Timber is one of the most important industries in our region. In many areas it is far and away the largest employer. It provides jobs at saw mills, paper mills, harvesting companies, trucking entities, timber management firms and forestry consultants to name a few. Forest landowners in our area cover the spectrum from large international corporations with thousands of acres to small land owners with just a few. The ripple effect of the industry's financial impact within the region has a profound influence on the overall health of our economy.

This page looks at a few aspects of income tax, business operations and estate planning that are important to many of the people whose lives are touched by the timber industry. Also, we highly recommend anyone involved with forestry landownership get a copy of the USDA's Agricultural Handbook 718.

Issue: Types of Forest Landowners

The Internal Revenue Service places forest landowners in three groups: Personal use (hobby) owners, investors and business owners. Which category an owner falls in effects how they report income and expenses. A description of the types of owners and a few important concepts for each group are as follows:

Personal use owners: This category covers most small tract owners. Typically they make only one or two timber sales in their life time. The timber is often natural growth versus planted seedlings. They can not deduct yearly expenses as other types of owners may, but they can "capitalize" the expenses and add it back to their basis in the timber. When they have a sell, they can reduce their taxable profit by the amount of basis they have in the timber sold. Personal use owners have always enjoyed capital gains tax treatment, which under current law caps federal income tax on timber sales at 15%. If they replant their property after a harvest, they can take advantage of special tax credits on the cost of replanting. Plus they may qualify for programs with the USDA for cost sharing programs that can approach 50% of the cost or replanting.

Investors: Persons who buy forest land with the intention of selling in the future for a profit, but are not actively involved in management of the property, are categorized as investors. Often they retain timber management firms or consultants to help them efficiently manage their properties for maximum profitability. Their expenses may be deducted annually on Schedule A of their annual personal tax return if they meet certain qualifications. Otherwise, they "capitalize" their expenses and recoup them when the timber is eventually sold. Investors qualify for capital gains treatment on their income tax as well as USDA programs for replanting costs.

Business Owners (Tree Farmers): Forestland owners who intend to sell timber in the future for a profit and are actively involved in the management of the property are categorized as business owners. This category actually has two classes of sub-groups: material participants and passive participants. Material participants are allowed to deduct their yearly operating expenses in the year they are incurred on either Schedule C or Schedule F of their federal income tax return. Expenses might include maintenance on fences, cost of travel to and from the property, property taxes, fuel and maintenance of equipment and depreciation on equipment to mow and maintain fire lanes and private roads. Passive participants are subject to special restrictions on the deduction of expenses and losses. Whether or not a person is a material or passive participant depends on whether or not they meet certain rules known as IRS Passive Loss Rules.

Business Owners are now generally afforded capital gains treatment on the sale of their timber in the same manner as other forestry landowners. This is a major change in the IRS Code that occurred in late 2004.

It is recommended that Business Owners maintain a written forestry management plan and document their management activities. This might be considered a tree farm journal. Further, the Business Owner should maintain accounts for land, timber, income and operating expenses. It is a good idea to keep a log of your time to prove your material participation. IRS Form T Timber Activities Schedule can be helpful.

Issue: Basis -What is Your Ownership Value?
A Very Important, Often Misunderstood Estate
and Income Tax Planning Concept

A foresty landowner's basis in their land and timber is extremely important. Basis is essentially the dollars and cents value the landowner has in each componet of the timberland . How much value do they have in the land, how much value do they have in the trees. The difference between a landowner's basis in his trees and the amount of money he receives when he sells them, is the profit on which he pays taxes to the federal and state govenrments. Basis is a fundamental concept all foresty landowners need to understand.

Forestry land basis is roughly determined in three ways: (1) the price paid for the property, with an educated allocation made to land and existing trees. (2) the value of the property on the date of death of the person from whom the property was inherited, with an educated allocation made to land and trees. (3) IF RECEIVED AS A GIFT, THE GIFT RECIPIENT'S BASIS IS IDENTICAL TO THE BASIS WHICH WAS HELD BY THE PERSON WHO GIFTED THE PROPERTY.

Gifting Considerations: Unfortunately there is a common misconception that when land and trees are gifted at Fair Market Value on the date of the gift, that value forms the recipient's basis in the property. This is a wrong concept and runs counter to the Internal Revenue Code. The Fair Market Value of the gift is what the gift giver must consider for purposes of filing an IRS Form 709 Gift Tax Return. But the Internal Revenue Code dictates that a gift recipient can only receive the basis that was held by the gift giver. This can be an unfortunate surprise when the day comes that the recipient sells the timber.

Nursing Home Considerations: Many older forestry landowners face the problem of trying to decide whether to gift land to their children for the purpose of preserving their holdings or letting their children eventually inherit the property. This can be a difficult problem when parents face the significant costs of elder-care, nursing homes, and the impact of Medicare rules on that agency's criteria for assisting to pay for those very significant costs.

Inheritance Considerations: When someone who owns forestry land passes away, it is very important that a proper appraisal and valuation be made of all timber property. As stated above, heirs inherit the Fair Market Value of the land and timber at the decedent's date of death. This is known as "stepped-up basis". Stepped-up basis can save heirs literally thousands of dollars in income tax when they sell the inherited timber as shown in this example:

Timber Property Owner A sells $250,000 of timber on June 1 for which he has a basis in the timber of $50,000. He will pay capital gains taxes on the $200,000 profit of as much as $30,000 in federal income tax..

Timber Property Owner B, who has a basis in some timber of $50,000, passes away on January 15 of the same year. An appraisal is conducted by a registered forester who issues a formal written appraisal in which a value on the timber at B's date of death is set at $240,000. (Proper documentation can be an issue with the IRS). The estate is settled on May 15 with the decendent's only child receiving all of the timber property. His stepped-up basis in the timber is $240,000. The child sells the timber on June 15 for $250,000. The child will pay capital gains taxes on the $10,000 profit of as much as $1,500 in federal income tax. In other words, a savings of $28,500 in federal income tax for the child over what his parent, Timber Property Owner B, would have paid.

Please Note: This is a highly simplified example. Issues including (but not limited to) federal and state inheritance laws are not addressed which may or may not have an effect on the parties involved. In this and all such matters, always consult a tax professional with specific facts and circumstances for appropriate guidance and advice.

We can help forestry landowners with the issues of gift, estate and income tax planning that effect their lives.

Steven J. Koskie CPA LLC

Forestry Landowner Issues

Issue: Types of Forest Landowners