Taxation of Timber Income

Income generated from timber sales can be treated as ordinary income or capital gains income. The long-term capital gains of individual taxpayers are taxed at significantly lower rates than ordinary income. This includes gains passed through to owners from partnerships and S-Corporations. Long- and shortterm capital gains, are not subject to the self-employment tax. Corporation capital gains are taxed at the same rate as ordinary corporate income.

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Capital Gains Status

Tax provisions allow taxpayers who meet the requirements to claim capital gains status if operations are classified as either a trade, business, investment, or personal use. The 1986 Tax Reform Act equalized federal income tax rates for ordinary income and long-term capital gain income. A differential was reinstated in 1991 when ordinary income tax rates increased to 31% of income, but capital gain income was capped at 28%. The differential widened in 1993 when a 36% and 39.6% ordinary income tax rate was enacted, but capital gain income was still capped at 28%. The Taxpayer Relief Act of 1997 lowered the capital gains rate to 10% for taxpayers in the 15% tax bracket and 20% for those in the 28% or higher bracket. The effective date is for assets sold after May 6, 1997.

Benefits of Capital Gains
At the federal level, capital losses only offset ordinary income to a maximum of $3,000 per tax year; excesses must be carried forward. There is no limitation to offsetting capital losses against capital gains. Ordinary income realized from a timber sale is subject to the self-employment tax; the self-employment tax does not apply to capital gain income. During 1994, the self-employment tax included 12.4% for FICA ($60,600 income limit), and 2.9% for Medicare (no income limit). These taxes were applied to 92.35% of self-employment income.
Qualifying For Capital Gains
While the benefit of capital gain treatment on income is significant, each landowner needs to satisfy three basic criteria to qualify. These questions involve the purpose for holding the timber, how long the timber is held before sale, and the method used to sell the timber.
Purpose for Holding the Timber
Timber can be held in one of three ways to qualify for capital gain treatment. First, it can be held as a capital asset if not used for trade, business, or for sale to customers. Second, it can be held for use in a trade or business. Third, it can be held for sale to customers in the ordinary course of a trade or business.
How Long the Timber is Held
The second criteria concerns how long timber is held before sale or disposal. Purchased timber must be held for a minimum of 18 months (for sales after July 28, 1997) prior to sale or cutting to qualify for federal capital gain treatment.

Timber received as a gift also must be held for more than 18 months. However, the giver’s time of ownership is counted in determining the length of ownership. For instance, if an individual is given a parcel of timber that had been owned by the giver for 3 years, the immediate sale of timber would meet the ownership time requirement for capital gains treatment. No holding period is re-quired for recipients of inherited timber. The recipient of inherited timber can sell or liquidate timber immediately after acquisition and still qualify for the holding period requirements associated with capital gain treatment.

How the Timber is Disposed Of
The final requirement to qualify for capital gain treatment concerns how the timber is disposed of or sold. The IRS recognizes three different methods of selling timber: l) lump-sum sale or exchange, 2) the stumpage sale of timber to a purchaser who harvests and markets the logs with pay based on scaled volume harvested, and 3) a sale by a landowner who harvests the timber (or hires a logging operator) and markets the logs, poles, or other timber products.

Lump-Sum Sale: A lump-sum sale or exchange is the outright sale of timber for a fixed amount determined in advance of harvest. Within this sale structure, payment for timber removed is not based on the volume of timber scaled during harvest. All financial exchange is agreed on before any harvesting begins. Title to the timber passes through a deed or contract between the landowner and the purchaser.

Individuals who hold timber for trade or business purposes cannot use a lump-sum sale or exchange and still qualify for capital gain treatment. A lump-sum sale can be used by those who hold timber as an investment This criterion is very important for all forest landowners to understand. A forest landowner who otherwise qualifies for trade or business ownership would lose that classification if he or she completes a timber sale using a lump-sum sale or exchange. Capital gain treatment would be denied, and the income generated would be taxed as ordinary income.

