Timber Sale Tax Treatment
Determining Amount of Gain or Loss
When reporting income from the sale of timber the woodland owner must determine the dollar amount and the type of gain or loss.
The amount of gain or loss in a timber sale is determined by reducing the amount received from the sale by the basis of the timber and the timber sale expenses.
Timber Sale Expenses
Timber sale expenses are those costs associated with preparing and offering timber for sale. Examples of timber sale expenses are marking timber, cruising, advertising and paying for professional services directly related to the sale.
For purchases, the basis is the allocated amount paid for the timber, plus additional costs such as seedlings and associated costs of planting. If the acquisition was inherited, the basis is the fair market value or the special use value that is reported on the federal estate tax return.
Generally, gifts take the donor's basis. If the gift is taxable, the basis is increased to include any gift taxes paid but not above the fair market value. When the timber is eventually sold, there will probably be a gain from the sale.
The gain is obtained by subtracting the basis of the timber sold and any other expenses directly related to making the sale. If only part of the timber is sold, the cost basis must be allocated or spread against the total timber potentially for sale. The allocation of basis is called depletion. Thus, basis is the dollar figure that one has to subtract; depletion is the method used to describe the recovery of basis.
The depletion unit is the basis amount per unit (tree, cord of wood, board feet, etc.) in the timber account. It is obtained by dividing the adjusted basis by the available quantity of timber.
For example, the cost of planting 4000 trees is $2,500. The depletion unit per tree is $0.625/tree; 2500 / 4000 = $0.625.
As another example, assume the cost of timber when land and timber are purchased is $10,000. It is estimated there are 100,000 board feet of marketable timber at time of purchase. The depletion unit of the marketable timber at time of purchase is $0.10 per board foot; $10,000 / 100,000 = $0.10.
As an example of the preceding definition, an individual purchased a 150-acre farm in 1987 for $200,000. A timber cruise prior to purchase revealed that 100,000 board feet of marketable timber were on the land with a value of $10,000.
The values placed on various assets when the farm was purchased were as follows:
- Land $175,000 (basis of land)
- Depreciable Assets 15,000 (basis of depreciable assets)
- Marketable Timber 10,000 (basis of timber)
- Total Purchase Price $200,000
- The timber was clear cut and sold later the same year for $13,000. Costs related to the sale were $250.
Below are calculations of gain from the sale:
- Sale Proceeds $13,000
- Less Sale Expenses 250
- Gross Sale Price $12,750
- Less Timber Basis 10,000
- Gain from Sale $2,750
The same individual decides to do a selective cut. When less than the entire tract of timber is sold, adjusted basis must be determined for the quantity sold. This is accomplished by calculation of the depletion unit.
The depletion unit is computed by dividing the adjusted basis in the timber account by the total quantity of timber in the account. In 1987, the year the timber was purchased, a sale of 20,000 board feet was made for $4,000. Sales expenses were $200.
The calculation would be as follows:
- Sale Proceeds $4,000
- Less Sale Expenses 200
- Gross Sale Price $3,800
- Less Basis (20,000 x .10) 2,000
- (remaining basis is $8,000; $10,000 - 2,000 = $8,000)
- Gain from Sale $1,800
The $2,000 basis was determined by dividing the original 100,000 board feet purchased into the original $10,000 sale price. Since 20,000 board feet were sold and the depletion rate per board foot is $.10, $2,000 of depletion was used.
In the following year of 1988 an additional 20,000 board feet were sold. The total board feet in the woodland just prior to the sale was 81,000 and the annual growth is 1,000 board feet per year. The original 100,000 board feet minus 20,000 board feet sold in 1987 plus 1,000 board feet of new growth from 1987 to 1988 equals 81,000 board feet.
The adjusted basis at the start of this year was $8,000. The depletion unit for Year 2 is $.0987 cents per board foot or $1,975. This is calculated by dividing 81,000 board feet into $8,000 of adjusted basis to get basis per board foot. Then multiply $.0987 by 20,000 board feet for a total of $1,975. The key is to divide the total board feet in the year of sale into the adjusted basis.
- Sale Proceeds $4,500
- Less Sale Expenses 200
- Gross Sale Price $4,300
- Less Basis 1,975
- (remaining basis = $6,025-$8,000 - 1,975 = 6,025)
- Gain from Sale $2,325
In subsequent years the same method of calculation will be used until the original $10,000 basis is used up — this is how depletion is determined and used.
Determining the Type of Gain or Loss
Standing timber is treated for income tax purposes as either a capital asset or a non-capital (ordinary) asset. This distinction is critical in determining whether a timber owner's gain or loss is considered ordinary or capital.
In 1987, 28 percent was the maximum rate at which long term capital gains could be taxed, while ordinary income of individuals could be taxed at rates as high as 38.5 percent. In 1988 and later, the maximum rate for individuals is 28 percent and will apply to both ordinary and capital gains income. Prior to 1987, ordinary income and short term capital gains were fully taxable but only 40 percent of the long term gains were taxable. In 1987 the 60-percent exclusion rate for long-term capital gains was eliminated.
