Capital ExpendituresCapital Expenditures

Chapter 2Chapter 2

Capital ExpendituresCapital Expenditures

• IRC defines capital expenditures in IRC defines capital expenditures in § 263 and § 263 and by by exception in exception in § 1221§ 1221

• Buying real property or equipment with a useful Buying real property or equipment with a useful life greater than one year and making life greater than one year and making improvements to property already ownedimprovements to property already owned

• Forestry examples: Forestry examples: – LandLand– Merchantable and pre-merchantable timberMerchantable and pre-merchantable timber– Building, equipment, and acquisition costs. Building, equipment, and acquisition costs.

Capital RecoveryCapital Recovery

• Capital costs recorded in books for recovery asCapital costs recorded in books for recovery as

• Depletion – deduction of investment in Depletion – deduction of investment in standing timber as it is sold or disposed ofstanding timber as it is sold or disposed of

• Amortization – deduction of capitalized Amortization – deduction of capitalized reforestation costs over amounts permitted to reforestation costs over amounts permitted to be expensedbe expensed

• Depreciation – deduction for building, land Depreciation – deduction for building, land improvements, and equipmentimprovements, and equipment

Taxpayer Must Decide Purpose For Taxpayer Must Decide Purpose For Owing TimberlandOwing Timberland

• Investment – income and appreciationInvestment – income and appreciation• Trade or Business – production of goods and Trade or Business – production of goods and

profitsprofits• Personal use – second homes, wildlife, Personal use – second homes, wildlife,

recreation, sentimental and other with no tax recreation, sentimental and other with no tax advantagesadvantages

• Combinations – it is important to distinguish Combinations – it is important to distinguish ““for profitfor profit” activities from those for fun. Some ” activities from those for fun. Some landowners have trouble with the difference.landowners have trouble with the difference.

Allocation to Original BasisAllocation to Original Basis

• Purchases – actual amounts paid plus costs of Purchases – actual amounts paid plus costs of acquisition are allocated acquisition are allocated proportionallyproportionally

• Inheritances – valuation reported on federal Inheritances – valuation reported on federal (Form 706), or state tax returns(Form 706), or state tax returns

• When estate tax return is not required, choose When estate tax return is not required, choose fair market valuefair market value on date of decedent’s death on date of decedent’s death

• Valuations under IRC Valuations under IRC § 2032A must be used § 2032A must be used when special use is electedwhen special use is elected

Gifts Take Donor’s BasisGifts Take Donor’s Basis

• If no gift tax is paid, property is If no gift tax is paid, property is dual basisdual basis– Disposals for gain use adjusted basisDisposals for gain use adjusted basis– Disposals for a loss use lower of adjusted basis or Disposals for a loss use lower of adjusted basis or

fair market value on date of giftfair market value on date of gift

• If gift tax is paid – If gift tax is paid – – Pre-1977 gifts use adjusted basis plus all tax paid; Pre-1977 gifts use adjusted basis plus all tax paid; – post 1976 gifts add tax on appreciated value onlypost 1976 gifts add tax on appreciated value only

• Basis for depreciation is donee's Basis for depreciation is donee's gain basisgain basis

Adjusted BasisAdjusted Basis

• The The adjusted basisadjusted basis is -- original basis, less is -- original basis, less depletion, amortization, depreciation or losses, depletion, amortization, depreciation or losses, plus capitalization of improvements, carrying plus capitalization of improvements, carrying charges, or additions to the assetcharges, or additions to the asset

• Allowable basisAllowable basis is the proportional amount that is the proportional amount that is offset against revenue when standing timber is is offset against revenue when standing timber is sold or otherwise disposed ofsold or otherwise disposed of

• See also Part II of Form T (Timber)See also Part II of Form T (Timber)

Land AccountLand Account

• Allocations have an indeterminate useful life Allocations have an indeterminate useful life and a permanent character.and a permanent character.– Bare land and permanent, non-depreciable Bare land and permanent, non-depreciable

improvements such as permanent roads, land improvements such as permanent roads, land leveling and earthen impoundmentsleveling and earthen impoundments

• Improvements on the land are depreciableImprovements on the land are depreciable– Building, temporary roads, bridges, fences, culvertsBuilding, temporary roads, bridges, fences, culverts

Merchantable Timber AccountMerchantable Timber Account

• Accurate ledger accounts must be kept in order Accurate ledger accounts must be kept in order to claim a depletion deductionto claim a depletion deduction

• Two entries are requiredTwo entries are required– Timber Timber quantityquantity– DDollar value or ollar value or basisbasis

• Basis is a proportion of overall asset valueBasis is a proportion of overall asset value• Quantity is shown in volume terms as cords, Quantity is shown in volume terms as cords,

tons, MBF, or other standard units of measuretons, MBF, or other standard units of measure

Options for Merchantable Timber Options for Merchantable Timber AccountAccount

• Taxpayer must have Taxpayer must have one or mone or more accountsore accounts• An “averaging account” combines timber value An “averaging account” combines timber value

into one basis and volume into a common unitinto one basis and volume into a common unit– Simplest for PNIF ownersSimplest for PNIF owners

• Depletion blocks may be recorded forDepletion blocks may be recorded for– Management or geographic unitsManagement or geographic units– Timber products, species or characterTimber products, species or character

• Thereafter, it must be followed consistentlyThereafter, it must be followed consistently

