset. It is best to do this allocation at the time of acquisition, but it may also be done years later if you have maintained good records by setting up an account for each of the timber assets, that would include the volume and value of the asset at the time of purchase.
The next step in establishing your cost basis in the timber is to have a trained professional forester conduct a timber inventory on your property to determine the quality and volume of forest products on your tract. If the timber inventory was not conducted at the time of purchase, a forester can "cruise" the timber and estimate both the current volume and what it was when you acquired the property. An estimate of the inventory value of the timber assets is also provided as part of the inventory.
The next step in this asset cost allocation process is to calculate the proportion (percentage in decimal form) of each asset to the total fair market value or appraised value, and then multiply this decimal by the purchase price of the timber to get the original cost basis.
Between the time that the timber assets are acquired and when they are sold could be several years. So what happens to the basis over time? It changes. The inventory volume in each account will grow each year, or it might be reduced as a result of mortality from ice damage, fire, or forest pests/disease. It may be necessary to conduct another inventory right before a timber harvest in order to determine just how much volume is in each account.
So why make all of these calculations and keep records? We do it so that we can recover the cost basis in our timber account at the time we sell our timber. From the actual timber sale revenue we can subtract the cost basis in our timber account based upon the volume we have harvested from the account.
Here's an example to demonstrate how this is done. Suppose you acquire a property for $165,000 purchase price. You also incur additional costs of $1,500 to hire a forester to complete a timber inventory, $2,000 to have a boundary survey, and $1,000 for closing costs. The total acquisition cost is then $169,500 ($165,000 + $1,500 + $2,000 +$1,000). The total appraised value of the property at the time of purchase was $159,000 (not the purchase price), which included buildings, fence, merchantable walnut sawlogs, mixed oak-hickory sawlogs, bare land, and a young (non merchantable) tree plantation. Furthermore, let's assume that the forester's inventory lists 19 MBF (thousand board feet) of walnut veneer logs valued at $20,330.
To continue calculating your cost basis in the walnut veneer log account, use the following procedure:
1. Divide the inventory value of the walnut veneer logs ($20,330) by the total appraised value of the property ($159,000) to get the proportionate value of this asset as a percentage of the total.
($20,330 divided by $159,000 = 0.1279).
2. Multiply this decimal (0.1279) by the total purchase price ($169,500) to get the original cost basis for the walnut veneer logs.
($169,500 x 0.1279 = $21,679.05)
You would want to follow this procedure for each of the merchantable timber products identified in the inventory when they are sold or harvested.By making these calculations, we can recover our cost basis in the timber account when the timber is harvested or when the logs are cut from the timber and sold or used in the owner's business. This process of recovering our cost basis is called depletion.
In order to calculate depletion, we first need to figure the depletion unit rate so that we can determine the depletion deduction allowance. To calculate the depletion unit rate, divide the original or adjusted basis (if the timber has grown or changed in some other way over time) by the current volume in the account. In our example, we divide the original cost basis of the walnut veneer logs ($21,679.05) by the volume (19 MBF) to get a depletion unit rate of $1.14 per board foot ($21,679.05 divided by 19,000 bf = $1.14 per bf).
To continue our example, if you sell 10 MBF of walnut veneer logs immediately after purchasing the property, then your depletion deduction allowance is $11,400 ($1.14 per bf x 10,000 bf). If you have waited a year or more from the purchase date, then the volume in the walnut veneer account would grow by some growth factor that would reflect the rate of growth of the trees and the number of years since acquisition.
Federal income tax for our example would be paid on the net taxable gain as shown below:
Gross gain from timber sale:$20,000
Consulting forester fee ($ 2,000)
Depletion deduction Allowance ($11,400)
Net taxable gain: $ 6,600
If you fall into the 28% federal income tax bracket, your action of establishing the cost basis in your timber saved you more than $3,700 in tax liability because you pay tax on $6,600 instead of the $20,000. How many forest landowners pay taxes on the gross gain each year? There are questions as to whether or not this is a capital gain. The determination of this point is made based upon your objectives for ownership of the property, length of time between purchase and sale of timber, and whether or not you meet certain material participation criteria.
Contact a consulting forester or public agency forester if you are interest in completing an inventory of your timber. It is the first step to realizing significant tax savings on timber income.
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