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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.

Basis and Depletion
This is the pitfall that can lead to problems. Timber accounting is depletion accounting, like that used for oil, gas and minerals. With the exceptions listed above, timber must be treated as a capital asset and its purchase price capitalized.

Basis. The total cost of purchasing forestland (or the value of inherited forestland) must be capitalized, with values allocated to land, timber, improvements, buildings and other relevant capital accounts. The value allocated to each asset is its basis. This allocation must be based on the fair market value (FMV) of the assets. Total purchase price is allocated to each asset based on its current FMV at the time of purchase.

Example: You purchase a forest property for $200,000 (including legal costs, surveying costs, appraisal and timber cruising costs, and transaction costs, all of which must also be capitalized). It includes timber, land and a building. The appraisal finds the timber is worth $132,000, the land is worth $66,000 and the building is worth $22,000.

The allocation must be based on these FMVs and is calculated as follows:
Account     FMV                 %FMV          Basis
Timber      $132,000          0.60             $120,000
Land         $66,000            0.30             $60,000
Building     $22,000            0.10             $20,000
                $220,000          1.00             $200,000

Depletion. The basis of timber is adjusted up for new purchases and it is adjusted down for sales or disposals of timber. That is, the capitalized amount can only be deducted against timber revenue (short of a casualty loss like a fire). This deduction is called a depletion allowance and must be in proportion to the amount of timber cut. Keep in mind that the amount of wood on a timber tract is almost always increasing. Trees grow. Depletion must be calculated based on total timber volume on the tract at the time of harvest. Depletion is usually calculated as a rate.

Example: In the example above, the timber purchased was 440 MBF (thousand board feet) worth $300/MBF. Three years later, when the timber volume has grown to 500 MBF, the forest owner contracts to sell 220 MBF for $350/MBF, or $77,000. First, a depletion rate is calculated as $120,000/500 MBF = $240/MBF. Then, a depletion allowance is calculated as 220 MBF X $240/MBF = $52,800. Another way to think about it is that 44% of the timber was harvested, so the depletion allowance is 44% of $120,000. Then the taxable capital gains income is $77,000 - $52,800 = $24,200.

Pitfall. It is common for a forest owner not to perform the basis allocation calculation at the time of purchase or inheritance. Years later, the accountant needs basis information to calculate depletion allowance. It is costly to hire a forester to determine the likely timber volumes and values for what might be decades in the past. All forest owners are required to perform the allocation or lose the chance for a depletion allowance. This is part of required IRS timber records. There is even a form, Form T (Timber) to report adjustments to basis and timber depletion. Many accountants have never heard of it.
www.timbertax.org

Anything you ever wanted to know about timber taxes is on the web at www.timbertax.org. This extensive site covers new changes to the tax law, timberland acquisitions, structuring ownership, timberland appraisal, basis, depletion, costs, depreciation, casualty losses, state timber tax laws, estate planning and tax research. It is by far the single best source of timber tax information in the country.

Thomas J. Straka is a forest economist at Clemson University in South Carolina.