I often receive questions from forest landowners about the differences between Internal Revenue Code (IRC) § 631(a) and § 631(b).
IRC § 631 provides capital gain treatment for qualifying timber sales. Capital gain treatment is beneficial to forest landowners, especially those that operate their forestland as a business, because of lower capital gains tax rates and exclusion from self-employment tax.
However, to qualify for capital gain treatment, forest landowners who operate their forestland as a business must understand the differences between § 631(a) and § 631(b) to ensure they meet all applicable requirements. A forest landowner may qualify for capital gain treatment under either § 631(a) or § 631(b).
§ 631(b) is the simpler of the two provisions, so we’ll begin there.
IRC § 631(b)
If a forest landowner, sells timber outright or with a retained economic interest, the profit from the sale is treated as a long-term capital gain according to § 631(b).
To qualify for § 631(b) treatment, the forest landowner must sell the trees on the stump. If the forest landowner cuts his own trees or hires someone to cut the trees for him, the sale must qualify under § 631(a) instead.
Selling timber outright is also known as a “lump-sum sale.” Any time a forest landowner enters into a contract for a set dollar amount for timber or an individual pays a set annual rental fee for the right to cut timber, it is a lump-sum sale.
In contrast, a retained economic interest occurs anytime the forest landowner receives payment based on the volume of timber harvested. A retained economic interest agreement is also known as a “pay-as-cut contract.”
Regardless if the timber is disposed of in a lump-sum or pay-as-cut agreement, the sale will qualify for § 631(b) treatment as long as standing timber is sold and the forest landowner owned the timber (or had the right to cut the timber) for more than one year.
Prior versions of § 631(b) only allowed capital gain treatment for retained economic interests and excluded lump-sum sales. However, §631(b) was amended in 2004 to include lump-sum sales.
While an election is required under § 631(a) (explained in the next section), no election is necessary for § 631(b) treatment. The forest landowner simply reports the capital gain properly on their tax return.
§ 631(b) Example
Tim Burr purchased forestland in 2010 with a merchantable timber account that contains 20,000 MBF of sawtimber with a basis of $3,000,000. In November 2022, Tim sells 5,000 MBF of the standing sawtimber to a logger for $1,250,000.
Does this sale qualify for capital gain treatment under § 631(b)? If so, what is Tim’s gain?
This sale qualifies for § 631(b) treatment because it is a lump-sum sale of standing timber that Tim owned for more than one year.
First, Tim’s depletion deduction should be calculated:
$3,000,000 basis / 20,000 MBF before harvest = depletion rate of $150 per MBF
5,000 MBF sold x $150 per MBF = $750,000 depletion deduction
Note: for a refresher, read this Q&A article about depletion.
Then, subtract the depletion deduction from the amount received upon disposal of the standing timber to calculate the IRC § 631(b) gain:
$1,250,000 timber sale proceeds – $750,000 depletion deduction = $500,000 long-term capital gain per IRC § 631(b)
IRC § 631(a)
A forest landowner, who is in the business of selling timber and cuts his own timber or pays someone to cut it for him, may qualify for long-term capital gain treatment if he meets the requirements of § 631(a).
First, the forest landowner must have owned the trees or had the right to cut the trees for more than one year.
Second, the forest landowner must split the sales proceeds into two amounts: (1) the gain that resulted from holding the standing timber until cutting, and (2) the added value from converting the standing timber into logs or wood products.
The forest landowner calculates the § 631(a) gain (or long-term capital gain) by subtracting the adjusted basis for depletion of the timber from its fair market value as of January 1 of the tax year it was cut. This is the gain from holding the standing timber until cutting.
The forest landowner then calculates the added value from converting the standing timber by subtracting the fair market value of the timber as of January 1 (and any processing costs) from the sale proceeds of the wood products.
Finally, the forest landowner must elect § 631(a) treatment on the tax return by checking the appropriate box on Form T and properly splitting the timber sale proceeds between long-term capital gain and ordinary income.
§ 631(a) Example
Same facts as the § 631(b) example. However, instead of selling the standing timber, Tim harvest 5,000 MBF of standing timber himself and sells it to a sawmill in November 2022 for $1,500,000. The fair market value of the standing timber on January 1, 2022 was $1,200,000. Tim properly elected IRC § 631(a) treatment on his 2022 tax return.
Does this sale qualify for capital gain treatment under § 631(a)? If so, what is Tim’s Ordinary and Long-Term Capital gain?
This sale qualifies for capital gain treatment under IRC § 631(a) because Tim owned the timber for more than one year, he cut the timber himself, and he properly elected § 631(a) treatment on his tax return.
First, Tim’s depletion deduction should be calculated:
$3,000,000 basis / 20,000 MBF before harvest = depletion rate of $150 per MBF
5,000 MBF sold x $150 per MBF = $750,000 depletion deduction
Note: depletion is the same regardless if the timber is sold under § 631(a) or § 631(b).
Then, subtract the depletion deduction from the fair market value of the standing timber as of January 1 of the sale year to calculate the § 631(a) gain:
$1,200,000 timber fair market value as of January 1, 2022 – $750,000 depletion deduction = $450,000 long-term capital gain per § 631(a)
Finally, subtract the fair market value of the standing timber as of January 1 of the sale year from proceeds received from selling the felled logs to the sawmill to calculate the ordinary gain:
$1,500,000 sale proceeds of logs to sawmill – $1,200,000 timber fair market value as of January 1, 2022 = $300,000 ordinary income
Conclusion
Hopefully, this article helps illustrate the differences between IRC § 631(a) and IRC § 631(b). A forest landowner can qualify for capital gain treatment under either provision depending on how a timber sale is structured. Real life situations are much more complex than the examples above, so consultation with a timber CPA or attorney is highly recommended!
