A common question forest landowners ask me is: how are cost-share payments taxed? Are the payments capital gain or ordinary income?
The short answer is that a forest landowner generally must report cost-share payments as ordinary income. However, a forest landowner may be able to exclude cost-share payments from income under certain circumstances.
What Are Cost-Share Payments?
As a quick refresher, cost-share payments are payments from a government agency to a forest landowner to help offset the cost of reforestation or other forest improvement projects. Cost-share programs are one way the government encourages productive use and management of private forestland.
General Rule
As a general rule, a forest landowner must report a cost-share payment as ordinary income on his tax return. Cost-share payments are not eligible for capital gain treatment.
However, cost-share payments may have a deductible expense associated with them, which will “offset” some or all of the income.
For example, a forest landowner reestablished trees on a tract of land at a cost of $10,000 and received a $5,000 cost-share payment. The $5,000 payment is ordinary income; however, the $10,000 would likely be eligible for immediate deduction as Qualified Reforestation Expenditures. Therefore, the $5,000 cost-share payment income is completely offset by a deductible expense.
Cost-Share Exclusion
As an exception to the general rule, Internal Revenue Code § 126 permits forest landowners to exclude certain cost-sharing payments from gross income. Many federal and state conservation programs qualify for this cost-share exclusion. A useful list of federal programs can be found here.
Generally, cost-share payments for capital improvements may be excludable, while cost-share payments for deductible expenses are never excludable.
For example, a cost-share payment for timber stand improvement (TSI) is not excludable from gross income because TSI expenses may be deducted in the year incurred. However, even though the TSI cost-share payment is included in income, the actual TSI expenses may be deducted on the return to “offset” the cost-share payment.
However, even if a cost-share payment is for a capital improvement, the entire cost-share payment may not be eligible for exclusion. If the cost-share payment “substantially increases” the annual income from the property, then part of the cost-share payment may not be excludable. “Substantially increases” is defined as in excess of the greater of $2.50 per acre or 10% of average annual income before the improvement.
The IRS requires a calculation on the tax return to determine if the cost-sharing payment substantially increases the annual income from the property. This calculation can be complex and is outside the scope of this article (but may be discussed in a future article!).
If a cost-share payment is partially or entirely excludable from income, no deduction for an expenditure associated with the cost-share payment is allowed. This rule prevents a forest landowner from obtaining a “double benefit.”
For example, a forest landowner spends $10,000 on planting vegetation as a habitat for endangered species and receives a $10,000 cost-share payment. Since the $10,000 is excluded from income and not taxed, the forest landowner may not deduct any part of the $10,000 cost of planting vegetation on his tax return.
Conclusion
Many forest landowners participate in cost-share programs as a cost-effective way to improve their forestland. However, forest landowners should consider the tax consequences before entering into any cost-share agreement. For more information about cost-share payments or to analyze the taxability of a cost-share payment, contact me.
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