End-of-Year Tax Review

Tree Farmer Magazine: November/December 2006 - Volume 25 No. 6

It's important to review your tax situation before the end of the year. you should identify opportunities to adjust your income, expenses, and charitable donations to minimize your 2006 tax liability. To be reportable on your 2006 return, you need to constructively receive the income or make payments by December 31. This assumes you're a cash-basis calendar taxpayer. Your options are tied to the amount of flexibility you have to schedule your income and expenses. You may be able, for example, to time withdrawals from IRA accounts and sales of assets, including timer. On the expense side reforestation projects and management activities may be flexible. remember that you can deduct up to $10,000 per year for each of your qualified timber properties (QTP).

Know Your Tax Bracket

You should be planning for the next four years because of lower capital gains rates in 2008, 2009, and 2010; and increased ordinary and capital gains rates starting in 2011.

In addition to lowering the tax on ordinary income, managing your ordinary income tax rate may lower your capital gains tax rate. The ordinary rates and brackets for 2006 for single and for married filing jointly are given in Tables 1 and 2. The 10-, 15-, 25-, 28-, 33-, and 35-percent marginal tax rates will apply through 2010. Thereafter, the rates will increase to 15, 28, 31, 31, and 39.6 percent. The 10-percent bracket will be eliminated.

Table 1

If Taxable Income is Over
But Not Over
The Tax Is
Of The Amount Over
$0
$7,550
$0 + 10%
$0
$7,550
$30,650
$755 + 15%
$7,550
$30,650
$74,200
$4,220 + 25%
$30,650
$74,200
$154,800
$15,107.50 + 28%
$74,200
$154,800
$336,550
$37,675.50 + 33%
$154,800
$336,550
$97,653.00 + 35%
$336,550

Table 2

If Taxable Income is Over
But Not Over
The Tax Is
Of The Amount Over
$0
$15,100
$0 + 10%
$0
$15,100
$61,300
$1,510 + 15%
$15,100
$61,300
$123,700
$8,440.00 + 25%
$61,300
$123,700
$188,450
$24,040.00 + 28%
$123,700
$188,450
$336,550
$42,170.00 + 33%
$188,450
$336,550
$91,043.00 + 35%
$336,550

If you can postpone selling timber until 2008, 2009, or 2010, and can keep your taxable income below the upper limit for the 15-percent ordinary income tax bracket, your capital gains rate will be 0 percent. Although the tax rates stay the same through 2010, the tax brackets are adjusted for inflation. By 2010, the upper limit of the 15-percent bracket may be in $33,000 range. After 2010, the lowest capital gains rate will be 10 percent, for those in the lowest ordinary tax bracket of 15 percent. If you're in a higher bracket, the capital gains rate will be 20 percent.

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 it you live on your Tree Farm.

For many expenses it's necessary to differentiate between those of 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.

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 forestland and improvements used strictly for business purposes is dedicated 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.

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 deductions as possible to get over the 2 percent of adjusted gross income 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 your Tree Farm will produce income that exceeds the expenses you expect to own the property. Keep these estimates in your files and update them regularly to reflect current costs and timber and land values.

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 or loss when assets are disposed, 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. Unless your circumstances are unusual, you'll want to take the $10,000 per qualified timber property deduction. Expenditures above $10,000 per QTP are amortized.

Timber Sales

If you sell timber this year make certain your records a4re 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 2006 - 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 gains 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.

Benefit From Donating an Easement Before Jan. 1

Under provisions of the Pension Act of 2006, the maximum charitable deduction of an individual donating a qualified conservation easement is 50 percent of his or her taxable income, instead of the usual 30 percent.

In addition the amount not currently deductible can be carried over to the following 15 years, instead of the usual five years. In addition, the charitable deduction for a contribution by a "qualified farmer or rancher" of real property - including a conservation easement - used in agriculture or livestock production is 100 percent of their taxable income, instead of 30 percent. The 15 year carryover also applies. A "qualified farmer or rancher" is an individual whose gross income from the trade or business of farming is greater than 50 percent of the taxpayers gross income for the tax year. The term "farming" includes the planting, cultivating, caring for, cutting down, and preparing trees for market.

A corporation that qualifies as a "farmer or rancher" can deduct up to 100 percent of the excess of the corporation's taxable income over the amount of all other allowable charitable contributions. Any excess may be carried forward for up to 15 years. To qualify as a farmer or rancher, a corporation must meet the rules applicable to individuals. In addition, the corporation's stock must not be readily tradable on an established securities market at any time during the year of the contribution.

In the case of an individual or a corporate farmer or rancher, if the contribution is made after August 17, 2006, the easement contract must provide that the property remain available to be used in agriculture of livestock production. There is no requirement that the property continue to be so used.

Additional information is available at www.timbertax.org and at the Land Trust Alliance's website.