My last article analyzed the factors that affect how much money a Christmas tree grower can save by making a capital gain election. I often receive similar questions from forest landowners about how much money they can save on timber sales by qualifying for capital gain taxation.
For forest landowners, forest operation classification is the most important factor that affects how much money can be saved by utilizing capital gain taxation under IRC 631.
Activity Classification
There are three potential ways a forest activity can be classified: personal, investment, or business.
Capital gains treatment is most important if your activity is classified as a business because the default taxation for the business income is: (1) at ordinary income rates and (2) often subject to self-employment tax.
If your activity is an investment, capital gain taxation is the default taxation because timber is deemed to be a capital asset is held for investment purposes.
Personal classification is rare because most people purchase forest land for income producing purposes. However, any taxable gain from selling timber held for personal use will also have capital gains as the default classification.
Tax Savings Example
In 2022, a single, forest landowner has a timber gain of $100,000 from a timber activity operated as a business. The forest landowner’s taxable income before the timber gain is $50,000 from other unearned income. How much money could the forest landowner save by qualifying for capital gain taxation?
Although the above example and calculations are simplified, forest landowners will often save thousands of dollars in taxes by utilizing the capital gain method.
Business Entities
The business entity may also affect the tax savings calculation. A C corporation generally does not benefit from capital gains. Very few forest landowners are likely taxed as C corporations, as sole proprietorships, partnership, and S corporation taxation are more frequently-utilized methods.
However, if a grower operates his forest activity as a C corporation, the capital gain method will likely not be advantageous and he should consider converting his C corporation to a different entity type.
Many forest landowners operate through sole proprietorships or single member LLCs. These operations are reported on an individual’s income tax return and are fairly straightforward.
Multimember LLCs or S corporations must file a separate tax return for the entity. The tax savings will be based on the tax situation of each individual owner because their share of income and loss flows through to the individual owner and is taxed on their personal tax return.
Summary
Forest landowners who operating their timber activity as a business, do not have other earned income over $140,000, and are not C corporations will likely save the most taxes under the capital gain method.
However, in my experience, most forest landowners will save at least a few hundred dollars, if not a few thousand dollars, in taxes by utilizing the capital gain method.
If you are considering switching to the capital gain method, make sure you keep proper records to support the capital gain method. Also, reach out to me if you’d like help!
