§ 8.8 - Timber and Timberland Taxes
Jurisdiction | Washington |
§8.8 TIMBER AND TIMBERLAND TAXES
This section discusses the application of federal and state tax law to timber and timberlands.
(1) Federal income taxes
Timber, owned either as part of the land or separately, is treated as a capital asset under either I.R.C. § 1221 or I.R.C. § 1231, unless held primarily for sale in the ordinary course of business. Thus, the sale of timber by a casual investor produces capital gain or loss like any other capital asset. The gain or loss is either long term or short term depending on whether the usual holding period requirements are met. When the timber was acquired as part of the land (or as part of a larger transaction), the basis must be allocated between bare land and timber based on their relative values on the date of acquisition.
Practice Tip: | Establishing those values may require expert testimony. The method of allocating the basis should be documented at the time of acquisition, particularly if the taxpayer is not in the business of dealing in timber and therefore not likely to have extensive records on the value of similar timber at that particular time. |
(2) Federal income taxes on leases and cutting contracts
Sales of timber under a contract whereby the seller either retains an economic interest in such timber or makes an outright sale of such timber produce capital gain or loss even if the timber is held primarily for sale in the ordinary course of business. I.R.C. § 631(b). A seller is allowed to subtract an amount equal to the adjusted basis for depletion from the amount realized in determining gain or loss. Treas. Reg. § 1.631-2(a)(1). On the other hand, lump-sum sales with no retained economic interest produce ordinary income (or loss) if the timber is held primarily for sale in the ordinary course of the taxpayer's business. If payment is to be made to the owner under the contract before the timber is cut, the owner may elect to treat its date of payment as the date of disposal.
The types of transactions covered by I.R.C. § 631(b) include leases, cutting contracts, and other similar arrangements in which the timber is cut by someone other than the owner. In general, a retained economic interest for purposes of I.R.C. § 631(b) requires that the taxpayer be entitled to a share of the proceeds from the timber cutting. The concept does not include a situation in which the taxpayer is assured of a fixed return independent of the proceeds of severance of the timber. In a lease situation, any amount paid to the taxpayer in excess of the fair market value of the timber standing when the lease was entered into will constitute ordinary rental income from the land. Rev. Rul. 62-81, 1962-1 C.B. 153. The same result can occur with respect to a long-term cutting contract.
For lump-sum sales, depending on the terms and length of the contract, deferred payments may be subject to the imputed interest rules.
(3) Federal election to treat cutting as sale
Taxpayers holding timber for sale or use in a trade or business may elect application of I.R.C. § 631(a), under which timber is treated as if it were sold on January 1 of the calendar year in which it is harvested. To qualify, the taxpayer must have held the property for more than one year at the time of harvesting. Any difference between its book value and its fair market value on January 1 is a long-term capital gain (or loss) if the taxpayer owned the timber on the first day of the year and for more than one year before harvest. An election to use I.R.C. § 631(a) applies to all subsequent years in which the taxpayer harvests timber, unless the taxpayer obtains permission to revoke the election on the basis of undue hardship. The taxpayer still must obtain permission to revoke the election. Pub. L. No. 99-514, §311(a), 100 Stat. 2085 (Oct. 22, 1986) (uncodified).
(4) Federal like-kind exchanges of timber interests
Income (capital gain) taxes can be deferred on certain exchanges of "like-kind" property. I.R.C. § 1031. A fee interest in timberland is considered of like-kind with a fee interest in any other real property. Taxpayers with a low basis in timberland and especially those organized in a tax inefficient manner will be keen to structure sales of timberland as qualifying like-kind exchanges so as to defer the tax liability. The economic value to deferring the tax liability can be substantial.
Practice Tip: | Given the rigid time constraints imposed on completing lawful like-kind exchanges as well as the unavoidable fact that, to defer the tax (and in essence avoid it by deferral, or repeated deferral, and ultimate payment with future dollars), informed timberland purchasers should negotiate to participate in the economic windfall that occurs to the seller through a structured like-kind transaction. |
An interest in timber that is considered realty under state property law also is considered of like-kind with fee interests in either timber or other real property. Accordingly, some taxpayers will look to defer tax liability by structuring sales of interests in long-term timber leases as like-kind exchanges.