631(b) Harvest: When a forest landowner sells timber to a purchaser (stumpage sale), he or she sells standing timber to a business that harvests the timber, and markets the wood to one or more log manufacturers. Under this criterion, the forest landowner’s payments for the logs must depend on the amount of timber actually harvested during the sale. Any timber remaining on the site after the harvest is completed is owned by the seller. Further, all payments must be based on the actual (scaled) amount of timber har-vested and removed from the property. This type of sale is called a section 63l(b) harvest by the IRS.

Under section 631(b) harvest requirements, all proceeds qualify for capital gains regardless of whether the property was held as an investment, a trade, or business venture, even if the timber was held primarily for sale to customers in the ordinary course of a trade or business (table 3). This sale structure is often called a “pay-as-cut” contract because it requires the purchaser to pay for all trees that are cut at a predetermined price.
 

Section 631(b) Harvest Calculation of Capital Gains
Proceeds from the Timber Sale
(+)
$75,000
Less Allowable Basis
(-)
$11,000
Net Capital Gain Income
(+)
$64,000

631(a) Harvest: The IRS treats two different timber sale structures alike under federal tax code. The first involves a forest landowner who harvests his or her own timber and sells the logs to mills or other log buyers. The second involves a forest landowner who hires a logging operator to complete harvest activities, but the actual marketing of the logs is done by the landowner or his or her agent. This sale structure does not permit the logging operator to determine the sale conditions of the logs. These sale structures are called 631(a) harvests by the IRS.

Under section 63l(a), a portion of the proceeds from the timber sale is capital gain income (Part l) and a portion is ordinary income (Part 2). Capital gain income includes the proceeds generated from holding the standing timber. The forest landowner must establish the value of the standing timber on the first day of the tax year in which that harvest occurs. The change in value from the date of acquisition until the first day of the tax year of harvest is considered capital gain income (table 4).

The proceeds generated from manufacturing and marketing the logs is considered ordinary income. To calculate the ordinary income portion, the forest landowner would subtract logging costs, administrative costs, and the fair market value (FMV) of the timber on the first day of the tax year from the proceeds of selling the logs (table 4). A specific election to treat the cutting as a sale under section 63l(a) must be made by the taxpayer by using IRS Form T or making an attachment to tax returns stating the election (example 3).

To qualify for capital gain treatment the taxpayer must meet the criteria previously discussed regarding: l) how the timber is held, 2) time of ownership, and 3) how the timber was disposed of or sold. Failure to qualify under any one of the provisions may result in the loss of the benefits provided under capital gain treatment. In that case all proceeds would be considered ordinary income and taxed accordingly. If the timber isn’t held for more than 18 months, but the sale otherwise qualifies as a capital gain, then it is short-term capital gain, not ordinary income. It becomes ordinary income if it is from the sale of cut products and section 631(a) was applied. It could also be ordinary income if the timber was held primarily for sale, was sold on the stump, and 631(b) was applicable.
 

Section 631(a) Harvest Calculation of Capital Gains
     Part I
Proceeds from the Timber Sale
(+)
$75,000
Less Allowable Basis
(-)
$11,000
Net Capital Gain Income
(+)
$64,000
     Part II
Gross Sale of Logs
(+)
$75,000
Less fair market value on Jan 1 of tax year
(-)
$55,000
Less Logging Costs
(-)
$18,750
Net Ordinary Income
(+)
$1,250

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Other Timber Related Income

Report income from the sale of forest products other than standing timber as ordinary gain or loss on federal tax returns. This rule applies to fence posts, fire-wood, chips, maple syrup, fruit, nuts, evergreen boughs, mushrooms, special forest products, live baled nursery stock, and other forest found items. Treat income that ensures payments for timber growth (lease) as ordinary income. Also treat rental payments for land growing trees or used for hunting purposes as ordinary income.
 
 

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Kamiak Econometrics, a Division of Kamiak Ridge, LLC