Farming Magazine - May, 2008


What if My Cost Basis in Timber is Zero?

By Thom J. McEvoy

A common question of forest owners who have owned land for more than 30 years is this: “How do we calculate the cost basis in timber for forests that were populated with saplings when we bought it?” The quick answer is, “Such a small portion of the original purchase price was due to timber that your current cost-basis in timber is virtually zero.”

Does this mean that the significant tax benefits of long-term capital gains treatment is disallowed for lack of a cost basis in timber? Absolutely not! A capital asset is a capital asset regardless of when it becomes available for sale. When the cost basis is zero, income from timber sales is pure profit. Provided the owner handles the sale to allow long-term capital gains treatment, then net income from the sale is still taxed at lower long-term capital gains rates (equal to 10 percent for many, 5 percent for some and zero for those in the lowest brackets for the next three years: 2008 to 2010).

It is tempting for some owners who are hosting their first sale to arbitrarily assign some portion of purchase price to timber. Unless there are solid, supportable reasons for an allocation of purchase price to timber, and other assets that came with the purchase, it is not possible to figure the timber basis. Technically, the IRS says that the allocation of acquisition costs (purchase price plus commissions, surveyor and forester fees, legal costs, etc.) must be “according to the separate fair market value of each asset independent of the others.” It is irrelevant when the taxpayer makes this allocation, so long as it reflects the fair market value of assets on the date the land was acquired.

For example, a forest owner that paid $25,000 for 150 acres of forestland in 1968 cannot arbitrarily say that $10,000 of the total was due to timber and the balance was the cost of bare land. Even though this may be a fairly close approximation of the actual cost basis in timber, without the numbers to support these values it is no better than a guess.

Since this same land may have in excess of $100,000 worth of timber on it today, the proportion of cost basis attributable to timber is so small in comparison to current values as to not warrant the expense of paying someone to allocate the 1968 purchase price to land and timber accounts. I would argue, as well, that the potential savings from an arbitrary estimation of timber basis is not worth the risk of back taxes and interest penalties if the numbers are not supportable at audit. Every number you use to figure tax liability must be supported with facts.

If a taxpayer does have a valid cost basis, generally the basis decreases after each timber sale. Even though the trend is normally downward, it is possible to add costs to the timber basis when there are capital expenditures. A capital expenditure is a cost, other than a regular expense, that makes capital assets more valuable. A class of expenditures known by the IRS as “carrying charges” can be treated—at the taxpayer’s discretion—as either an annual expense or a capital expenditure. The costs of property taxes and insurance are examples of carrying charges. The timber owner who does not account for these expenses in the year they were incurred can instead add them to the basis of assets and allocate a portion to the timber basis.

If you believe there are carrying changes associated with forestland that you did not report as expenses during your years of ownership, it is possible to capitalize these expenditures. But, the same documentation rules apply: you must have factual evidence to support the capital expenditures you’re claiming. Otherwise, you run the risk of back taxes and penalties if the IRS disagrees with you at an audit.

A distressing number of forest owners assume that if there is no cost basis in timber then capital gains treatment is disallowed, so they report their receipts as “other income” on the front of Form 1040 and pay self-employment tax, which is equal to 15.3 percent of “other” income. Self-employment tax is really a taxpayer’s contribution to the Social Security trust fund, but it is not levied against investment income (such as from timber) or business profits.

Income from timber sales is reported on Schedule D, Form 1040. List “timber” as the asset being sold and the date the contract was finished as the date of sale. Sale price is gross income less any sale-related expenses. In the column that asks for “Cost or Other Basis,” enter “0” with a footnote that refers to an attachment stapled to Schedule D. In this attachment, briefly explain why there is no cost basis for the sale you’re reporting, and itemize the sale expenses you’re claiming. In the unlikely event that your return is pulled to review your capital gains income, the reviewer will quickly see why you reported the basis as zero.

One final personal note is worth mentioning. About four years ago during a conversation with a timber tax colleague, he told me—in confidence at the time—that the IRS had performed an informal study of returns from the Northeast that reported timber sales. Less than 15 percent of the returns had allegedly reported timber sale income “correctly.” The reason my colleague wanted this held confidential was because it was not clear at the time exactly what the IRS would do with this information. If the issue was one of taxpayer compliance, this is an abysmally low rate.

Naturally, we assumed the only reasonable outcome would be wide-spread audits of taxpayers reporting income from timber, but four years later, no such policy has gone into effect. I’m guessing that upon closer inspection of the incorrectly filed returns, the IRS probably discovered that the vast majority of errors were in its favor. If this is true, it is doubtful they would go to the expense of attempting to correct a situation that was netting more revenue than should have been paid.

The bottom line: Always report income from timber sales as a long-term capital gain. Doing so is not only correct, but it could save thousands of dollars in taxes that you don’t owe.

The author is a professor and extension forester with the Rubenstein School of Environment and Natural Resources at the University of Vermont.