(5) Federal taxation of casualties
If timber is destroyed by storm, fire, volcanic eruption, disease, or pest infestations under circumstances in which the owner is entitled to compensation, or is condemned or sold under threat of condemnation, the taxpayer may defer taxes on the "involuntary conversion" by investing in property "similar or related in service or use." I.R.C. § 1033. Investments in a timber deed or timber sale contract may qualify, in appropriate circumstances, as a replacement for timber owned as part of the land.
Destruction of timber by storm, fire, volcanic eruption, disease, or pest infestation creates a casualty loss deduction equal to the fair market value of the timber immediately before the casualty and its fair market value after, up to the tax basis of the timber. When the timber is under contract, the casualty loss deduction is taken by the person having "risk of loss."
Practice Tip: | Timberland sales pursuant to threat of condemnation should be carefully documented. For example, a timberland sale by a private taxpayer does not become an "in lieu of condemnation" sale simply because the taxpayer figures out prior to closing a clever way to manage the tax liability. The condemnation threat needs to be real as opposed, for example, to a tool "to make the numbers work." Both the taxpayer and the party entrusted with condemnation authority should take this requirement seriously and document the threatened condemnation. |
(6) Federal tax treatment of expenses
Expenses incurred by a seller in connection with the sale of timber (e.g., timber cruising, marking, scaling, brokerage commissions, forestry consultant's fees, and title insurance premiums) are deducted from the selling price in determining taxable gain. Thus, they are generally deducted against capital gains rather than ordinary income from other sources. Transfer taxes are deductible as state or local taxes.
Road construction costs generally are capitalized and recovered in proportion to the timber removed as a percentage of the timber benefited. For example, if a road costs $400,000 and provides access to 100 million board feet of timber, then the taxpayer can depreciate the road at the rate of $4.00 for every thousand board feet harvested or sold. Alternatively, roads may be depreciated under the accelerated cost recovery system. I.R.C. § 168. Generally, logging roads will be considered 15-year property under this system and depreciated under a 150 percent declining balance method over 15 years.
Costs for state and local taxes are expensed. Costs for harvest, slash control, and compliance with related regulations generally are expensed. Costs for site preparation and reforestation generally are capitalized and recovered through cost depletion at the time of harvest or sale. The following normally are expensed as costs incurred in connection with production of income: costs for brush control, precommercial thinning, fertilizing, and other silvicultural expenditures; emergency firefighting; pest and disease control; government assessments for firefighting; expenses (including attorney fees) incurred in connection with enforcement actions under the environmental laws; and costs of maintaining roads, fences, signs, etc.
(7) Federal depletion of timber interests
Under federal income tax law, a deduction is allowed for depletion of timber as the timber is cut. Timber depletion represents a form of cost depletion and not the percentage depletion allowance applicable to oil and gas and other minerals.
To qualify for depletion, the taxpayer must own an economic interest in standing timber. No depletion allowance is available to a taxpayer who has disposed of timber in a transaction qualifying under I.R.C. § 631(b) in which an economic interest is retained. The purchaser of timber in a transaction qualifying under I.R.C. § 631(b) generally will have a depletable economic interest. The amounts paid by a lessee for timber rights are considered payments for timber and are treated as part of the lessee's depletable basis. No depletion allowance is available if the taxpayer can be paid even if the timber is not cut.
The amount of the depletion allowance is calculated by allowing a taxpayer to recover that portion of its basis in the property represented by the proportion that the current units cut in a particular year bears to the total units available for cutting on the property. Treas. Reg. § 1.611-3(b)(2).
(8) Timber excise tax
In Washington, the term "real property" includes both the land and "all standing timber growing thereon, except standing timber owned separately from the ownership of the land upon which the same may stand or be growing; ..." RCW 84.04.090. Standing timber owned separately from the...
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