This is the third post in a series covering timber tax basics. Part 1 discussed timber activity classification and how classification affects timber taxation. Part 2 covered calculation of cost basis, capital accounts, and the reforestation deduction. This post (Part 3) will explore the taxation of timber sales. Future articles will explore other issues, including completing IRS Form T, and much more!
Ordinary Income vs. Capital Gain Income
Under US tax law, there are two main types of income: ordinary income and capital gain income.
Ordinary Income
Ordinary income is all income other than capital gain income, and most often consists of wages, salaries, and interest income.
Ordinary income is taxed at ordinary income tax rates, which are the tax rates often discussed in the news. Ordinary tax rates currently range from 10% to 37%.
Also, ordinary income is often subject to employment taxes, an additional 15.3% tax, if the taxpayer is actively involved in earning the ordinary income.
Capital Gain Income
Capital gain income is any profit from the sale of a “capital asset.”
The Internal Revenue Code has a complicated definition of what a capital asset is (and is not). The most common capital assets are stocks, bonds, and real estate.
The gain on sale of a capital asset held more than one year is a “long-term capital gain” and is taxed at lower rates than ordinary income. Long-term capital gain tax rates currently range from 0% to 20%.
Capital gain income is also not subject to employment taxes.
Ordinary Income vs. Long-Term Capital Gain Comparison
Business vs. Investment
As discussed in Part 1, the tax classification of a timber activity is extremely important.
Investment
A timber activity classified as an “investment” activity is one that does not meet the requirements of “primarily for profit” and “regularly and continuously carried on,” but is still motivated by profit rather than personal or hobby reasons.
If a timber activity is classified as an investment, any gain on timber sales will be classified as a capital gain, rather than ordinary income.
However, as discussed in Part 1, the Tax Cuts and Jobs Act of 2017 changed the law regarding the deductibility of investment expenses. Investment expenses are no longer deductible on an individual’s tax return as miscellaneous itemized deductions. This leads to an unfortunate situation where income from an investment activity is fully taxable but very few (if any) of the related expenses are deductible.
Business
Clearly, an owner of timberland wants their activity to be considered a business, so he can deduct all allowable expenses and also deduct losses from the timber activity in years without timber sales.
However, the downside of business income is that it is ordinary income, which is generally subject to ordinary income tax rates (higher than long-term capital gain tax rates) and self-employment tax (additional 15.3% tax on net earnings from self-employment).
Fortunately, Congress realized this inequity subjecting timber held in a business to higher tax rates and self-employment taxes. They passed IRC § 631, which allows for capital gain treatment for business timber sales under certain conditions.
IRC § 631
IRC § 631 has two different ways to qualify for capital gain treatment for timber sold in a business. IRC § 631(a) covers timber that the timber owner cuts himself or pays someone to cut. IRC § 631(b) covers standing timber sold outright or with a retained economic interest.
IRC § 631(a)
A timber owner, who is in the business of selling timber and cuts his own timber or pays someone to cut it for him, may qualify for long-term capital gain treatment as long as he meets the requirements of 631(a).
First, the timber owner must have owned the trees or had the right to cut the trees for more than one year.
Second, the timber owner must split the sales proceeds into two amounts: (1) the gain that resulted from holding the standing timber until cutting, and (2) the added value from converting the standing timber into logs or wood products.
The timber owner calculates the 631(a) gain (or long-term capital gain) by subtracting the adjusted basis for depletion of the timber from its fair market value as of January 1 of the tax year it was cut.
The timber owner then calculates the added value from converting the standing timber by subtracting the fair market value of the timber processed (and any processing costs) from the sale proceeds of the wood products.
Finally, the timber owner must elect 631(a) treatment on the tax return by checking the appropriate box on Form T and separating the income between long-term capital gain and ordinary income.
IRC § 631(a) Example
Paul Bunyan cut 20,000 board feet (20 MBF) of timber and converted them into sawlogs during 2020. The sawlogs were sold for $30,000 on 4/1/20.
The fair market value of the timber cut as of January 1, 2020 was $1,000/MBF, or $20,000. Paul’s adjusted basis for depletion in the timber cut, which he had owned for more than one year, was $5,000.
Paul should report a long-term capital gain of $15,000 and an ordinary gain of $10,000 calculated as follows:
IRC § 631(b)
If a timber owner, who is in the business of selling timber, sells timber outright or with a retained economic interest, the profit from the sale is treated as a long-term capital gain.
To qualify for 631(b) treatment, the timber owner must sell the trees on the stump. If the timber owner cuts his own trees or hires someone to cut the trees for him, the sale must qualify under 631(a) instead.
Selling timber outright is also known as a “lump-sum sale.” Any time a timber owner enters into a contract for a set dollar amount for timber or an individual pays a set annual rental fee for the right to cut timber, it is a lump-sum sale.
In contrast, a retained economic interest occurs anytime the timber owner receives payment based on the volume of timber harvested. A retained economic interest agreement is also known as a “pay-as-cut contract.”
Regardless if the timber is disposed of in a lump-sum or pay-as-cut agreement, the sale will qualify for 631(b) treatment as long as standing timber is sold and the timber owner owned the timber (or had the right to cut the timber) for more than one year.
In contrast to 631(a), no election is necessary for 631(b) treatment. The timber owner simply reports the capital gain properly on their tax return.
IRC § 631(b) Example
Paul Bunyan sold 10,000 board feed (10 MBF) of standing timber in a lump-sum sale on 4/15/20. The contract price was $15,000. His adjusted basis for depletion in the timber sold is $5,000 and he owned the timber for more than one year. Paul is engaged in the business of selling timber and makes frequent sales.
Paul should report a long-term capital gain of $10,000 ($15,000 contract price – $5,000 timber adjusted basis) on his 2020 tax return.
Conclusion
Timber owners in the business of selling timber should ensure they are meeting the requirements of IRC § 631 in order to pay less tax on their timber sales.
This article is just an overview of IRC § 631. There are many more nuances that were outside the scope of this article. A timber owner looking to meet the requirements of IRC § 631 should consult with a knowledgeable timber CPA. All tax situations are different and the information explained above might not result in the best outcome for all timber owners.
As always, feel free to reach out with any questions or comments!
