This is the first post in a series covering timber tax basics. Part 1 will cover timber activity classification. Future posts will explore issues such as calculating cost basis and depletion, taxation of timber sales, completing IRS Form T, reforestation deductions, and much more!
3 Classes of Timber Activities
One of the most important determinations regarding a timber activity is its classification for tax purposes. There are three ways a timber activity can be classified: (1) business, (2) investment, or (3) personal. How a timber activity is classified for tax purposes can affect the deductibility of expenses and losses, as well as other important tax issues.
Business
A timber activity that qualifies as a “business” activity is one that is entered into primarily for profit and is regularly and continuously carried on (See Commissioner v. Groetzinger).
“Primarily for Profit”
“Primarily for profit” refers to the owner’s motive for growing timber. Is the owner growing timber primarily to sell to customers and make a profit? If so, those facts indicate a business activity. Or is the owner growing timber as a hobby, and earning a profit is a secondary consideration? If so, a hobby would not meet the “primarily for profit” requirement.
“Regularly and Continuously”
“Regularly and continuously carried on” refers to how active and involved the owner is in the timber activity. Does the owner regularly and consistently spend time managing the timber activity? If so, then the owner likely meets the “regularly and continuously” requirement. If the owner’s participation or management is less regular, then this requirement may not be met.
Material Participation
Even if a timber activity meets the requirements of being a trade or business, a timber owner must also determine whether they “materially participate” in the business. This issue most frequently arises when there are multiple owners of a timber activity; however, it can still be an issue in sole proprietorships.
The IRS has devised seven tests regarding material participation that are explained in Treas. Reg. 1.469-5T. To materially participate, an individual only has to meet one of the seven tests. Some of the seven qualifying tests include:
- Participating in the activity for more than 500 hours per year
- Participating in the activity for more than 100 hours per year, and such individual’s participation is not less than the participation of any other individuals (including non-owners)
- Based on all facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis
The material participation rules are intended to prevent a passive investor from being considered “active” and offsetting (or “sheltering”) other ordinary income (such as wages from a job or other business profits) with losses from a passive activity. An individual that does not materially participate in an activity is deemed “passive” and may only offset a loss from the passive activity against other passive income.
Business Classification Benefits
The main benefit of having a timber activity classified as a business is that any loss may be fully deductible against other ordinary income (assuming material participation). Also, only equipment used in a business is eligible for Section 179 expensing (to be discussed in-depth in a future article). Further, all “ordinary and necessary” expenses related to the timber activity are deductible if it meets the requirements for a business classification.
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.
“Held for the Production of Income”
Often, investment property is described as “held for the production of income.” Before the Tax Cuts and Jobs Act of 2017 (TCJA), expenses related to an investment activity were deductible as a miscellaneous itemized deduction. However, the TCJA changed the law and investment expenses are no longer deductible. 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.
Personal
A timber activity classified as a “personal” activity is one that does not meet the requirements to be a business or an investment activity. In a personal activity, the property is not held primarily for the production of income. For example, a personal residence or a vacation home is typically considered personal property. A timber activity is not often considered a personal activity, unless special circumstances exist, such as selling timber from land the owner’s personal residence is on.
Hobby
Another common occurrence of a personal activity is a “hobby.” The IRS’ definition of a hobby is an “activity not engaged in for profit.” The IRS gives nine factors in Treas. Reg. 1.183-2(b) to determine if an activity is engaged in for profit:
- Manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in the activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
- Elements of personal pleasure or recreation
There is no single factor or combination of factors that is dispositive in determining whether an activity is a hobby. The IRS analyzes the nine factors in total when determining whether the activity is “engaged in for profit.” However, timber owners should make sure as many factors as possible indicate a profit motive, rather than a hobby or personal motive.
Currently, there is generally the same treatment between investment and personal activities due to the TCJA. Any income from personal property or an activity is fully taxable; however, no expenses are deductible. In the future, investment activities could become more desirable if tax law changes to allow deduction of investment expenses.
Substance Over Form
In determining the classification of a timber activity, the IRS follows a doctrine known as “substance over form.” Basically, this means the IRS looks at the facts and circumstances surrounding the timber activity, rather than the label the owner puts on it.
For example, an individual transfers their ownership of a timber activity to a corporation which the individual owns. In this instance, the timber activity is not considered a business simply because the corporation owns it. The IRS would look at all of the facts surrounding the timber activity, such as how involved the individual (shareholder) is, when determining the timber activity’s classification.
Conclusion
Tax classification is the first step in determining the tax treatment of a timber activity. Timber activity classification is extremely fact-specific; therefore, consultation with a knowledgeable timber CPA is recommended for your individual situation. The next post will discuss cost issues, such as basis, depletion, and the reforestation deduction. Feel free to reach out with any questions or comments!
