WOODEN YOU KNOW:

IMPORTANT TAX TOPICS FOR TIMBER

AND OTHER LAND OWNERS

David D. Aughtry, Esq. J. Scot Kirkpatrick, Esq. Rose K. Drupiewski, Esq.

ATLANTA

Thirty-Fourth Floor

191 Peachtree Street, N.E.

Atlanta, GA 30303

(404) 659-1410

(800) 800-0745

HOUSTON PHILADELPHIA DENVER SAN ANTONIO

INTRODUCTION• Income Tax Issues

• Capital Gain vs. Ordinary Income

– Capitalization and Depletion

– Election to Treat Cutting as Sale or Exchange

– Election for Sales of Timber Under Pay-As-Cut Contract

– Long Term Timber Leases

– Like-Kind Exchanges

– Charitable Contribution Deductions

– Reforestation Expenditures

– Captive Insurance Companies

• Estate and Gift Tax Issues

– Overview of Current Law

– Valuation in General

– Special Use Valuation

– Family Limited Partnerships

– Gifts and Sales to Irrevocable Trusts

– Charitable Trusts

– Liquidity Issues

• Other Tax Issues

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Capital Gain vs. Ordinary Income

• In general, the determination depends on whetherthe property is personal use, investment, orbusiness property.

• Gains from sales of timber held for personal use orinvestment are entitled to capital gains treatmentunder section 1221.

• Proceeds from sales of timber held as inventory aretaxed as ordinary income, with certain exceptions.

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Timber Held for Use in a Trade

or Business • Section 1231 provides rules for the characterization of

gain on property used in a trade or business.

• In general, when "section 1231 gains” for any taxableyear exceed “section 1231 losses”, the net gain istreated as capital gain. If section 1231 gains do notexceed section 1231 losses, the net loss is treated as anordinary loss.

• Section 1231(c) provides for recapture of section 1231gain if the taxpayer has “non-recaptured losses” in anyof the preceding 5 tax years.

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Example

Paul Bunyan sells a 100 acre timber tract owned

by his forest products business at a gain of

$10,000. The same year, Paul sells an adjoining

50 acre timber tract at a loss of $5,000. Because

the section 1231 gains exceed section 1231

losses, the net $5,000 gain is treated as capital

gain.

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Example

Assume the same facts as set forth in the

previous Example, except that Paul Bunyan

claimed an ordinary loss of $5,000 on section

1231 property in the preceding tax year. Under

the recapture provision of section 1231(c), the

entire amount of gain is recharacterized as

ordinary income. The effect is that Paul has

$5,000 of ordinary income.

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Depletion

• The costs associated with acquiring timber mustbe capitalized.

• With respect to the standing timber, costs arerecoverable over time through the rules ofdepletion.

• Section 611(a) authorizes a depletion deductionfor a taxpayer holding an “economic interest” intimber. The depletion allowance is computedusing the taxpayer’s adjusted basis in theproperty.

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Calculating Depletion Deductions

• The taxpayer is required to create separate

depletion accounts at the time the taxpayer

acquires the property.

• The cost basis of the property is allocated among

the land, timber, and any other resources.

• After a timber account is created, the “depletion

unit” is calculated each year.

Depletion Allowance = # of Units Cut x Depletion Unit

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Example

Smokey the Bear bought 100 acres of timberland in 2010 andpaid $400,000 for the property. There were 1,000 cords oftimber on the property at the time of purchase. The fair marketvalue of the timber (separate from the land) at the time ofpurchase was $20,000. Smokey cuts and sells 500 cords oftimber in 2012 for $12,000 when the property has 2,000 cords oftimber.

Depletion unit = $20,000 basis ÷ 2,000 cords

= $10.00/cord

Depletion allowance = $10.00/cord x 500 cords = $5,000

Taxable income from sale = $12,000 - $5,000 = $7,000

Basis of remaining timber = $15,000

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Election to Treat Cutting as Sale

or Exchange

• Taxpayers who cut timber for sale or for use in their owntrade or business may elect under section 631(a) to treatthe cutting as a sale.

• The election is available to taxpayers owning timber, orhaving rights to cut timber under a contract, for morethan one year.

• The taxpayer will have gain or loss equal to the differencebetween the FMV of the timber on Jan. 1 of the taxableyear and its adjusted basis for depletion.

• The sale is allowed capital gain (or ordinary loss)treatment as if it is section 1231 property.

