After reading What is Basis and Why Does It Matter, you’re probably asking yourself, how do I calculate timber basis?
As discussed in my previous article, a forest landowner must calculate an accurate timber basis for maximum tax savings.
This article will explain how to calculate timber basis under the four main ways forestland is acquired.
The four main ways to acquire forestland are:
1) Purchase
2) Gift
3) Inheritance
4) Like-Kind Exchange
1) Purchase
The most common way to acquire forestland is to purchase it.
When an individual purchases forestland, he pays a single price and receives multiple assets: the land itself, any existing timber, and any land improvements.
Although a forest landowner will view the transaction as a single purchase, for tax purposes, the transaction is a separate purchase of each asset or type of asset.
A forest landowner must allocate the total purchase price of the forestland to the multiple assets acquired based on their relative Fair Market Values (FMV).
The resulting allocation of the purchase price is the assets’ “cost basis,” and is the amount used to determine gain or loss, depletion, depreciation, amortization, and other tax calculations.
Cost Basis Example
Paul Bunyan purchased 50 acres of forestland in 2021 for $100,000. The FMV of the land was $50,000, the FMV of the existing timber was $40,000, and the FMV of existing logging roads were $30,000 (FMV Total = $120,000).
How should Paul allocate the $100,000 cost between the purchased assets?
Land cost basis = ($50,000 / $120,000) * $100,000 = $41,667
Timber cost basis = ($40,000 / $120,000) * $100,000 = $33,333
Land Improvements (logging roads) cost basis = ($30,000 / $120,000) * $100,000 = $25,000
Allocation of cost basis depends upon the FMV of the assets at the time of purchase. For this reason, an appraisal performed by a consulting forester at the time of purchase is extremely important! An accurate appraisal will maximize cost basis and lessen the risk for any tax changes due to an IRS audit. Although later appraisals can be adjusted retroactively, the best practice is to have the forestland appraised as close to the acquisition date as possible.
2) Gift
A forest landowner may also receive a gift of forestland.
A gift is a transfer of property or money out of “detached and disinterested generosity” while the donor (individual making the gift) is still alive. A gift does not include an inheritance (a transfer of property after an individual’s death), which is discussed in the next section.
Generally, the donee (individual receiving the gift) takes the donor’s adjusted basis in the asset, often referred to as “carryover” basis. Adjusted basis is the original owner’s cost basis after taking into account certain adjustments, such as depreciation, depletion, or capital expenditures.
Tax law uses carryover basis to prevent tax gain shifting from high-income taxpayers to low-income taxpayers or tax loss shifting from low-income taxpayers to high-income taxpayers.
Gift Example #1
Instead of purchasing the land in the cost basis example, Paul’s father gifted Paul the 50 acres of forestland. His father’s adjusted basis (AB) in the land was $25,000, the AB of the existing timber was $10,000, and the AB of the existing logging roads were $30,000. The FMVs of the assets are the same as in the cost basis example (FMV land = $50,000, FMV existing timber = $40,000, and FMV existing logging roads = $30,000).
What is Paul’s basis in the assets?
Land carryover basis = $25,000
Timber cost basis = $10,000
Land Improvements (logging roads) cost basis = $30,000
In this instance, Paul takes a carryover basis in the assets equal to his father’s adjusted basis in the assets. However, a carryover basis is not used in every gift situation. The next example will illustrate such a scenario:
Gift Example #2
Same as Gift Example #1; however, the FMV of the logging roads were $10,000 instead of $30,000 because they are in disrepair.
What is Paul’s basis in the assets?
Land carryover basis = $25,000
Timber cost basis = $10,000
Land Improvements (logging roads) cost basis = $30,000 for computing gain; $10,000 for computing loss
In Gift Example #2, the FMV of the logging roads ($10,000) is less than Paul’s father’s AB in the logging roads ($30,000). In a scenario like this where the FMV < AB, two separate carryover bases are computed: one for a gain scenario and one for a loss scenario. The carryover basis for computing gain is the donor’s adjusted basis in the asset, while the carryover basis for computing loss is the FMV of the asset. This rule prevents a low-income taxpayer from gifting an asset with a built-in loss to a high-income taxpayer who would recognize larger tax savings by deducting a loss.
Additionally, the donee’s basis will also increase by any gift taxes paid. This is generally a rare situation, but occasionally applies and may apply more frequently if the estate tax exemption decreases.
3) Inheritance
A forest landowner may also inherit forestland.
In this article, I’m using “inheritance” to refer to any way a forest landowner acquires forestland from a deceased individual’s estate, whether through a will or intestate succession (no will). If an individual receives forestland from a deceased individual through a trust, it may or may not qualify for “stepped-up” basis (as described below) depending on the type of trust.
Generally, inherited property receives a “stepped-up” basis. This means the heir’s adjusted basis is “stepped-up” to the FMV of the property on the date of the decedent’s death.
