Over 200 years ago, Benjamin Franklin wrote “. . . but in this world, nothing is certain but death and taxes.” Like many of his other observations–in many ways this one still holds quite true. This article describes some of the ideas you should consider when planning income-generating activities on your forest. Because of some unique properties of generating income from resources, the situation is more complex that most other investments. When we describe estate planning, “death and taxes” combine in a manner that Franklin might never have imagined.
Taxation of income derived from forestry
investments is a complex topic at both the federal and state levels.
Tax laws, regulations, and guidelines are many, detailed, and
technical. Tax legislation is subject to frequent change and judicial
interpretation. This discussion is intended only as an introduction
to a number of detailed taxation concepts related to forest land in
the state of California. The landowner is well advised to seek the
advise of a professional tax consultant, familiar with timber
taxation.
Income taxes on timber revenues is a complex
subject, especially in regards to capital gains treatment. Since
income taxation was established in 1913, timber assets have gone from
almost no treatment as capital gains to nearly full treatment. Recent
legislation has further confused the issue.
For individuals, California state income taxes are generally similar
to federal income taxes. Some important differences are pointed out
in the following discussion. Other differences may apply to your
particular situation. Check the references listed in sources of
additional information, and consult a professional tax
consultant.
Assuming that you want to pay the least amount of
taxes that you legally can and you are willing to spend some time
learning about tax law, doing some bookkeeping, and possibly hiring a
qualified accountant to help you out, the following suggestions hold
for most people. Your situation will vary, and you are advised to
consult with a tax professional for specific advice.
- Keep excellent and detailed records
- Keep your records well organized
- The costs of owning land should be expensed (deducted in the year they occur), depreciated if they cannot be expensed, and added to the basis (capitalized) when they can be neither expensed nor depreciated.
- Treat your property like a business.
- Spread income over tax years if possible.
- Learn more about timber taxation.
- Hire a tax professional knowledgeable about resource based taxation.
- Plan for the future, especially your estate.
Capital gains is the difference between the
selling price of a capital asset and its cost, or basis. A capital
asset is property held by the taxpayer. Capital loss occurs when the
cost of an asset is greater than its selling price. The conditions
under which forestry investments are considered capital or ordinary
are discussed later.
A major difference between a capital gain and
ordinary income is the manner in which costs are recovered from
income for tax purposes. With ordinary income, costs are expensed,
deducted from income in the year that the cost is incurred. Capital
expenditures, costs that give rise to a capital assets, are
considered an exchange of one capital assets (cash) for another
(property). Thus, no outflow of assets occurs. This exchange cannot
be deducted from ordinary income.
Capital expenditures are recovered for tax
purposes, when the capital asset is sold. Expenditures are then
deducted from the capital gains. Considering the time value of money,
it is generally in the best economic interest of the taxpayer to
write off costs as short-term expenses, deductible from ordinary
income, whenever possible.
The advantage to capital gains treatment is that
mid-term and long-term capital gains income are taxed at lower rates
than ordinary income. Capital gains reported before 1987 are exempt
from taxation. Capital gains income is not taxable for Social
Security purposes as is ordinary income. For retired people receiving
Social Security benefits, when earned income exceeds certain levels,
then part of the Social Security benefits have to be paid back.
Capital gains income is not used in this calculation.
Another difference between capital gains and
ordinary income is the treatment of losses. Capital loss occurs when
the cost is higher than the selling price. A capital loss is first
deducted from capital gains from other transactions. Any remaining
loss is deducted from other income, but not more than $3,000 can be
so deducted in any tax year.
The difficulty in assigning capital gains
treatment to timber is that the product is essentially the factory
that produces the product. This discussion will summarize some
considerations important to nonindustrial private forest
landowners.
Timber for capital gains purposes includes
standing trees used for sawlogs, firewood, pulp, veneer, posts,
pilings, poles, crossties, and other wood products. It also includes
Christmas trees older than six years in age from seed. Timber does
not include logs already cut, tops, limbs, stumps, chips, seedlings
grown for transplanting, or evergreens in a live state and used for
ornamental purposes.
The timber must be held for a period of 18 months
or longer as measured by the difference between the date of
acquisition and the date of disposal to be eligible for long-term
capital gains treatment. The date of disposal is the contract date.
