With a volatile stock market and low yields on fixed income, many high net worth individuals are looking for alternative investments. One alternative is nontraditional real estate investments such as farm property or timber land. However, the tax rules relating to timber can be extraordinarily complex for those lacking experience in the area.
A few basic distinctions determine the basic tax treatment of the various revenue streams that can occur when investing in timber property.
Such property can be classified as personal property, income-producing/investment property, or business property. This determination is based on facts and circumstances including the purpose of ownership of the property, the use of the property and the activities that take place on the property.
If the property is mainly used recreationally (camping, hunting, etc.), it is considered personal property and treated like a vacation home. As such, real estate taxes will be deductible on Schedule A and any gain on the sale of the property will be a capital gain. Losses from the sale of the property will not be deductible and treated as a personal loss.
If the timber land is used to generate a profit relatively infrequently, it is considered income-producing or investment property. As such, the sale of standing timber is eligible for capital gain treatment. Here, the expenses for maintaining the property are treated as miscellaneous itemized deductions, subject to the 2% adjusted gross income floor. Real estate taxes are not subject to the 2% floor. Many high-income taxpayers do not gain a tax benefit from these expenses due to the floor. As a result, this can be a significant tax disadvantage.
The property is used as a business, if there is a rotational harvest whereby the owner receives regular, ongoing revenue. One of the distinctions between investment property and business property is that business properties are usually larger and have more frequent transactions than properties held for investment, with the implication that business activity is continuous. Timber owners whose property is classified as a business may also get long-term capital gain treatment on sales of standing timber under Internal Revenue Code Section 1231.
Further, if a timber activity is construed as a business, the passive activity rules will apply, so unless the taxpayer materially participates in the activity, the timber business will be subject to that regime.
The sale of cut timber is more complex than the sale of standing timber and requires the use of Form T (Forest Activities Schedule). The sale of cut timber involves two parts assuming the election described below is made. First is the deemed disposal of standing timber and second is the sale of the cut timber.
Generally, these sales are treated as ordinary income, unless an election is made under Section 631(a) of the Internal Revenue Code. The election is made on Form T and is available if the taxpayer owned the standing timber for one year before it was cut. Under the election, the capital gain amount is the difference between the value of the timber on the first day of the tax year and its basis (this is the gain from the deemed disposal of the standing timber). Any sales proceeds (net of cut and haul expenses) in excess of the value on the first day of the year is treated as ordinary income.
When using the 631(a) election, it is imperative to have complete and accurate cost basis records. When timber property is acquired, the purchase must be documented on Form T. Properly recording the basis can not only reduce the taxable gain upon sale, it is essential for providing timber owners the ability to recover the costs of reforestation that occur after the cut. Form T requires great detail and a large quantity of information with respect to the purchase of timber, so it is important to establish basis in the year of purchase.
Investing in timber property can be complex, and investors need to consider the best way to approach this three-category system before putting capital into timber land.