This is the second post in a series covering timber tax basics. Part 1 discussed timber activity classification and how classification affects timber taxation. This post (Part 2) covers calculation of cost basis, capital accounts, and the reforestation deduction. Future posts will explore issues such taxation of timber sales, completing IRS Form T, and much more!
Why is Timber Cost Basis So Important?
Having an accurate timber cost basis is extremely important for a number of reasons:
First (and perhaps most important), a timber owner must know the cost of their timber to determine if they make a profit or loss (and how much) when the timber is sold. Not only does an accurate profit calculation matter for tax purposes, but also a timber owner’s finances in general. Knowing the profit details of a timber activity will assist with future planning.
Second, a timber owner wants the maximum allowable timber basis to lower taxable profit. The IRS taxes a timber owner on the net profit of their timber activity. An overly simplified equation is:
Timber Sale Price – Timber Cost Basis (aka Depletion) – Other Expenses = Timber Profit
The larger the timber cost basis, the lower the taxable net profit. However, this does not mean an individual should look to pay as much as possible for timberland in order to increase their basis. The economics of the investment must still make sense. But after purchase, a timber owner should make sure their timber cost basis is computed correctly.
Finally, timber cost basis is also used to determine a tax deduction if there is a casualty loss, such as due to a forest fire. Recent tax law changes have made deducting casualty losses more difficult; however, a casualty loss deduction is still available to timber owners in some instances.
Allocation of Original Basis Upon Acquisition of Timber Property
When a timber owner purchases timberland, they pay a single price and receive multiple assets: the land itself, any existing timber, and any land improvements.
Although a timber owner will view it as a single purchase, for tax purposes, the transaction is viewed as separate purchases for each asset or type of asset. The total purchase price of the timber property must be allocated to the individual assets acquired based on their relative fair market values (FMV).
Basis Allocation Example
Paul Bunyan purchased 50 acres of timberland in 2020 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 $20,000.
How should Paul allocate the $100,000 cost between the purchased assets?
Land cost basis = ($50,000 / $110,000) * $100,000 = $45,455
Timber cost basis = ($40,000 / $110,000) * $100,000 = $36,364
Land Improvements (logging roads) cost basis = ($20,000 / $110,000) * $100,000 = $18,181
This allocation of the cost among the acquired assets must also be performed even if a timberland owner acquires the timberland in a non-purchase transaction, such as gift, inheritance, or like-kind exchange. In a gift transaction, the recipient uses the donor’s cost basis. In an inheritance, the recipient uses the FMV of the timberland at the date of the decedent’s death. A like-kind exchange is outside the scope of this article, but involves trading one piece of property for another, often without any immediate tax due.
Maintaining Capital Accounts
After the initial allocation of original basis, a timber owner should create separate accounts to track the cost of the assets in future years. These accounts will also track any new assets added, improvements made, and any assets sold. There are four main types of accounts that a timberland owner should create:
Land Account
The land account should track the cost basis of the land itself, as well as any land improvements that are not depreciable. Nondepreciable land improvements are typically “permanent” improvements, such as permanent roads, land grading/leveling, land clearing, dam construction, and any other improvements that will benefit the land indefinitely.
Depreciable Land Improvements Account
The depreciable land improvements account should track the cost basis of all land improvements that are eligible for depreciation. In contrast to “permanent” nondepreciable land improvements, depreciable land improvements typically wear out and have a definite useful life. Depreciable land improvements include fences, bridges, temporary logging roads, temporary firebreaks, and graveling.
Timber Account
The timber account should track the cost basis of all timber, as well as the estimated quantity of timber. Further, the timber account should contain any applicable subaccounts to make recordkeeping easier and more useful to the timberland owner.
Timber subaccount categories often include merchantable timber (timber ready to sell), young growth (young trees acquired with the land that are not ready to sell yet), and plantations (tree stands established after the land was acquired). The timber accounts or subaccounts can also track other variables such as tree species and location.
How the timber accounts are structured in regards to location is especially important for determining any applicable casualty loss deduction. A casualty loss deduction is typically calculated based on a “single, identifiable property (SIP).”
For timber purposes, an SIP is typically based on the “depletion block” or the trees established at the same time that have the same cost basis. However, an SIP can also be based on the amount of timber damaged or lost in terms of cords, board feed, or other timber measurement.
Equipment Account
A timber owner should also track the cost basis of any equipment they own and use in their timber activity, such as vehicles, chainsaws, ATVs, and other machinery. The cost of equipment used in a timber activity often qualifies for a depreciation deduction. The type and timing of the depreciation deduction depends on how the activity is classified. Special depreciation allowances, such as 179 expense and bonus depreciation, can result in significant tax savings for a timber owner and will be discussed in a future article.
Qualified Reforestation Expenditures
Generally, the cost of planting tree seedlings is not deductible until the trees are sold as timber. However, the IRS permits a timber owner to immediately deduct up to $10,000 each year of “Qualified Reforestation Expenditures.”
Qualified Reforestation Expenditures include the cost of land preparation, the cost of the seeds or seedlings themselves, and the cost of planting labor. Although called “reforestation expenditures,” the expenses need not be incurred to replace a harvested timber stand. Qualified Reforestation Expenditures can be deducted for establishing new timber stands.
This special tax treatment for Qualified Reforestation Expenditures is not automatic. A timber owner must make an election on their tax return to be eligible for the maximum $10,000 deduction.
Conclusion
Timber cost basis is extremely important for tax purposes and varies greatly based on the type of timber activity; therefore, consultation with a knowledgeable timber CPA is recommended for your individual situation. The next post in this series will discuss how to minimize taxes from timber sales. Feel free to reach out with any questions or comments!
