Ways to Increase Basis in Timberland
Tree Farmer Magazine: July/August 1999 - Volume 18, No. 4
An astute Oklahoma tree farmer asked recently if he could increase the basis of his timberland by selling it and then repurchasing it. This is another of those "never-say-never, but" questions I seem to like. In tax jargon timber is a "highly appreciated asset" in the hands of most tree farmers. The growth of the timber adds volume and thus value without a proportionate increase in your timber basis. The value also increases due to inflation and in many cases a real price increase. Thus, many lucky tree farmers are stuck with a valuable asset with a low basis.
There have been attempts to amend the Internal Revenue Code (IRC) to allow the basis of assets to be increased for inflation. This would mean taxing only the "real" increase in value, not the inflationary increase. Unfortunately we're stuck with our original basis plus increases for improvements to the timber. The original basis is what we paid for purchased timberland – either as cost basis ( the basis of the timberland in the hands of the person giving the timberland to us) or as carryover basis ( the fair market value of the timberland on the date of death of the person leaving it to us in their will).
The major expenses added to the basis of most small ownerships are carry charges which aren't deducted currently because of the 2 percent of adjusted gross income floor on miscellaneous itemized deductions for tree farmers treating their activity as an investment instead of a business. If you're treating your activity as a business most of your expenses will be deductible currently, assuming they aren't restricted by the passive loss rules.
So, why not give your timberland to a friend and then buy it back? Or, how about giving or selling it to someone who is expected to die in the near future, and have them return the timberland to you in their will? Well, as Elizabeth Barrett Browning might have said it, "why not do it?, let me count the problems."
Who Do You Trust?
First there's the pragmatic issues of trusting someone to resell the timberland to you, or to die on schedule and include you in their will. If that's not enough to turn you off, there's the issue of your "co-conspirator" having the funds to buy the land from you.
Would they be expected to come up with the funds to pay you and cover the holding costs for the timberland? Would they manage it according to your wishes? The real stopper, however, is the IRS rules on such transactions. An underlying principal of tax law is that substance rules over form. Things done strictly for a tax advantage and not as legitimate arms-length transactions motivated by sound economic reasoning are not likely to be recognized for tax purposes in an audit. So lets tick our way through the rules, starting with the sale and repurchase approach.
Sale and Repurchase (Plan A)
Mr. Brown wants to sell timber during his lifetime rather than wait until he dies and leave the timberland to his heirs and have them sell it. He's aware that he could instruct his executor to have the estate sell the timber with little if any income tax due because the basis of the timber in the hands of the estate is its date- of- death fair market value. Mr. Brown has a wife but the timberland is solely in his name. His attorney tells him that he can't get a step-up in basis by selling it to his wife because the basis of property acquired from a spouse is the basis in the hands of the spouse selling or giving the property to the other spouse.
How about "using" one of your children? If your daughter, say, has the financial means, pays full fair market value, and if the intent of neither party is for father to buy back the property, then this might be considered an arms' length transaction that would be recognized. But of course father has to pay the income tax on the sale for it to be legitimate. doesn't this bring us back to the original problem since Mr. Brown will have to use his low basis to determine his gain?
If daughter doesn't have the funds to make the purchase and father either gives her the land or the money to buy the land from him a gift tax may be due. No payment is due, however, until father's unified credit is used up. The same thing would apply in the case of an installment sale with father forgiving the loan payments. It may be possible to use the $10,000 annual exclusion for the loan payment, but this usually doesn't stand up under audit. The same rules would apply if even an unrelated party was involved. It's not obvious what has been gained with this approach, but there may be very unusual circumstances in which it makes sense to pay the tax and buy back the property.
Give to Soon-To-Be-Dead-Person (Plan B)
Mr. Brown gives up on Plan A and moves on to Plan B. He gives the timberland to a good friend with terminal cancer. The friend promises to leave the timberland to Mr. Brown in his will. This is a really good friend were talking about and there's no chance that any of friend's heirs will talk him into changing his will.
This technique has some possibilities. There are at least two conditions for success. The transfer of title has to be legally binding. This will involve the usual legal and recording costs. And, more than one year has to elapse between the date on which the gift is made and the date of death. If less than one year elapses Mr. Brown would be stuck with his basis at the time he gave the land to his dying friend. Of course the impact of the gift on Mr. Brown's unified credit has to be considered.
From a financial standpoint it's unlikely any Plan A approach will work. Plan B has some possibilities, but not without very very good legal advice (and a very, very good friend). Either way you need to make certain the potential benefit from increasing your basis for income tax purposes is worth the risks and emotional and financial costs. Please pay careful attention to the impact of these strategies on your overall estate plan. Good luck!
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)