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Sub-Section 211, When IRC 631(a) Is Applicable

Internal Revenue Manual
Specialized Industry Guidelines - Timber
Sub-Section 211, When IRC 631(a) Is Applicable
Last amended: 8-4-1981

When IRC 631(a) Is Applicable

(1) Senate Report No. 627, 78th Congress, 1944 C.B. 993, indicates that section 117(k)(1) of the 1939 IR Code (the predecessor and equivalent of section 631(a) of the 1954 IR Code) was enacted to eliminate the inequity that occurred when a timber owner cut his/her own timber instead of selling it outright to another. Prior to the enactment of this section, profits realized from the timber cut were taxed as ordinary income whereas the gains realized from sales of standing timber were capital gains. IRC 631(a) permits a taxpayer to treat a portion of total income earned as a capital gain when timber is cut for use in his/her own trade or business or is sold as logs or other products.

(2) IRC 631(a) is an elective section. It applies when a timber owner cuts his/her own timber for the purpose of either selling the logs or wood or for using them in his/her own trade or business, provided such owner has held the timber long enough to comply with the law.

(3) The law requires that for IRC 631(a) to be applicable, the following conditions must prevail.

(a) For taxable years beginning before 1977, the timber must have been held by the taxpayer for more than six months before the first day of the taxable year in which it was cut.

(b) For the taxable years beginning in 1977, the timber must have been held by the taxpayer for more than nine months before it was cut.

(c) For taxable years beginning after 1977, the timber must have been held by the taxpayer for more than 12 months before it was cut.

(4) In effect, IRC 631(a) provides for a hypothetical sale, on the first day of the taxable year, of the timber that was cut in that year. The "sale price" to be used for this hypothetical sale is the fair market value of the standing timber as of the first day of the taxable year in which it was cut. The difference between the "sale price" and the adjusted basis for depletion of the timber cut is the taxable gain. This gain is taxable as a capital gain; therefore, examiners will need to pay special attention to the amount claimed by the taxpayer as the fair market value of the standing timber as of the beginning of the year, and the amount of depletion that is allowable.

(5) The following is a simple illustration of how the capital gains are accounted for and how ordinary income is affected. In 1974, a calendar year taxpayer cut 3,000 units (board feet, cords, cunits, etc.) of standing timber he/she had owned for more than 6 months before January 1, 1974. The fair market value of the stumpage (standing timber) on January 1, 1974 was $8.22 per unit. The unit rate for depletion was $5.10 per unit. The taxpayer elected to consider the cutting as a sale or exchange under IRC 631(a). Accordingly, the difference between $24,660 and $15,300 was reported as IRC 1231 gain. The taxable income was reported on the taxpayer's 1974 return in the following manner. The Fair Market Value on January 1, 1974, (3,000 units x $8.22/unit) was equal to $24,660. The Basis for Cost Depletion (3,000 units x $5.10/unit) equaled $15,300. The Gain per IRC 631(a), taxable as from sale of capital asset in accordance with IRC 1231(a), equaled $9,360.

(6) The examiner should clearly understand that even though the taxpayer in the foregoing illustration realized a taxable gain, he/she may still be carrying in inventory the timber products such as cordwood, tree-length logs, sawlogs, peeler blocks, or chips. The term "timber," for tax purposes, applies to standing timber only. Once the tree is severed from the stump, it is no longer timber but an inventoriable forest product. Under IRC 631(a), the cost of the various products recovered from the timber includes the same fair market value used in the computation of IRC 1231 gain and becomes part of the cost of goods sold upon the eventual disposition of the products.

(7) Assume in the foregoing illustration that the timber was owned by a taxpayer who was in the pulpwood business. His/her timber crews cut the timber and hauled the pulpwood to a pulpmill where it was sold for $25.00 per unit. The taxpayer's costs of falling, bucking, yarding, loading, and transportation to the mill were $11.00 per unit. All other costs attributable to the sale of the pulpwood total $500.00. The ordinary gain or loss is computed as follows:The Fair Market Value, on 1-1-74, equaled $24,660. The cost of cutting and hauling pulpwood to the market (3,000 units x $11.00) equaled $33,000. Other costs totaled $500. Therefore, the total cost equaled $58,160. The sale price of pulpwood (3,000 units x $25.00) equaled $75,000. The ordinary gain totaled $16,840.

(8) By cutting the timber and selling the wood, the taxpayer earned a total income of $26,200. Of this amount, $9,360 is taxable as a capital gain. In the illustration, if the fair market value is increased by $1 per unit, the IRC 1231 gain will be increased by $3,000 and the ordinary income will be reduced by the same amount.

(9) When timber products are on hand at the end of the year, the taxpayer may compute this inventory at either cost or market, whichever is lower, if this is taxpayer's normal method of computing inventories. If the pulpwood in the preceding illustration were on hand at the end of the year, it would be valued at $58,160 or at market, whichever is lower. However, if LIFO inventories are used, the pulpwood must be valued at cost. If, at the end of the year the market value of the cut pulpwood is $55,000 and the taxpayer values the inventories at cost or market, whichever is lower, the examiner should determine the reason for the decrease in value. This investigation may indicate the fair market value of standing timber at the beginning of the year was overestimated.

(10) Standing timber may be a capital asset as defined by IRC 1221 or it may be treated for tax purposes as if it were a capital asset if IRC 1231(a) applies. As a capital asset, standing timber may not be included in year-end inventories used to compute taxpayer's cost of goods sold and net income for the year.