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
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
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.