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Section 631(a) Transaction (Election to Treat Cutting as a Sale)

Timber owners who cut timber for use in their own trade or business can, under certain conditions, obtain partial capital gains treatment by "electing to treat the cutting as a sale" under the provisions of Section 631(a) of the Internal Revenue Code. The gain from timber cut under a section 631(a) election, that has been held for more than one year, and was cut as part of a trade or business is reported in two parts.

Calculating the proceeds from a Section 631(a) transaction - First, the difference between the allowable basis of the standing timber cut during the taxable year and its "fair market value" as of the first day of the taxable year in which it was cut may qualify for capital gains treatment.

Fair market value as of the first day of the taxable year in which it was cut

less

The allowable basis of the standing timber

This amount is reported on Federal Form 4797 where it is netted together with any other Section 1231 transactions for the year to determine one net long-term gain (loss) or short-term gain (loss).

Second, the difference between the fair market value of this timber on the first day of the tax year and the proceeds from the sale of the products produced from the timber cut, less processing costs.

Income from the sale of the logs

less

Logging and other expenses

less

Depletion allowance

This amount is reported as ordinary income on Federal Form 1040, Schedule F (for farmers) and Schedule C for businesses.

In addition to computing the proceeds from the sale and reporting them on the appropriate form, Part III of Form T (timber activities schedule) should be completed. Once an election to use section 631(a) has been made for the year it is binding to all eligible timber cut in the current year and all subsequent years, and requires the consent of the IRS to discontinue the election. However, under the provisions of the Tax Reform Act of 1986 a taxpayer with a section 631(a) election in effect may revoke the election one time without affecting their ability to make a subsequent section 631(a) election.

Definitions - To properly apply the provisions of Section 631(a) it is important to understand some of the definitions associated with it.

Owner: Section 631(a) treatment is available for timber you which you owned, or held a contract right to cut timber for more than one year. A contract right to cut timber exists if the person holding the contract has the unrestricted right to sell the timber cut under the contract on his own account or to use it in his own trade or business. This means that if you were a logger who bought timber under a cutting contract, you would be the owner of that timber for Section 631(a) purposes just as if you had outright title to it, or to the land and the timber together. However, a person who provides only a logging service for another does not qualify.

Timber: For the purposes of Section 631(a) timber is defined exactly the same as for section 631(b).

Intended Use: Only timber cut for sale or use in a taxpayers trade or business qualifies. Timber cut for personal use does not qualify. "Timber cut by the taxpayer" includes that which is personally cut by the taxpayer or which is cut by persons in the taxpayer's employ or under contract to the taxpayer.

Fair Market Value: The fair market value used as the sales price is that price at which the standing timber that was felled would have changed hands between a buyer and a seller on the first day of the tax year in which the trees were cut, assuming both parties had reasonable knowledge of all the necessary facts and neither was required to buy or sell. The trees must be valued as they existed on the first day of the tax year regardless of any changes that occurred to them between that date and the date of the actual cutting.

The best indicators of fair market value are the actual prices paid for similar timber in the area in which the timber being valued was located. Such prices, however, have to be adjusted to account for any differences between the condition of the trees being valued and the markets for them, as compared to the timber for which actual prices are known. The fair market value used must be for the actual trees cut; they must be valued on their own merits and not on the basis of a general average for the region. Among the factors to be considered are the following:

• The character and quality of the timber as determined by species, age, size and condition.
• The quantity of timber per acre, the total volume under consideration, and its location with reference to available markets.
• The accessibility of the timber from the standpoint of the probable cost of cutting and transportation.
• The competition likely to develop from other timber buyers.

Holding Period: The holding period under Section 631(a) runs from the date you acquired the timber or the contract right to cut timber to the date it is cut. Timber is considered cut when, in the ordinary course of business, the quantity felled is definitely determined. This is the same as Section 631(b), determining the volume cut.

Election of Section 631(a): You elect to use Section 631(a) by computing your taxes according to its provisions. You indicate the election by answering the question in item 44 and supplying the information asked for in items 45 through 51 of Schedule F Form T. The election must be made on the original tax return (including extensions) for the year to which it applies, and not on an amended return for that year.

An election under Section 631(a) is binding with respect to all eligible timber you cut in the year of the election and in all subsequent years. The basic rule of discontinuance is that consent must be obtained from the IRS. This permission may be given only where there is a showing of undue hardship and , if given, consent to reelect must also be obtained. However under the provisions of the Tax Reform Act of 1986 a taxpayer with a Section 631(a) election in effect may revoke the election one time without affecting their ability to make a subsequent 631(a) election. The one time revocation can be made simply by attaching a statement made on a plain sheet of paper to the tax return for the year in which the revocation is to be effective.

Reporting Requirements: Reporting requirements under Section 631(a) are the same as for section 1231 gains and losses and for any other income realized from a trade or business. The gain or loss on the standing timber is reported on Federal Form 4797 with other Section 1231 transactions for the year. The profit or loss from the sale of the cut products is reported by sole proprietors on a business schedule, either Schedule F or Schedule C of Form 1040. The cost of the timber cut and the expenses of cutting and sale are listed as "other" expenses on Schedule C or Schedule F.

An attachment giving the details of the cutting and sale should be included with your tax return. Attach Schedule F of Form T or provide the information required by Schedule F on a plain sheet of paper attached to your tax return. You should include details of how the depletion basis was determined, if one was used, as well as information on how the fair market value was determined.