When disposal occurs at severance of the timber from the stump, the
date of disposal is when the volume of the timber is first accurately
determined through scaling. The choice of scaling date must be
consistent with normal practice and cannot be shifted about for the
convenience of the taxpayer.
For landowners who purchase their property as an
investment, infrequent lump sum sales of timber made to assist
financing are allowed capital gains treatment. In a lump sum sale,
payment is made for the standing timber as a whole unit and not
dependent on the amount actually cut. Payment is usually made before
the timber is cut. These sales must be discontinuous and isolated. If
the taxpayer makes a substantial effort to promote the sale, then
capital gains treatment might be denied. This type of sale is
generally for owners who are not managing their property for
timber.
Section 631b of the Internal Revenue Code (IRC) is
of special interest to forest landowners who manage their land. This
section affords capital gains treatment to the taxpayer who retains
an economic interest in the timber. The seller must retain legal
title to the timber until it is cut. The date of cutting is when the
volume of the timber is first accurately determined. The seller must
be paid on a per unit cut basis. When selling timber on the stump,
your contract must state that you retain title to the timber until it
is scaled and that you are paid on a per unit basis. A well-written
contract is essential to demonstrate a retained economic interest in
the timber.
Depletion Allowance: As timber is cut, the original capital investment, the
basis of the timber, is reduced or depleted. Because the trees are
rarely all cut at the same time, the original cost must be modified
to give the adjusted basis. The adjusted basis is the original
purchase price of the timber adjusted for addition or deletion of the
capital of the property. The depletion allowance is deducted from
timber sale receipts in calculating taxable income. In this way the
investment in timber is recovered. Depletion is calculated the same
for California income tax as it is for federal income taxes.
To use the depletion allowance, the cost basis of
the timber must be established. The cost basis is the fair market
value of the timber at the time of acquisition. The cost of land and
improvements are carried in a separate account. At the time of
purchase or inheritance, the fair market value of the property is
allocated between the timber and the land. These amounts can be
estimated well after original acquisition; however, there is a cost
in making such determinations. For most landowners, if the property
was acquired more than 10 years ago then the basis may have been so
small that the cost of calculating the original basis may exceed the
gain in tax savings. The more recent the purchase, the greater the
justification of the expense.
If more land is purchased, the original basis must be updated. Remember to allocate between the land and the timber. As timber is cut, the basis must be depleted to reflect the amount removed. The depletion unit is defined as:
The depletion allowance is determined by multiplying the amount of timber removed by the depletion unit. The basis is then adjusted by subtracting the depletion allowance from the previous adjusted basis. Land and timber translations relating to these sections of the IRC (Sections 1221, 1231, 631a, and 631b) are documented on IRS Form T, Forest Industries Tax Schedules.
Up-to-date records must be kept to accurately
assess tax liability and take advantage of tax reduction provisions.
Good records are also necessary to take advantage of cost sharing
programs. A written management plan is a useful tool to establish
these records.
Two basic accounting methods may be used - accrual
accounting or cash accounting. With the accrual method, transactions
are recorded as they occur. The date of payment is not considered.
Transactions under cash accounting are recorded when cash is received
or paid out. Either system may be used. For the small landowner, cash
accounting is often the easiest. Cash accounting is used in the
examples.
The accounting system consists of a transaction
journal and a series of ledgers documenting various accounts and
subaccounts. The transaction journal is a chronological listing of
all transactions regarding the property. Each transaction is given a
number, which is used to key to the various ledgers. The date,
description, amount, intent, and other pertinent details are given.
Non-financial information, such as the results of a timber cruise,
can be included.
Ledgers documenting the various accounts should be
maintained. At a minimum, accounts should be established for land,
timber, buildings and improvements, and Christmas trees. Subaccounts
are established in some of these to give a more specific
representation.
The timber account is usually divided into three
subaccounts: a plantation subaccount, a submerchantable timber
subaccount, and a timber subaccount. The plantation subaccount
documents the costs of site preparation, seedlings, planting,
planting tools, and some costs of releasing the plantation. As the
seedlings reach the sapling stage, the plantation subaccount is
closed out and amounts are transferred to the submerchantable timber
subaccount. Likewise, when the timber becomes merchantable, it is
transferred to the merchantable timber subaccount. For mature timber,
both cost and volume data should be kept.