Alternate valuation dates (instead of the decedent’s date of death) may be used in certain instances. These alternate dates are very specific; however, I’m noting they exist and discuss them with your tax professional if you inherit property.
Basis can also be “stepped-down” if the FMV is less than the AB on the date of death.
Inheritance Example #1
Instead of receiving the forestland as a gift, Paul’s father left Paul the 50 acres of forestland in his will.
His father’s adjusted basis (AB) in the land was $25,000, the AB of the existing timber was $10,000, and the AB of the existing logging roads were $30,000.
The FMV of the land was $50,000, the FMV of the existing timber was $30,000, and the FMV of the existing logging roads were $25,000. All FMVs are as of the date of Paul’s father’s death.
What is Paul’s basis in the assets?
Land “stepped-up” basis = $50,000
Timber “stepped-up” basis = $30,000
Land Improvements (logging roads) “stepped-down” basis = $25,000
Inheriting assets is one of the best ways to avoid income taxes. If Paul immediately sold the forestland upon inheriting it, he would report no gain or loss, as well as have $105,000 in tax-free proceeds.
If Paul’s father instead gifted him the forestland one day before his death and Paul sold it, Paul would recognize a $35,000 taxable gain (assuming Paul sells at the FMVs). This is a huge difference and illustrates why it is much better to inherit appreciated assets rather than receive them as gifts.
Inheriting Entity Interests
The above example assumes Paul’s father wholly owned the forestland in his own name and not through a business entity. What if Paul and his father were instead each 50% owners in an LLC that owned the forestland?
Upon Paul’s father’s death, Paul would inherit his 50% LLC interest. Paul’s basis in the LLC interest itself, also called “outside basis,” would be stepped-up to FMV. However, the LLC’s basis in the forestland, also called “inside basis,” does not get stepped-up unless the LLC makes a special election on its tax return.
Assuming the LLC files as a partnership, it would need to make a § 754 election on the partnership tax return to step-up the inside basis (basis of the forestland) to FMV when Paul’s father dies. If this election is not made, the basis of the forestland remains the same. This results in lower depletion deductions and less depreciation expense, which leads to higher taxes than if a § 754 election had been made.
Inheriting entity interests and § 754 elections are extremely complex. If you are in this situation, I strongly recommend consulting with a knowledgeable timber CPA or attorney.
4) Like-Kind Exchange
A like-kind exchange (also known as a section 1031 exchange) is a tax-deferral strategy where business or investment property is exchanged for “like-kind” property that is also used for business or investment purposes.
A like-kind exchange uses a carryover basis similar to gifted assets. The AB of the property given up is carried over and used as the basis for the like-kind property received. Since carryover basis is used, any taxable gain in a pure like-kind exchange is deferred until the received property is disposed of in a taxable transaction.
Like-Kind Exchange Example #1
Building on Inheritance Example #1, Paul exchanges the 50-acre parcel (with a total adjusted basis of $105,000) he inherited from his father for a different 75-acre parcel (with a total FMV of $125,000). Paul received no money or nonqualifying property as part of the exchange.
What is Paul’s total basis in the 75-acre parcel? Does he recognize any taxable gain or loss?
Total carryover (exchange) basis = $105,000
Paul recognizes no gain or loss
Paul’s total basis would have to be allocated based on FMVs as of the exchange date to each of the individual assets, similar to Cost Basis Example #1.
However, partial gain recognition can occur if “boot” is received as part of the transaction. Boot is any money or nonqualifying property received as part of the like-kind exchange.
Like-Kind Exchange Example #2
Same facts as Like-Kind Exchange Example #1; however, Paul received $10,000 in addition to the 75-acre parcel.
What is Paul’s total basis in the 75-acre parcel? Does he recognize any taxable gain or loss?
Total carryover (exchange) basis = $105,000
Paul has a realized gain of $20,000 ($125,000 FMV – $105,000 AB)
Paul recognizes gain to the extent of “boot” = $10,000
Like-kind exchanges are a great tool to defer taxes, especially when highly-appreciated property can be exchanged for another desirable property. If like-kind exchanges are coupled with leaving the property to your heirs, you or your heirs may never pay tax on the appreciation!
Summary
An accurate tax basis is necessary for a forest landowner to maximize tax savings. This article discussed the four main ways forestland is acquired and how basis is calculated under each scenario.
The examples in this article were fairly simple illustrations. In real life, calculating basis is often much more complicated due to acquisition of multiple parcels with multiple timber tracts and numerous land improvements.
A forest landowner should consult with a knowledgeable timber CPA or attorney whenever forestland is acquired to ensure basis is properly calculated.
Stay tuned for Back to Basis (Part 3), which will cover how the Qualified Reforestation Expenditures deduction accelerates basis deductions!
