An accurate timber basis is extremely important for every forest landowner.
After my webinar on the Top 5 Ways Forest Landowners Save Taxes, I received many comments requesting further explanation of basis. This is the first article in a three-part series on basis, which will hopefully be followed by another webinar in the coming months to explain basis further.
This article will answer the question: what is basis and why does it matter?
What is Basis?
Original and Adjusted Basis
In its most simple terms, basis is the measure of an individual’s investment in an asset. Basis can also be thought of as the amount of money that has already been taxed in an asset.
For example, Tim Burr purchased an acre of forestland for $10,000. Tim’s total basis in the forestland is $10,000 because Tim invested $10,000 to purchase the forestland. Also, Tim purchased the forestland using money generated from other sources that has either already been taxed or was exempt from tax. Assuming no other changes, basis ensures Tim will not be taxed on the $10,000 again when he sells or otherwise disposes of the forestland.
Forestland is generally acquired in four ways: purchase, gift, inheritance, or like-kind exchange. Original basis is calculated differently depending on the scenario and will be explained in the next article.
Basis may also be adjusted over time. The basis after adjustments is referred to as “adjusted basis.” Original timber basis may be increased by additional acquisitions of timber or decreased by depletion expense when timber is sold.
Basis vs. Expenses
Basis must also be distinguished from other expenses. Basis is a cost that must be capitalized, meaning it may not be immediately deducted on a forest landowner’s tax return.
Going back to the previous example, Tim’s purchase of an acre of forestland for $10,000 does not result in an immediately deduction of $10,000 on his tax return. Tim must capitalize the $10,000. He may be able to deduct a portion of the $10,000 in the year when he harvests timber. Also, if Tim sells the forestland, he may deduct $10,000 (or the current adjusted basis) from the sales price to determine his taxable gain or loss.
However, basis does not consist of ordinary and necessary expenses to managing forestland. Common expenses for forest landowners include timber stand improvements, property taxes, and consulting forester fees. These expenses may be immediately deducted and do not have to be capitalized.
The cost of planting seedlings and establishing additional timber stands must be capitalized (but may be eligible for a Qualified Reforestation Expenditures deduction). Also, land improvements, such as establishing forest roads, must be capitalized (but may be eligible for depreciation).
Why Does Basis Matter?
An accurate basis is used by forest landowners in three important ways:
1) Used to calculate a depletion deduction when timber is sold
2) Used to calculate a casualty deduction if timber is destroyed by a natural disaster
3) May be used to calculate basis in another property or a future owner’s basis
1) Timber Depletion Deduction
A forest landowner generally 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 Sale Expenses = Timber Sale Profit.
The larger the timber cost basis, the larger the depletion deduction, and the lower the taxable net profit. However, this does not mean a forest landowner 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.
2) Casualty Loss
Cost basis is also used to determine a tax deduction if there is a casualty loss, such as due to a forest fire. A casualty loss deduction is based on the basis of the destroyed property, not its fair market value. Recent tax law changes have made deducting casualty losses more difficult; however, a casualty loss deduction is still available to forest landowners owners in some instances.
3) Basis in Another Property or Basis of a Future Owner
If you trade your forestland in a like-kind exchange for another property, your basis in the new property will be determined, at least in part, on your current basis in the forestland.
If you gift forestland before your death or pass forestland to your heirs in a way that does not qualify for a stepped-up basis, your basis in the forestland may be used to calculate the donee’s or heir’s basis.
Conclusion
An accurate timber basis is extremely important for every forest landowner. This article gave a quick overview of basis. Many of these scenarios will be discussed further in future articles in the Back to Basis series. Stay tuned to learn more about basis!
