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Timber Related Provisions

Until the IRS issues regulations implementing the provisions of this act it is not possible to guarantee that these summaries reflect actual law.

(1) Capital gains treatment for timber "held primarily for sale to customers in the ordinary course of a trade or business"

Under current law timber held primarily for sale to customers as part of a trade or business that is disposed of on the stump must be done so under a so-called "pay-as-cut" contract to qualify for long-term capital gains treatment. In tax lingo it must be "disposed of with an economic interest retained." The bill amends Internal Revenue Code (IRC) Section 631(b) to provide that the disposal of timber on the stump qualifies for capital gains treatment if sold with either a pay-as-cut, or a lump sum contract. Lump sum is the type of contract generally preferred by landowners because the total amount to be received from the buyer is fixed in advance, rather than depending on the volume actually harvested by the buyer. Note that even with this change it is still necessary for the timber owner to determine whether the timber is held as an investment asset (IRC Sec. 1221), or a business asset (IRC 1231). This is because the former are reported on Schedule D of Form 1040, and the latter on Form 4797. Effective date: Sales after December 31, 2004.

Example under current law - Mr. Jones has operated a 350 acre tree farm in Georgia since 1974. He uses Form 1040, Schedule C, Sole Proprietorship, a business form, to report his tree farm incomes and expenses. In November 2004 he offers 80 acres of sawtimber timber for sale. He has sold timber 7 times since 1974. Because he operates as a business and has made frequent sales, he tells buyers that he must use a pay-as-cut contract in order to receive capital gains treatment. This limits the buyers he accepts offers from because he must trust them to accurately scale the logs produced and report this volume to him. He is payed based on the volume cut and the price per unit specified in the contract.

Example under revised law - Assume the same circumstances as in the above example, except that Mr. Jones tells buyers that the sale will be closed January 2, 2005. He also tells them to offer him a fixed dollar amount for the timber on the 80 acres. He asks for 50% of the proceeds at the time of signing and 50% before logging starts. This "lump sum" sale qualifies for long-term capital gains treatment under IRC Sec. 631(b), even though the timber is a business asset.

(2) Expensing of up to $10,000 of reforestation costs

Under prior law a qualified taxpayer could elect to amortize over an 84-month period up to $10,000 of qualified reforestation expenditures, adjusted based on the tax credit claimed. A 10% tax credit could also be claimed on up to $10,000 or qualified expenditures. The bill amended IRC Secs. 194, to convert it from an amortization election to an election to expense up to $10,000 of qualified expenditures. This expenses is reported as a business expense for taxpayers reporting their timber activities as a business. Taxpayers reporting their timber activities as an investment would report the expense as an adjustment to gross income. It also amends Sec. 46 to eliminate the tax credit. Qualified expenditures over $10,000 can be amortized. Effective date: October 22, 2004

Example under current law - Mr. Jones incurred $19,200 of reforestation expenses in 2004. He elected to amortize $10,000 of the expenses. The balance of $9,200 was capitalized to his deferred reforestation (plantation) account. He claims a $1,000 tax credit (10% of $10,000), and amortizes $9,500 over 84 months.

Example under revised law - Assume the same circumstances as above, but Mr Jones waits until 2005 to incur the $19,200 of qualified reforestation expenses. He elects to expense $10,000 of the reforestation expenditures. The balance of $9,200 is capitalized to his 2005 reforestation amortization account for amortization over an 84-month period.. On his 2005 business tax return he adds the $10,000 and the first year's amortization to his other business expenses to determine his net income.

(3) Revocation by a corporation of election to treat a cutting of timber as a sale

Under current law timber owners who cut their own timber or have it cut under a logging services contract can receive capital gains treatment on the value of the stumpage cut by electing to treat the cutting as a sale under IRC Sec. 631(a). Once made this election is binding on all future timber cut by the taxpayer. The bill provides that an election by a corporation made for a taxable year ending on or before October 22, 2004, to treat the cutting of timber as a sale or exchange, may be revoked by the taxpayer without the consent of the IRS for any taxable year ending after that date. The prior election (and revocation) is disregarded for purposes of making a subsequent election. This change apparently applies only to corporations. Effective date: October 22, 2004.

(4) Modification of safe harbor rules for timber REITS

Real estate investment trusts (REITS) are a standard investment vehicle for investments in real estate. A majority of REITS generate ordinary income from rents received from leasing commercial real estate. The IRC treats the "operating income" of REITS differently than gains from the disposal of the underlying assets. Over the last 20 years or so there have been major flows of capital into timberland. This resulted from institutional investors such as life insurance companies and wealthy individual investors seeking to diversify their portfolios. These institutional investments were possible because the large supply of timberland on the market from diversities of timberland by integrated forest products corporations. A timberland REIT obviously generates cash flow by selling timber, which means disposals of the underlying asset. The bill revises IRC Sec. 856 and 857 to provide the same tax treatment to timber REITS as received by REITS in general. Effective date: October 22, 2004.