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Example

Smokey the Bear grows timber for sale or use inhis business. The fair market value of the timberis $12,000 on January 1 of the tax year andSmokey’s basis in the timber is $2,000. Smokeycuts that timber from business property that hehas held more than one year and then sells theresulting logs to a saw mill for $15,000. Smokeymakes a section 631(a) election and reports$10,000 of capital gain ($12,000 - $2,000) and$3,000 of ordinary income.

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Sales of Standing Timber

• Section 631(b) applies to taxpayers who sell standingtimber under a lump sum or pay-as-cut contract wherethey retain an “economic interest” in the timber.

• Timber sold under such a contract is allowed capitalgain (or ordinary loss) treatment as if it is section 1231property.

• The section applies to timber held more than one yearprior to disposal.

• The gain is equal to the excess of the amount realizedover the timber’s adjusted depletion basis.

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Long Term Timber Leases

• In general, payments made under a long term

timber lease are allocated between two

components: sales proceeds and rental

income.

• The sale proceeds equal the FMV of the

timber at the execution of the contract.

• The rental portion consists of the excess of

payments over the FMV of the timber.

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Like Kind Exchanges

• Section 1031 provides that no gain or loss is recognizedon the exchange of property held for productive use ina trade or business or for investment if such property isexchanged for “like kind” property.

• "Like kind" refers to the nature or character of theproperty and not to its grade or quality.

• Exchanges of timber properties require specialconsideration in the “like kind” analysis.

• Exchanges of timber property for timber rightsseverable from the land may not always qualify for like-kind treatment.

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Smalley v. Commissioner, 116 T.C. 450 (2001)

• A section 1031 case in which the taxpayerexchanged 2-year timber cutting rights for a feesimple interest in three parcels of real estate.

• The taxpayer argued that he exchanged standingtimber for standing timber with land attached,both of which were characterized as real propertyinterests under Georgia law.

• The Tax Court agreed with the taxpayer regardingthe characterization of the exchanged property asreal property under Georgia law.

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Charitable Deductions

• Undivided interests in timber property may be given to charity and qualify for an income tax charitable deduction under section 170.

• If a donor donates cut timber to a public charity, donations of personal property items are subject to special rules.

• In general, personal property must be put to “related use” by the charity for a FMV deduction.

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Example

Paul Bunyan gives a rare oriental tree to a state

university in 2012. The tree has a cost basis of

$100 and a fair market value of $2,000. The tree

will be used by the university’s botany

department for classroom display. Because such

use is directly related to the university’s exempt

educational purpose, Paul may take a charitable

deduction for $2,000.

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Conservation Easements

• Although gifts of partial interests in real estate aregenerally not deductible, there is an exception forcontributions of conservation easements.

• The property must be used exclusively for conservationpurposes:

– the preservation of land for outdoor recreation or forthe education of the general public;

– the protection of natural habitat for fish, wildlife, orplants; and

– the preservation of open space.

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Butler v. Commissioner, T.C. Memo 2012-72

• The taxpayer contributed conservation easements andretained certain rights to the properties, including the rightto subdivide the property, build homes, clear timber foragricultural uses, and commercially harvest timber.

• The Service argued that the easements failed to protectconservation purposes due to these retained rights.

• The Tax Court found that the taxpayers provided credibleevidence that the conservation deeds served theconservation purpose of protecting a significant habitat forwildlife.

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Reforestation Expenditures

• Section 194 allows two levels of tax incentives for

reforestation.

• At the first level, the first $10,000 ($5,000 for

married taxpayers filing separately) of

“reforestation expenditures” made with respect

to “qualified timber property” may be deducted.

• At the second level, expenditures in excess of the

applicable limit may be capitalized and amortized

over 84 months.

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Captive Insurance Companies

• Many risks can jeopardize a timber business, some ofwhich may not be insurable at a reasonable cost.

• A Captive Insurance Company ("Captive") may be usedto manage the risk of a timber business while alsoproviding income tax benefits to the business and itsowners.

• Use of a Captive may be helpful when full, or evenadequate, outside coverage may not be available to thebusiness, outside coverage is so costly that thebusiness cannot or does not want to incur the expense,and/or when the business is otherwise unable toaccess the reinsurance market.

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Current Estate & Gift Tax Laws

• $5 million unified exclusion amount for estate,

gift, and GST tax purposes that is indexed for

inflation in 2012.

• 35% tax rate in 2012.

• Gift tax annual exclusion amount of $13,000 per

donee in 2012.

• On Jan. 1, 2013, the exclusion amount is set to

drop to $1 million, with a 55% tax rate and a 5%

additional estate tax on estates over $10 million.

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General Valuation Concepts

• Section 2033 provides that the value of anindividual’s gross estate includes the value of allproperty in which the decedent has an interest atthe time of this death.