Pre-merchantable Natural Pre-merchantable Natural GrowthGrowth

Seed Trees, Sprouting, and OtherSeed Trees, Sprouting, and Other • Natural young growth – stands of sufficient Natural young growth – stands of sufficient

stocking and area to contribute substantially to stocking and area to contribute substantially to total asset valuetotal asset value

• Purchased tracts – market value on date of Purchased tracts – market value on date of acquisition by comparables or income approachacquisition by comparables or income approach

• In owned stands, basis is the cost of controlling In owned stands, basis is the cost of controlling competing vegetation and pestscompeting vegetation and pests

Pre-merchantable PlantationsPre-merchantable Plantations

• Basis is cost of Basis is cost of establishmentestablishment by planting or by planting or seeding, including replanting or reseeding, seeding, including replanting or reseeding, necessary for survival of young treesnecessary for survival of young trees

• Costs include site preparation, planting, release, Costs include site preparation, planting, release, depreciation of equipment, and a portion of depreciation of equipment, and a portion of supervising forester’s salarysupervising forester’s salary

• Quantity is recorded as number of Quantity is recorded as number of acresacres until until young stands reach merchantabilityyoung stands reach merchantability

Equipment AccountsEquipment Accounts

• Established for depreciable equipmentEstablished for depreciable equipment

• Each class of items is usually carried in separate Each class of items is usually carried in separate accounts – e.g., trucks, tractors, fire plows, accounts – e.g., trucks, tractors, fire plows, planting machines, etc.planting machines, etc.

• Major repairs or overhauls that increase value or Major repairs or overhauls that increase value or extend useful life should be used to adjust basisextend useful life should be used to adjust basis

IRS Form T (Timber)IRS Form T (Timber)

• Taxpayers claiming deductions for depletion, Taxpayers claiming deductions for depletion, depreciation, or making a 631 (a) election must depreciation, or making a 631 (a) election must file a Form T (five schedules)file a Form T (five schedules)

• IRS has not rigorously enforced this regulation, IRS has not rigorously enforced this regulation, but it clearly has the authority to do so and has but it clearly has the authority to do so and has recently signaled interest in this arearecently signaled interest in this area

• Accounts should be established upon acquisition Accounts should be established upon acquisition while information is at handwhile information is at hand

Hypothetical Tree Farm ValuesHypothetical Tree Farm ValuesAppraisal ResultsAppraisal Results

• Stands: 50 acres of sawtimber, 30 acres of Stands: 50 acres of sawtimber, 30 acres of pulpwood, 20 acres of plantation = 100 acrespulpwood, 20 acres of plantation = 100 acres

• Bare land (without timber) valued at $500 per Bare land (without timber) valued at $500 per acre -- total estimated value of $50Macre -- total estimated value of $50M

• Sawtimber valued at $2,400/acre (6MBF x Sawtimber valued at $2,400/acre (6MBF x $400/MBF) -- estimated value $120M$400/MBF) -- estimated value $120M

• Pulpwood valued at $750/acre (30 cords/acre x Pulpwood valued at $750/acre (30 cords/acre x $25/cord) -- estimated value $22.5M$25/cord) -- estimated value $22.5M

Estimation of Tree Farm ValuesEstimation of Tree Farm Values

• Pre-merchantable timber valued at $500/ac. for a Pre-merchantable timber valued at $500/ac. for a total estimated value of $10Mtotal estimated value of $10M

• Equipment valued at $5MEquipment valued at $5M

• Other (a building) is valued at $22.5MOther (a building) is valued at $22.5M

• Total estimated value of the tree farm on the Total estimated value of the tree farm on the date of acquisition is $230,000, plusdate of acquisition is $230,000, plus

• Acquisition costs of $10,000 for legal, etc.Acquisition costs of $10,000 for legal, etc.

Estimated Market Value Of Estimated Market Value Of Hypothetical AccountsHypothetical Accounts

Account Account FMV ($)FMV ($) FMV (%)FMV (%)

LandLand 50,00050,000 2222

SawtimberSawtimber 120,000120,000 5252

PulpwoodPulpwood 22,50022,500 1010

Young growthYoung growth 10,00010,000 44

EquipmentEquipment 5,0005,000 22

OtherOther 22,50022,500 1010

TotalTotal 230,000230,000 100100

Allocation of $180M Price + $10M Allocation of $180M Price + $10M Acquisition Costs to BasisAcquisition Costs to Basis

AccountAccount FMV (%)FMV (%) Basis ($)Basis ($)

LandLand 2222 41,80041,800

SawtimberSawtimber 5252 98,80098,800

PulpwoodPulpwood 1010 19,00019,000

Young growthYoung growth 44 7,6007,600

EquipmentEquipment 22 3,8003,800

OtherOther 1010 19,00019,000

TotalTotal 100100 190,000190,000

Establishing BasisEstablishing BasisAfter The FactAfter The Fact

• Determine market value of assets contributing to Determine market value of assets contributing to value on value on date of acquisition (DOA)date of acquisition (DOA)– Find comparables for bare land on DOAFind comparables for bare land on DOA– Project current timber stands backward by product Project current timber stands backward by product

and species to DOAand species to DOA– Find comparable prices for timber productsFind comparable prices for timber products

• Construct table of estimated values by asset Construct table of estimated values by asset classclass

• Then ,allocate value on DOA to basisThen ,allocate value on DOA to basis