By Nick Jensen, CPA, CFP®
Owning land is a dream for many. It offers a chance to diversify investments while owning a tangible asset that can be enjoyed in many ways. Compared to looking at your investment account statement, there is something viscerally more satisfying about fertilizing your woodlot with your own footprints. Owning and taking care of the land has carrying costs that other investments do not have. Taxes, equipment purchase & maintenance, and insurance premiums are just a few examples. Woodlots do not operate on the same timeline as us humans. Often the economic benefit is not so much for the current generation but rather for the generations to come. It is tempting to selectively harvest some areas of your woodlot to provide some much needed liquidity while simultaneously improving the ecosystem; especially when timber prices are buoyant. Many landowners are unaware that they could be paying more of this hard earned money to the IRS than they should, come harvest time. Why is that? The answer lies in the concept of basis.
Any asset that you own has basis. In its most basic form, basis is what is paid for the asset. When the asset is sold, the owner gets taxed only on the difference between the selling price and its basis. This difference is known as capital gain (or loss). The purchase of a parcel of land should be looked at as a purchase of a collection of assets. First there is the raw land. Then there is any structure already existing on the land. Finally, there is the value of the timber growing on the land. Each of these assets should be assigned a value at the time of purchase. Unfortunately, many landowners fail to understand this concept at that time. As a result they do not know the basis of their woodlot and at the time of timber sale, tend to record the entire sales price as income rather than just the gain on the sale.
Establishing the basis of the standing timber is not that easy. Often it requires the services of a consulting forester. This ‘timber cruise’ is not cheap so even landowners who understand the concept of basis fail to get this done because they are already cash strapped from purchasing the parcel in the first place. If you are purchasing property with standing timber of 10 acres or more, you should look at the cost of establishing basis in the timber as another closing cost and build it into your purchase calculations rather than looking at it as a cost after the fact. The future tax benefit can exceed the cost of hiring a forester. Also, establishing a relationship with a consulting forester is a great early step in forming a long lasting partnership that will help you clarify your land ownership goals and help you improve the overall health of the woodlot.
But what if you are completely unaware and become educated on this important topic some years after the original purchase while reading this article? What if you inherited the property? What if the property was gifted to you? How is basis impacted by storm damage? How does one account for reforestation costs? Does growth of the trees affect basis? What is the tax impact if you harvest some of the wood to feed into your wood stove? What happens when you sell the wood for less than its basis? Answers to these questions will be explored in the balance of this article.
The basis of timber can be arrived at after the initial date of ownership. The services of a consulting forester are definitely needed in order to perform this calculation. A ‘back cruise’ is more expensive than performing the calculation at the date of purchase and any trees already cut down cannot be included.
Under the United States Tax Code, the basis of property inherited is ‘stepped up’ to the value on the Date of Death (DOD) of the person who bequeathed the property. This makes a cruise fairly easy because it only needs to go back to the DOD. If the property is gifted the basis of the original owner carries over to the new owner. This can make determination of basis almost impossible; especially if the property has been owned by the grantor for many years.
Timber basis should be looked at as a savings account. Some things such as reforestation costs can get added to the timber’s basis. Other things like storm damage or cutting trees of lesser value for firewood get taken away from basis. The ‘passbook’ for this savings account comes in the form of IRS Form T for Timber (aka forest activities schedule). It is a good idea for woodlot owners to maintain this schedule annually and to keep it in their tax file even if it is not required to be submitted to the IRS. Growth of the trees, like the growth in the value of a stock, does not get added to basis. This is the gain that you would eventually be taxed on at the time of timber sale. If at the time of sale, the timber is sold for less than its basis, then there is a loss on the sale. Any capital losses can be offset against capital gains. If there are more losses than gains then the net unused loss can be carried forward into future years to offset capital gains.
100 acres of timberland was purchased for $200,000
A timber cruise conducted at the time of purchase determines the basis of the timber to be $100,000 for 300,000 board feet of timber or .33 cents per board foot. One year later 75,000 board feet of undesirable growing stock and over mature stems are harvested yielding $40,000. A depletion allowance from this harvest is calculated by multiplying the $40,000 by .33 to arrive at $13,200. The net taxable income from this transaction is $40,000 – $13,200 = $26,800. Because the timber was owned for longer than one year, lower capital gains tax rates apply to this income instead of ordinary income tax rates.
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Nick Jensen, CPA, CFP® is an Associate Advisor at the wealth management firm of John G. Ullman & Associates, Inc. in Corning, NY. Nick welcomes your feedback and questions. He can be reached at (607) 936-3785 or via email at firstname.lastname@example.org