If you would like to read Part I, please click here.
Taxes are an important aspect of timberland investments. Taxes can be tricky and not all financial advisors and accountants are familiar with the nuances of timber taxation. Congress knows that reforesting harvested timber tracts is important for the environment and has enacted significant tax advantages for doing just that. Depletion accounting is required for timber, and many forest owners lose valuable deductions for not keeping adequate records.
Expensing and Amortization
Depletion accounting requires timber-growing costs and sales revenue be matched. This means tree planting and timber growing expenses could not be claimed until timber was harvested, sometimes 30 to 50 years in the future. If owners were required to capitalize the reforestation and timber management costs until they could be deducted against future timber revenue, many acres would not be replanted. The tax code reflects that Congress knows these acres need to be replanted.
Reforestation. The American Job Creation Act of 2004 allows taxpayers to expense up to $10,000 of qualified reforestation costs annually. If timber is treated as a business, this is a business expense, and for investors this is an adjustment to gross income. Any excess reforestation costs over $10,000 can be amortized over the next 84 months.
Example: You incur $25,000 of qualified reforestation expenses in 2009. You can elect to expense $10,000 of these costs and the rest of the costs are capitalized to be amortized over the next 84 months. You also get to expense the first year's amortization on your 2009 tax return and expense the remainder over the next seven years.
Management and maintenance costs. You are allowed to deduct most management and maintenance expenses for your timber stand. These are the costs for the day-to-day management of your forest property. These include costs for traveling to and from the timber tract; the fees paid to a consulting forester or another professional for management services; the costs for silvicultural treatments, prescribed fire, fertilizer, chemical control of unwanted vegetation, thinning, control of insects and disease and timber stand improvement; workshops and short courses on forest management; hired labor; and even short-lived tools.
A forest owner might also pay property taxes, mortgage interest and insurance premiums. These types of costs are usually called "carrying costs." Management costs and carrying costs are considered the "ordinary and necessary" expenses of managing a forest and growing timber, thus they are deductible in the year incurred, even if no timber income was earned that year. That is, these costs can be expensed in the year incurred.
Capital Gains And Cost Share Payments
Timber income and cost-share income from planting trees is allowed tax advantaged treatment by the IRS.
Capital gains. In general, capital gains treatment is available for most timber income. Obviously, this is attractive because the capital gains tax rates are lower than for ordinary income. But perhaps more important is that capital gains income is not subject to the 15.3% self-employment tax. Timber must have been held over 12 months to qualify for capital gains treatment.
Cost-share payments. Federal and state forestry incentive programs are often available to share the costs of reforestation or other approved conservation practices.
These payments are usually about 50% of the cost of the practice (the government reimburses the forest owner for performing qualified practices), and they can go up to 75% in some cases. One option is to include the payments in ordinary income and then to use the expensing and amortization provisions discussed above to deduct them.
You are also allowed to exclude the "excludable portion" of the payments from ordinary income. The rules are too complex to discuss here. But as a general rule, if you harvested your forest tract within the last three years, it is very likely any cost-share payments will be excludable.