Capital Recovery
ForestTax.com Newsletter

A landowner can recover capital expenditures when selling or disposing of the asset. For instance, deduct the value in the land account from the proceeds of the land sale to determine taxable income. Many forest landowners fail to take advantage of this very important tax regulation. Landowners often purchase a tract of land with timber growing on it. But, when they sell that timber, they pay income taxes on the total amount generated from the sale. A landowner need only pay taxes on profits: the difference between the value generated from the sale and the value recorded in the timber account.

Ways to Get Your Money Back on Your Tax Forms...

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Methods of Capital Recovery

Methods of capital recovery are different ways to reduce tax liability by deducting qualified expenses from taxable income. Forest landowners may consider four different methods.

Depletion of Timber

The first method of capital recovery is depletion. This method allows forest landowners to deduct the purchase price of timber from the proceeds of selling it. This is analogous to buying a CD for $1,000, letting it accumulate interest for 5 years, then cashing it in for $1,220. The informed investor only pays taxes on the $220 profit, not on the total investment. An aware forest land investor only pays taxes on timber volume increases and value changes from the date of acquisition.

The value recorded in the appropriate capital account determines the amount of depletion allowed. When disposing completely of a block of timber, such as a clearcut, the landowner deducts the entire value in that timber account from the sale. If the landowner disposes of only a portion of the block of timber, such as a commercial thinning, then the amount of depletion allowed is based on the percentage of the asset disposed of or sold. If 45% of merchantable timber is sold, then 45% of the timber account is allowed as a depletion deduction (IRS Form T details this calculation).
 

  to calculate your
Depletion Allowances!

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Reforestation Specific Deductions


 
Amortization Allowed for Reforestation
Amortization allows qualified forest landowners to deduct up to $10,000 of reforestation costs each year. Expenses above the $10,000 limit are capitalized into a reforestation subaccount, allowing those costs to be deducted from the proceeds of a timber sale, or when the property is sold.

Internal Revenue Code Section 194 allows forest landowners to amortize up to $10,000 of the costs of seed, seedlings, site preparation, planting, brush and weed control, and other reforestation activities each year. Forest landowners have no limit on the number of consecutive years they can take this special treatment of reforestation expenses. However, the costs must be directly related to the establishment of commercial tree species.

The actual amortization is done over a seven-year period using beginning and ending year conventions. Only 1 / 14th is deductible in the year of the cost. During years two through seven, 1 / 7th of the costs are deducted from income. During the eighth year after the reforestation activities, the final 1 / 14th of the reforestation costs are deducted.
 

 
Investment Tax Credit—Reforestation
A tax credit is a direct reduction of tax liability, dollar for dollar, as opposed to a deduction in taxable income. The 10% investment tax credit for reforestation is a big tax incentive to reforest property. Generally, tax incentives (deductions) reduce taxable income by the amount of the qualified expense. Tax credits directly reduce tax liability. Reforestation costs eligible for the reforestation amortization deduction also are eligible for the reforestation tax credit. Trees must have a useful life of greater than 10 years to qualify for the full 10% tax credit. Penalties are imposed if landowners dispose of the trees within the 10-year period.

When the full 10% reforestation tax credit is used, only 95% of the reforestation expense is available for reforestation amortization. Forest landowners can take a smaller tax credit at their option. When this happens, half of the tax credit percentage is reduced from the costs available for the reforestation amortization. For example, if the taxpayer takes a 6% tax credit, then the reforestation amortization is limited to 97% of total reforestation expenses. It is generally more beneficial for taxpayers to take the maximum 10% tax credit and amortize 95% of reforestation expenses.
 

Combining the Tax Credit and Amortization
Assuming a total reforestation
cost of $8,000 (2001)
Year
Amortization
Tax Credit
2001
$541
$800
2002
$1,086
 
2003
$1,086
2004
$1,086
2005
$1,086
2006
$1,086
2007
$1,086
2008
$541
  to calculate your
Amortization and 
Tax Credits!
ForestTax.com Newsletter

Depreciation of Equipment

Depreciation allows recovery (deductions) of capitalized costs for items such as machinery, equipment, and buildings. These assets are worn out while being used in the process of producing income. Annual depreciation deductions may be taken for many types of property used in either trade or business or held as an investment.

Internal Revenue Code section 611 authorizes the deduction of a reasonable allowance for depreciation of real property improvements particular to timber. These include: temporary roads, bridges, fences, and culverts.

Capital improvements such as graveling, paving, bridges, culverts, and trestles are recoverable through the annual depreciation allowance (IRC 167). General IRS depreciation rules apply for forest landowners with one exception. The portion of annual depreciation allowance for machinery and equipment associated with forestry site preparation, planting, and seeding must be capitalized into a timber account rather than taken as depreciation deductions. This makes the portion of depreciation attributable to reforestation activities available for reforestation amortization and the reforestation tax credit.

Section 179 Deduction

As of the year 2000, forest landowners may expense up to $20,000 per year of certain qualifying depreciable property costs purchased and placed in service that tax year if the property is used in the active conduct of a trade or business. This special treatment of depreciable property expenses is not available for forest landowners whose activities qualify as either passive trade or business or as an investment. Expensing these items allows deduction of an annual maximum $20,000 worth of qualified costs directly from business income rather than being depreciated over the assets’ useful life. This deduction, prior to 1997 was limited to $17,500 each year. This amount has been increasing each year and will reach its maximum in the year 2003 and beyond at $25,000. Below is a table sumarizing the annual deductions allowed for the Section 179 Deduction.
 

Tax Year
Maximum 179 Deduction
Before 1997
$17,500
1997
$18,000
1998
$18,500
1999
$19,000
2000
$20,000
2001
$24,000
2002
$24,000
Beyond 2002
$25,000
To learn more about how to depreciate property download this IRS Publication 947 titled,
"How to Depreciate Property"

ForestTax.com Newsletter

Expensing Versus Capitalization

Generally, it is more advantageous to expense an item currently, instead of capitalizing it. An expensed item is deducted in the year the cost is incurred. Thus, a landowner would deduct a $500 expense for a qualified silvicultural practice from income in the same year as the expenditure.

If the same expense were capitalized, it would be offset against a certain account, such as premerchantable reforestation, later to be transferred to a merchantable timber account, and finally offset against the timber harvest income (often that is some 50 or more years later).
 

  to learn more about Operating Costs!

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Kamiak Econometrics, a Division of Kamiak Ridge, LLC