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Gaining a Lower Rate

Tree Farmer Magazine: July/August 2000 - Volume 19, No. 4

We need to revisit the rules about lower capital gains rates for assets held more than five years. If you're in the 15-percent ordinary income tax bracket you'll get a tax break next year if you sell timber or other assets. If you're in the 28-percent or higher ordinary income bracket you''ve got a decision to make between now and April 15, 2002 when you're 2001 tax return. Here are the details on what is known and my call on issues to be clarified by forthcoming IRS regulations.

What's the Advantage?

The new rule is that if you hold an asset for more than 5 years and sell it after December 31, 2000, you may qualify for an 8-percent maximum capital gains rate instead of the 10-percent rate, or an 18-percent rate instead of 20-percent.

There's a caveat, however, based on when you acquired the property. If you're in the 15-percent ordinary income tax bracket it doesn't matter whether you acquired the property after December 31, 2000. You just have to sell it after December 31, 2000 and have held it for more than 5 years. Bingo, your maximum rate is 8 percent, instead of 10 percent, assuming the sale otherwise qualifies for long-term capital gains treatment. But, if you're in the 28-percent or higher ordinary income tax bracket you must also have acquired the property after December 31, 2000 and held it for 5 years thereafter.

Special Election and Deemed Sale

What if you acquired the property before January 1, 2001 and you're in the 28-percent or higher bracket? Congress gave you relief, but at a very stiff price. On your 2001 tax return you can elect to report a hypothetical sale of the asset to yourself. This is referred to as a deemed sale. This means paying the 20-percent capital gains tax on the built-in gain. Let's try an example.

Example. The Smith's bought a Tree Farm in 1991 for $134,000. Since then they had a timber sale for which they reported an allowable basis of $23,000. As of December 31, 2000 they had also capitalized $3,400 of expenses. Their adjusted basis as of December 31, 2000 was therefore $114,400 ($134,000 - $23,000 + $3,400). On their 2001 return they elect to qualify for the 5-year holding period by making a deemed sale. An appraiser for an $800 fee estimates that the fair market value of the Tree Farm on January 1, 2001 is $210,000. They had no other capital gains or losses in 2001. On their 2001 tax return the Smith's pay a capital gains tax of $18,960. This is 20-percent of the net gain of $94,800 ($210,000 - $800 - $114,400). As a result of this transaction a new holding period starts and the basis of the Tree Farm is stepped-up to $210,000.

Will the Election Benefit You?

The election to start a new holding period and step-up the basis will be beneficial only in certain circumstances. This is because the income tax you pay on the built-in gain is another cost you'll have to carry long-term on your investment. But, what if you were planning on giving the Tree Farm to your children while you're alive and don't want them to have to pay the income tax on your built-in gain? The election followed by a gift would in effect transfer the income tax liability to you. This is because your basis becomes your children's basis in the case of a gift.

Another possibility might be to take a loss on other assets to offset against the gain on the deemed sale. It's not clear, however, whether this will be allowed under forthcoming IRS regulations. Congress did make it clear that if the election results in a loss on the deemed sale the loss is not allowed. My assumption is that a loss realized from the actual sale of other assets could be offset against a gain from the deemed sale. There's no reason to assume that the standard netting rules for capital gains and losses won't apply.

Another reason for paying the tax on the built-in gain and stepping-up the basis would be to have a higher basis in case of a casualty loss. For this purpose you might want to consider making the election just for the timber and not the land. I'm assuming this will be allowed under forthcoming regulations if you have established on your books a separate basis for the timber and otherwise treat it as a separate asset.

Make Your Decision Soon

Talk your situation over with your accountant soon if you think the election may benefit you. Consulting foresters would be well advised to make a special effort to collect comparables data for the December 2001 to January 2002 period for use in making January 1, 2001 appraisals of timberland, and timber separately.

The following article has been reproduced here from the "Tree Farmer" magazine with the permission of the American Forest Foundation, 1111 19th Street, N.W., Suite 780, Washington, D.C. 20036. (Telephone 202.463.2462)