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2007 End-of-Year Tax Review

Tree Farmer Magazine: November/December 2007 - Volume 26 No. 6

This year's end-of-year review is motivated by the IRS's increased interest in the number of small businesses reporting losses. This is a result of a recent statistical sample of income tax returns that included Schedules Cs (Non-Farm Sole Proprietorships) and Schedule Fs (Farm Proprietorships). A total of 20, 590,691 Schedule Cs were filed i n204. Negative net income averaging $7,800 was reported on 27 percent of these. Positive net income averaging $19,300 was reported on 73 percent. However, when the 48,400 Schedule Cs classified in the "Forestry & Logging, incl. nurseries & timer tracts" industry category are separated out, 42 percent showed losses averaging $10,700 and 58 percent showed positive net income averaging $20,600.

The picture is bleaker for farm returns. Two million Schedule Fs were filed in 2004. Seventy percent reported a loss. The 30 percent reporting positive net income were for returns with adjusted gross income less than $100,000 - i.e., small farmers were more likely to make a profit. "Forestry & Logging" activity was reported on 2.7 percent of farm returns and accounted for 1.1 percent of net profit and 1.8 percent of net losses.

As anecdotal evidence of the IRS's interest in returns reporting business losses, there has been a significant increase in the number of inquiries I've received over the last year directly and through the National Timber Tax Website from Tree Farmers seeking input on how to deal with audits they are undergoing. I strongly suggest consulting with your tax attorney or accountant regarding the profitability of your Tree Farm and whether or not your level of activity constitutes a business.

If you report positive net income in three out of five years, the IRS presumes you have a profit motive. But if timber capital gains is your major source of income, it isn't reported on Schedule C or F, increasing the likelihood of being audited.

Justify Your Profit Potential & Motive

Given your increased chance of being audited, I strongly encourage you to end this year by pulling together the information that needs to be in your files regarding the profit potential of your Tree Farm. There are two aspects to profitability: potential and motive. Profit potential is based on the productivity of your timber and other products and their current and expected value. It also includes the expected increase in the value of the land used for your Tree Farm. Unless your speculating on the land, the increase in land value can be added to the increase in the value of the timber to get the potential income for a given year. Profit motive focuses on how you balance your expenses against the income potential. Here's how I like to make this point.

If during the last 10 years the value of your land and timber has increased by $10,000 per year on average, but your average operating expenses per year are significantly more than $10,000, than it's hard to argue you're working to balance your expected income and expenses in order to eventually have an overall profit. If you keep estimates of expected income and records of your costs, it's possible to make a case for having a profit motive. But a larger percentage of Tree Farmers don't keep records on the value of their land and timber. Cost records are easier to come by, of course. If you are audited and can't discuss with the revenue agent the balance between your expected income and expenses, it will be very hard to convince them that you are operating your Tree Farm to eventually make a profit.

Business or Investment

ISR auditors are also questioning Tree Farmers about whether their Tree Farm is a business or simply an investment activity. The basic treatment of what is and isn't deductible is the same either way, but the benefit you receive is different. Except for qualified reforestation expenses and property taxes, investment expenses only help to the extent you itemize and your miscellaneous itemized deductions exceed 2 percent of your adjusted gross income. Your only option is to keep good records of the time and effort devoted to the Tree Farm. There is no hard-and-fast rule on what constitutes a business. The criteria most often used are the regularity and frequency of activities.

Year-End Decisions

As always, 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 2007 tax liability. To be reportable on your 2007 return, you need to constructively receive the income or make the payments by December 31. This assumes you're a cash-basis, calendar year taxpayer. Your options are tied to the amount of flexibility you have to schedule income and expenses. You may be able, for example, to time withdrawals form IRA accounts and sales of assets, including timber. 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). Consider scheduling discretionary ordinary income in years when you incur reforestation costs.

Know Your Tax Bracket

You should be planning know for any timber sale over the next three years because of a lower capital gains rate in 2008, 2009, and 2010 and increased ordinary and capital gains rates starting in 2011. 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. After 2010 the lowest capitals gains rate will be 10 percent for those in the lowest ordinary tax bracket of 15 percent. If you in a higher bracket, the capital gains rate will be 20 percent.

Keep Your Records Audit-Ready

Always keep you 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 for 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 to the production of income. Develop a procedure for allocating costs between theses 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 expenses 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 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.

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 percent of adjusted gross income limit. Of course, this doesn't matter for reforestation expenses,since they are adjustments to gross income if you file as an investor.

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. An again, I emphasize that if you haven't done so already, document how your 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 costs assets you acquire are capital expenses recovered over time or when you dispose of the asset. Capital accounts are needed to determine the gain or loss when disposing of assets, and to determine casualty and 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. File an 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 amortization business deduction or adjustment to gross income if you report as an investor 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 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 sales 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 that 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.