Under current tax law, the entire gain on a timber sale will be taxed at the same rates that apply to ordinary income. It may, however, still be beneficial to the woodland owner to qualify the timber sales for long term capital gains (this will be discussed later in the text.) Whether a timber owner's gain or loss qualifies for capital gains treatment depends on three factors:
Primary Purpose for Holding the Timber
Timber is a capital asset if it is neither used in a trade or business or held primarily for sale to customers in the ordinary course of a trade or business. Timber held as an investment by a woodland owner could qualify as a capital asset under Section 1221 of the Internal Revenue Code (IRC). Although timber used in a trade or business is not a capital asset, its outright sale may nevertheless result in a long-term capital gain if the holding period has been met.
How the Timber is Disposed Of
A taxpayer may dispose of timber in one of three ways:
- Lump Sum-Standing timber is often sold for a lump sum or fixed amount agreed upon in advance. Assuming sales are infrequent, gain or loss on the sale of timber if owned more than the required holding period is a long term capital gain or loss.
- Pay-As-Cut or Economic Interest Retained-IRC Section 631(b): Sometimes called a pay by scale, the price per unit is determined in advance, but the amount of timber to be harvested is not. Income from the sale is based strictly on the volume actually harvested. The seller retains an economic interest and legal title to the standing timber until it is cut. In this type of sale, the timber is included within a special tax category of business property identified by Section 1231 subject to capital gains treatment.
- Election to Treat as a Sale-Timber owners who cut timber for use in their trade or business can, under certain conditions, obtain capital gains treatment by "electing to treat the cutting as a sale." This is the so-called Section 631(a) treatment. In simple terms, the owner "buys" the timber from himself and then sells it back to his trade or business.
If a taxpayer cuts timber owned for more than one year (six months after June 22, 1984 and before January 1, 1988) before the beginning of the year in which the cut-for-sale or use in his/her trade or business, and a Section 631(a) election is made, the gain is reported in two parts:
- The difference between the allowable basis for the standing timber cut during the taxable year and its fair market value as of the first day of the taxable year in which it was cut may qualify for capital gains treatment.
- The difference between the fair market value of this timber on the first day of the tax year and the proceeds from the sale of the products produced from the timber cut, less processing costs is ordinary income.
How Long the Taxpayer Has Held the Timber
To qualify for long-term capital gains, the taxpayer must have held the timber for more than one year prior to cutting, unless it was acquired after June 22, 1984, and before Jan. 1, 1988. Timber acquired during that time need only be held for more than six months. However, when cutting under a Section 631(a) election, the timber (or the contract right to cut timber) also must be held on the first day of the taxpayer's taxable year during which the timber was cut. Under prior law, Section 631(a), elections could be revoked only with permission of the IRS. The new law permits revocation upon notice to the Internal Revenue Service.
Capital Gain Status Can Still Be Important
Even though the rate differential between ordinary income and long-term capital gains were eliminated in 1988, capital gains will remain as a separate entity in the federal tax law. Technically, there will continue to be a recognized difference between ordinary income and capital gains.
William C. Siegel, writing in the 1987 March/April issue of American Forests, gives two reasons why this difference is important. "The...capital gains concept was deliberately retained by the writers of the Tax Reform Act so that if rates on ordinary income are raised in the future, the current rates on long term gains would not be changed-once again creating a rate of differential."
"The second important reason is that it may continue to be advantageous for certain taxpayers to report timber-sale income as a long-term gain on their tax returns even though the proceeds will be taxed the same as if reported as ordinary income."
For example, capital losses may be used to offset only $3,000 of ordinary income per year, but there is no limit on using such losses to offset capital gains. Thus, if a taxpayer has large capital losses from any source, he or she will be able to use a greater proportion of those losses during any year in which he/she has capital gains.
Some forest landowners will also be able to avoid paying Social Security tax on timber sale income. This is because gains that qualify for capital gains treatment are not subject to the self-employment tax.
Sale of Forest Products Other Than Standing Timber
Proceeds from the sale of forest products other than standing timber are treated as ordinary income. This includes logs, lumber, pulpwood, poles, mine timbers, maple syrup, nuts, bark, Christmas greens and nursery stock. In addition, income from the sale of firewood or pulpwood produced from the limbs and tops of trees is ordinary income.
Reporting Timber Income or Losses
The timber income or loss and the forms used are determined by the type of taxpayer involved. They include:
Non Timber Business
- Timber income or loss incidentally realized other than farming.
- Ordinary Income-Form 1040 as Other Income
- Capital Gains-Schedule D, Form 1040
Timber income incidental to Farming-use Schedule F, Form 1040 for ordinary income and Schedule D, Form 1040 for capital gains
Timber Related Business
- Ordinary Income-Schedule C, Form 1040 if sole proprietorship
- Capital Gain-Form 4797 and Schedule D, Form 1040
Form T is an information return. As a matter of good business practice and record keeping, the appropriate sections of Form T such as purchases, sales, planting should be completed routinely by the woodland owner. If you claim a deduction for depletion of timber or for depreciation related to the timber account, you must complete and attach Form T to your tax return. Form T should be filed when a taxpayer sells or cuts standing timber or has a casualty claim.