• Similarly, Section 2501(a) provides that gift tax isimposed upon the value of property transferredby gift during each calendar year.

• The measure of the value of the property is its“fair market value”.

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Special Use Valuation –

Section 2032A• If elected, property devoted to a special use in a closely-

held business may be valued based on such use.

• There are numerous requirements, including:– the decedent must be a U.S. citizen or resident;

– the property must be located in the U.S.;

– the property must have been used by the decedent ormember of the decedent’s family for a qualified use on thedate of the decedent’s death and for a number of yearsprior to death (at least 5 of the prior 8 years);

– property must pass to a qualified heir; and

– the qualified heirs must agree to continue the property’squalified use.

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Determining Special Use Value

• Two methods are provided:

– Application of a specific formula that uses the averagerental income from comparable properties for the 5years preceding the date of death; or

– Application of a subjective “five factor” method thatconsiders: capitalization of income, capitalization ofrents, assessed ad valorem values, comparable sales,and other relevant factors that fairly value the land.

• The formula method must generally be used unless thereis no comparable land.

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Qualified Woodlands Election

• A "qualified woodlands" election may be madeunder section 2032A(e)(13) with respect totimberland which would allow any timber on theproperty to be valued as part of the underlying realestate rather than as a separate asset.

• "Qualified woodlands" is defined as an identifiablearea of land (such as an acre) which are normallyused for planting, cultivating, caring for, or cuttingtrees, or preparing trees for market (other thanmilling).

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Estate of Rogers v. Commissioner,

T.C. Memo 2000-133

• This case concerned the valuation of land undersection 2032A for which a qualified woodlandselection was made.

• The land was timber property subject to longterm timber leases.

• Tax Court agreed with the estate that there werecomparable properties available.

• The Court also held that the value determinedunder the formula method included the value ofthe timber.

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Family Limited Partnerships

• Fractionalized interests in timber property canbe particularly difficult to manage.

• A family limited partnership (“FLP”) can allowcentralized management and facilitatetransfers of ownership.

• For tax purposes, a partnership interest is lessvaluable than its underlying assets (due toapplicable discounts for lack of control andmarketability).

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Sales to Irrevocable Trusts

• Discounted timber property or timber business

interests may be removed from the gross estate

through a transfer to a defective grantor trust.

• A taxpayer can transfer assets to the next generation

at a substantially lower transfer tax cost if business

interests are transferred instead of outright land

ownership .

• Sale transactions are particularly attractive now due

to low interest rates.

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Charitable Trusts

• Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts(CLTs) are referred to as “split interests trusts” because theyhave both a charitable beneficiary and a non-charitablebeneficiary.

• Donors make charitable gifts while retaining beneficialinterests in the donated property.

• Charitable Lead Annuity Trusts (CLATs) are particularlyattractive in 2012 for a number of reasons.

• If an interest in a timber business is being given to a charitabletrust, there are a number of issues and potential pitfalls thatshould be considered.

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Estate Liquidity Issues

• Section 6166 allows the executor to make an election to paypart or all of the estate tax liability in two or more (but notmore than (10)) equal installments. In general, such anelection is available if the gross estate includes an interest in aclosely held business worth more than 35% of the decedent’stotal adjusted gross estate.

• The election also allows a 5-year deferral for payment.

• An illiquid estate may also employ a “Graegin loan” togenerate an up-front interest deduction for the total interestto be paid over the life of the loan.

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Georgia Property Tax – Conservation

Use Valuation (CUVA)

• Owners of agricultural land, timberland and

environmentally sensitive land may qualify for conservation

use assessment under O.C.G.A. § 48-5-7.4.

• CUVA valuation is determined based on the property’s

current qualifying use rather than its highest and best use.

• If CUVA is employed, the property owner must covenant to

leave the land undeveloped and continue its qualifying use

for 10 years.

• Owners who breach the covenant must pay back twice the

savings they have received over the life of the covenant.

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Georgia Ad Valorem Tax

• Standing timber is only taxed for ad valorem tax

purposes at the time of its harvest or sale.

• Standing timber does not include orchard trees,

ornamental or Christmas trees, byproducts of

harvesting (bark or stumps), and fuel wood

harvested by the owner which is used exclusively

for heating the owner's home.

• The tax is not imposed if the taxpayer sells the

entire tract of land with the timber.

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CONCLUSION

• There are numerous tax advantages and

opportunities available to owners of timber

property, as well as some pitfalls to avoid.

• With consideration and planning, timber

owners can ensure that their timber

investment or business provides a wealth of

benefits, whether the horizon is short term or

for many generations to come.

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