A similar series of accounts are kept for
Christmas trees. Because they become merchantable faster than most
other forest products, special rules apply.
The land, building, equipment, roads, and other assets should have a separate account. In short, any asset on which depreciation is taken or that may affect the adjustment of the basis should be included in the accounting system.
Expenses are either capital, ordinary, or carrying
charges. Capital expenses are related to obtaining or improving a
capital asset. Capital expenditures are recovered when the capital
asset is sold. Capital expenditures are not deductible. The expenses
of a sale are costs that must be charged against capital gains.
Ordinary or current expenditures are deducted from
income in the year that they occur. Because of the time value of
money, it is usually advantageous to the taxpayer to write off costs
as short-term expenses whenever possible. Which expenses are capital
or ordinary deductible expenses is frequently debated.
Carrying charges are ordinary expenses that may be
capitalized at the election of the taxpayer. These costs are
deductible, but because of the individual's tax situation, expenses -
such as interest on mortgage, fire protection costs, or insurance -
may be treated as a capital expense. Taxpayers who take a loss for
the year or take the standard deduction instead of itemizing
deductions may benefit from capitalizing these expenses.
Some taxes are deductible as ordinary expenses if itemized on your
federal return. These include state and local taxes for real and
personal property and income taxes. Federal income, excise, gift,
inheritance, or estate taxes are not deductible.
Most of the costs for reforestation are considered
capital expenses in that they give rise to a capital asset. These
costs should be included in the basis for depletion. Brush removal
within 2 years of planting is considered a cost of reforestation and
should be capitalized.
Because reforestation is considered a capital
expense, it has generally been a disincentive to small landowners to
manage their land due to the long time required to deduct these
capital expenses. In 1980, Congress passed PL 96-451, that allows a
10% tax credit for planting and reforestation expenses to a maximum
$10,000 per year. The amount of money that is received as cost-share
assistance cannot be included in the total. In addition to the 10%
tax credit, certain eligible expenses may be amortized over seven
years.
The following example illustrates the procedure
used to calculate the reforestation tax credit.
Assume a small landowner has $12,000 in eligible reforestation expenses, of which 75% are covered by cost-sharing programs. Under the current law, 10% of the amount, exclusive of the the cost-shared amount is eligible for the reforestation tax credit.
Thus:$12,000 - (.75 X $12,000)
= $12,000 - $9,000
= $3,000The landowner can take a 10% tax credit on the $3,000 invested.
$3,000 X .10 = $300 In addition, the full $3,000 can be amortized over a 7-year period. Because the investment is assumed to occur in mid-year, only 1/14 may be deducted in years 1 and 8. In years 2 to 7 the landowner deducts 1/7 of the investment. This deduction for the $3,000 investment is calculated as follows:
In California different laws apply to reforestation. Certain expenses may be amortized over 60 months. Election to amortize is decided by the taxpayer but must continue until fully amortized.
The costs of timber cruises are deductible from ordinary income when the expenses are incurred to assess the state of the property for management purposes, such as developing a management plan. Timber cruises for the purpose of establishing a sale volume are a cost of the sale and are deducted from sale proceeds when the sale occurs.
Temporary logging roads that are used for one operation and then abandoned are depreciated over the period of use. Permanent roads have various costs that are treated separately. Costs of establishing the road, such as surveying, clearing the roadbed, or other nonrecurring costs, are capital investments used to adjust the basis. Costs for culvert repair, bridges, or other periodic events are depreciable. Annual maintenance costs, such as graveling, repairing water bars, and mowing roadsides, are deductible from ordinary income.
Casualty losses resulting from a sudden, unanticipated natural disaster may be deducted from ordinary income. Fire losses are the most common example. In contrast, losses due to insect attack usually must be capitalized. These types of losses are considered capital losses because they can be lessened by planning.
Three types of income or loss are recognized:
active, portfolio, and passive. Active income includes salary,
bonuses, and other income derived from for-profit activities in which
the taxpayer "materially participates." Portfolio income is derived
from investments and includes interest, dividends, and royalties,
unless earned in the ordinary course of a trade or business. Passive
income or loss is derived from limited partnerships and other
business, trade, or investment activities in which the taxpayer does
not "materially participate."
