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How to Delay Paying Tax on Gains from Involuntary Conversions

Tree Farmer Magazine: March/April 2005 - Volume 24 No. 2

Damage from wind, fire, ice, or other casualty type events may have made it economically prudent for you to sell damaged timber, a so-called salvage sale. This assumes that your local market is not saturated with salvaged timber. You do not have to pay tax in the year of the sale on the gain realized from a salvage sale if certain conditions are met. In this discussion I'll describe what these conditions are for timber held for the production of income as part of a business or an investment activity. When you are forced to dispose of timber because of unusual and unexpected events, you have made an "involuntary conversion." An involuntary conversion can also result from a timber theft, or a sale under the threat of or actual condemnation of your property for a public use. The applicable Internal Revenue Code (IRC) section is 1033.

The tax on the gain is said to be delayed or postponed because the basis of the timber disposed of is carried over and becomes the basis of the replacement property, as demonstrated in Example 1.

Example 1 - The Brown's timber is damaged by a bad ice storm. Their forester recommends a salvage sale to capture the remaining value since the growth potential of the stand has been destroyed. The revenue from the salvage sale totaled $18,000 and the basis of the timber was $3,000. Rather than pay tax on the $15,000 gain, the Browns purchase qualified replacement property at a cost of $18,000. The basis of the replacement property is the $3,000 carryover basis from the damaged timber that was sold.

Postponement of the gain is available regardless of how the timber is disposed of, that is, sold on the stump with a lump-sum contract, a pay-as-cut contract under IRC section 631(b), or the fair market value of timber cut under an IRC section 631(a) election. However, the gain does not have to qualify as a log-term capital gain to qualify for postponement of tax on the gain. In the case of timber theft insurance proceeds or compensation paid by the guilty party would qualify for non-recognition treatment.

Election to Postpone Gain

You are assumed to have elected to postpone gain if you do not report the gain in full in your gross income in the year the gain is realized. If you elect to postpone gain by buying replacement property, you must file a statement with your tax return in the year the replacement property is acquired indicating that you made the election. Include all pertinent information regarding the circumstances of the involuntary conversion , the basis of the property converted, and the replacement property purchased.

Replacement Property

The rules for replacement property are more restrictive than the rules for voluntary like-kind exchanges. In the case of involuntary conversions you must buy property specifically to replace the timber destroyed. Property you inherit or receive as a gift does not qualify. The replacement property must be similar or related in service or use. You do, however, have flexibility within the timber and timberland category. The property acquired with the revenue from the salvage sale can be the cost to reforest the timberland. The cost to restore the land to a productive condition also qualifies. This includes the cost of clearing debris from drainage ditches, repairing or replacing fences, gates, and drainage structures and roads.

The reforestation could be on the land from which the damaged timber was disposed of or other land you own or lease or newly acquired land. You could also buy or lease other land to grow timber. You could also buy timber rights on other land (Revenue Ruling 80-175). In addition, the revenue could be used to purchase a controlling ownership interest (at least 80 percent) in a corporation owning timber, timberland, or both.

You have not acquired replacement property if, for example, you make advanced payments to a tree planting contractor to reforest the land salvaged or other land you own or lease. The reforestation project must be completed within the replacement period allowed or any extension there to.

If the gain to be postponed exceeds $10,000 property acquired from related parties does not qualify as replacement property.

Receipt of Cash Qualifies

Unlike voluntary like-kind exchanges for which non-recognition of gain is desired, you can receive cash from the salvage sale. You can even spend this cash for something else and borrow the funds to buy the replacement property. All other requirements have to be met, however.

Replacement Period

The replacement begins on the date your timber was damaged, destroyed or stolen. It ends two years after the close of the first tax year in which any part of your gain is realized, as demonstrated in Example 2. In the case of condemned property the replacement period is three years.

You can apply to the director of the Internal Revenue Service for an extension of the replacement period. Your application should be made prior to the end of the standard replacement period. It must provide full details of the justification for granting an extension. However, you can apply after the end of the standard replacement period for good and substantial reason. Extensions are usually not granted until near the end of the replacement period. The extension is for not more than one year. High market value or scarcity of replacement property are not grounds for granting an extension.

You can change your mind about whether to report or postpone reporting the gain on involuntarily converted property anytime within the replacement period.

Example 2 - Mr. and Mrs. Brown are calendar year taxpayers. Their tree farm was severely damaged by a windstorm on October 10, 2004. Their forester designated stands to be disposed of because of the severity of the damage. The contract with the buyer was signed and one-half of the contract price paid on January 5, 2005. The balance is due before harvesting starts. The Brown's first realized a gain from the wind storm in 2005, so they have until December 31, 2007 to replace the timber sold.

Consult Your Tax Preparer

If you are considering postponing gain consult your forester and tax preparer to assess your options and develop a plan. Opportunities to acquire replacement property need to be realistically assessed. You will also want to consider whether you'll have losses that could be offset by the gain from a salvage sale or other sources of revenue from an involuntary conversion.