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End-of-Year Tax Review

Tree Farmer Magazine: November/December 2005 - Volume 24 No. 6

It's important to review your tax situation before the end of the year. The objective is to identify opportunities to adjust your income, expenses, and charitable donations to minimize your 2005 tax liability. This discussion assumes you are a calendar year cash basis taxpayer. As such, to be reportable on your 2005 return you need to receive the income or make the payments by December 31.

Reporting Status

Several critical decisions should be made before the end of the year. For example, should you continue reporting timber expenses as you have in the past? If you've been reporting as an investor, should you switch to a business, or vice versa?

Are you truly a business

There is no hard and fast rule to determine when an activity is a business. The IRS has been generous in letting rather small operators file as businesses. It's the regularity of activity in general, as well as income, that's important. If you can meet one of the tests for materially participating for purposes of the passive loss rules, it's more likely that you qualify as a business. But, there is no single factor that you can use. The National Timber Tax Website at http://www.timbertax.org has a questionnaire you can use for guidance. Don't forget that if you convert from an investment to a business you will be subject to the passive loss rules.

Reporting as an investor

If you report as an investor will you have enough itemized deductions to itemize this year? You will if your total itemized deductions exceed the 2005 standard deduction of $10,000 for joint filers and $5,000 for singles and married filing separately. If you do itemize will your miscellaneous itemized deductions exceed 2 percent of your adjusted gross income? If not, can you elect to treat some of your expenses as carrying charges and add these expenses to the basis of your timber? Also, remember that investors report the first $10,000 of their 2005 reforestation expenses as an adjustment to gross income, not as a miscellaneous itemized deduction. Reforestation expenses over $10,000 are amortized, and the allowable amortization deduction is also an adjustment to gross income. Taking reforestation expenses as an adjustment reduces the number of you who will hit the $145,950 limit on adjusted gross income above which allowable itemized deductions are reduced.

Keep Your Records Audit-Ready

Always keep your records "audit ready." Make journal entries to accompany your receipts. Explain what the expense was and its purpose. Explain how the expense is related to the income potential from your tree farm. This is especially important if you live on your tree farm. For many expenses it's necessary to differentiate between personal and household use, and those directly related to the production of income. Develop a procedure for allocating costs between these two categories. Document this procedure and use it. The amount of time something is used in each category is a common method. If you're a so-called absentee tree farmer and make frequent trips to your tree farm to relax as well as work you must clearly separate on the ground and on paper what's done for income and what's done for personal reasons.

Treatment of Specific Expenses

How an expense is treated depends on both the nature of the expense and what it was used for.

Property Taxes
Regardless of what you do on your tree farm property taxes are deductible, assuming you itemize. If your tree farm is for personal use or an investment and it's to your advantage to itemize, you report the tax as an itemized deduction with the tax on improvements. If your tree farm is a business the property tax paid on the forest land and improvements used strictly for business purposes is deducted with your other business expenses. If your tree farm is a mix of personal use and investment or business you'll need to allocate among these uses.

Mortgage Interest
If the forest land is held for the production of income as an investment you should allocate interest between the personal use portion (house and lot) and investment use (forest land). The interest on the forest land would be deductible only to the extent you have investment income to offset it. The interest on your personal residence portion is an itemized deduction. If the forest land is held as a business the interest is a business expense.

Operating Expenses
Other expenses are deductible only if they directly affect potential income and are not capital in nature. If you report as an investor and itemize, make certain to include as many other miscellaneous itemized deductions as possible to get over the 2% limit.

Profit Guidelines
For any of your expenses other than property taxes and mortgage interest on your residence, you must be engaged in the tree farm activity with the intention of making a profit. If you haven't done so already, document how you tree farm will produce income that exceeds the expenses you expect to incur for the length of time you expect to own the property. Keep these estimates in your files and update them regularly to reflect current costs, and timber and land value.

Capital Expenses
The costs of major assets you acquire are capital expenses recovered over time or when the asset is disposed of. Capital accounts are needed to determine the gain of loss when assets are disposed of, and to determine casualty or non-casualty business losses. Don't forget to make an allocation between personal and for-profit use of assets. You'll also want to update capital accounts for any improvements made this year.

Reforestation costs
If you reforested land this year, make certain the details of the project are in your records. If you take the reforestation deduction and/or amortization deduction you'll need to file at attachment to your return giving the details of each project. Don't forget to go back to the amortization schedules for reforestation expenditures in prior years. Your total deduction or adjustment to gross income is the sum of the amortization for this year and previous years.

Timber Sales

If you sell timber this year make certain your records are complete. File a copy of sales contracts. If you have not established the basis for the timber contact a consulting forester who handles basis determinations. If you have a basis established you'll need to update the accounts. This requires an estimate of the total volume of timber as of 2005, not just the volume you sold, so you can calculate the depletion unit. Your depletion allowance is the depletion unit times the number of units sold. Don't forget to add your sale expenses to the depletion allowance when completing Form 4797 or Schedule D.
Except in unusual circumstances proceeds from the sale of standing timber will qualify for long-term capital gains treatment. Long-term means held more than 12 months before selling it. If you operate as a business it is no longer necessary to use a pay-as-cut contract to qualify for capital gains, but the gain or loss is still reported on Form 4797, not Schedule D. Also remember that having a basis for your timber is not required for capital gains treatment.
Timber income is reported in the year actually received, even if you defer payments from the year of the sale solely for tax purposes.

Gifts

The annual gift tax exclusion is still at $11,000. It's expected to increase to $12,000 starting in 2006. The exclusion applies to gift made to non-charitable organizations and individuals. Whether for charitable purposes or not, don't wait until the last day of the year to make gifts unless by cash or cash equivalents. Gifts of property are not complete until title has transferred.