Losses from passive activities can only offset
passive income. They cannot be deducted from active or portfolio
income. Passive losses can be carried over to future years and
applied against future passive income. Tax credits from passive
activities, such as the reforestation tax credit, can only offset tax
payable on passive income. The basis in property is reduced by
depreciation even if the deductions are not usable because of passive
loss rules.
Most taxpayer losses from real estate operations
are considered passive, even if the taxpayer is materially
participating. If the taxpayer has at least a 10% interest in the
venture, up to $25,000 of losses may be considered nonpassive and,
therefore, deductible.
The use of consultants should not make an activity passive if the consultant, such as a forester, acts at the request of the taxpayer rather than as a paid advisor directing the conduct of the taxpayer. This means that the taxpayer must make the actual decisions; however, the forester can make suggestions and recommendations.
If an activity makes a profit in less than three
out of the past five years, the IRS assumes that the activity is a
hobby and not a profit-making activity. All such assumptions are
rebuttable, usually successfully. A written management plan
demonstrates the long-term nature of forestry investments and the
landowner's objective of a profit-making activity.
Tax laws are complex and subject to interpretation
by the taxpayer, courts, and the IRS. Landowners with complicated tax
situations should consult with a professional tax consultant or
Certified Public Account who is familiar with tax treatment of
timber. Many are not. Conversely, foresters, who are technically
proficient in their field, may be unfamiliar with tax laws. Some
foresters do specialize in tax preparation.
All professionals will charge for their time, usually by the hour. The landowner whose records are clear and organized may save a significant amount of money in tax preparation costs. Current knowledge of tax legislation and regulations, including recent changes, may allow the landowner to minimize tax liability within the law's constraints. Joining landowner associations is one means of keeping current.
We return to Franklin’s saying about
“death and taxes” to briefly discuss estate planning.
Estate taxes, imposed on the value of the property to be transferred
prior to transfer and inheritance taxes imposed on the recipient of
the property after transfer, may force the sale of the property if
these taxes are not carefully accounted for in an estate plan. Estate
planning professionals are fond of saying that estate and inheritance
taxes are the only voluntary tax. Legal strategies exist that can
drastically reduce your tax liability as your property passes to your
heirs.
Estate planning is even more complex than timber
taxation. Careful knowledge of the estate tax laws is necessary to
ensure that your estate is taxed at the minimum legal rate. The
services of good estate tax lawyer, trust officer, and estate planner
may be necessary if your efforts for producing a valuable timber crop
on your land are to be continued by your heirs.
Remember that the professionals that you employ
charge by the hour, and an expert's time is costly. Those charges,
though, are frequently money well spent in terms of the amount of
taxes assessed. Be prepared to answer at least the following
questions:
- Who will receive your assets? You must supply the name of your beneficiary and any special considerations such as if the beneficiary is under age.
- Why are you making your estate plan? What are your objectives?
- When do you want to implement the transfer - during life, at death, or after death?
- What property rights do you wish to transfer and to whom? You should have a reasonable inventory of the assets on your property.
- How, given the owner's objectives, is the property to be transferred? Tax savings are important at this point but only to the extent that it does not interfere with the owner's objectives.
Due to the great complexity of estate planning,
this discussion will stop here covering only the most general
principles. The landowner is strongly advised to consult a
professional in order to insure that the land, that is such an
important part of their life, continues to benefit the family.
Two references that you should have in your library regarding
forestry related taxes and estate planning are:
1. Timber Tax Management for Tree Farmers, William L. Hoover, Ph.D.Professor of Forest Economics, Purdue University West Lafayette, IN 47907-1159.
Make $25 check payable to: Purdue University
Mail order to: Ag. Com. Svc. Media Distribution Center
301 South 2nd Street
Lafayette, IN 47901-1232
Phone orders may be placed by calling:
(317) 494-6794
2. Estate Planning for Forest Landowners: What will Become of Your Timberland? Harry L. Haney, Jr. and William C. Siegel. 1993. USDA Forest Service General Technical Report SO-97, which is available on this CD under Resources as gtrso97b.pdf.
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Publication of this series was in part funded by the
California Department of Forestry and Fire Protection
under Contract numbers 8CA96027 and 8CA96028