New Developments On Taxes

The United States government and the IRS and continually changing the laws and rules on how you and your investments are taxed.   This page is here to help you stay up to date on issues that could impact your timberland and the tax treatment of timber.  Timbertax.org is a website dedicated to helping forest landowners, foresters, tax consultants, attorneys, and other professionals  answer their questions.  The following information was found their website.  There is a wealth of other information available.  If you have tax questions concerning your timberland investment, consult with their site.  A link can be found in the box on the left.

Revised IRS Form T

As expected the IRS has revised Form T. Two major changes are obvious when you read the form. First, the minor schedules have been eliminated and the term “schedule” has been replaced by “Part”. Part I is Acquisitions, Part II is for Timber Depletion, Part II is Profit or Loss From Land and Timber Sales, Part IV is Reforestation and Timber Stand Activities, and part V is land Ownership. The second change is the guidelines on when Form T must be filed. Quoting from page 1: “You are not required to file Form T if you only have an occasional sale of timber (for example, one or two sales every 3 or 4 year). However, you must maintain adequate records of these transactions and other timber-related activities during the year, as discussed in Recordkeeping on this page. These transactions may be treated as an investment for tax purposes if your property is not held for use in a trade or business.”

The instructions on the form indicate a greater awareness by the IRS of the distinction between a timber activity conducted as an investment and an activity that rises to the level of a business. They also place greater emphasis on the need to keep records adequate to substantiate transactions reported on your tax return.

2004 Inflation Adjustments

Each year the IRS uses the previous year’s inflation rate to adjust various key amounts that the Congress has authorized to be adjusted for inflation.

INCOME TAX

Personal exemption for 2004 increases to $3,100 from $3,050 in 2003.

Standard deduction for 2004 for married filing jointly is $9,700. It’s $4,850 for singles and for married filing separately, and $7,150 for heads of households. The additional standard deduction in 2004 for aged and blind is $950 each.

The itemized deduction phaseout in 2004 will start at adjusted gross incomes of $142,700 and $71,350 for married filing separately.

The annual gift tax exclusion stays at $11,000 in 2004.

ESTATE TAX

Special use valuation.  For the estates of decedents dieing in 2004, that use IRC Sec. 2032A, the maximum amount by which the property’s value can be reduced for estate tax purposes is $850,000, up from $840,000 in 2003

Conservation easement exclusion. For the estates of decedents dying in 2004 the maximum exclusion for conservation easements is $500,000.

IRS Rulings and Regs

Revenue Ruling 2004-62 - If you fertilize your established stands of timber you may now deduct this cost.  The IRS previously asked you to amortize this cost over the number of years the fertilizer was expected to affect growth. Revenue Ruling 2004-62 represents a welcome change of position. Note that this treatment requires that the timber be grown for the production of income as a business, or presumably as an investment. You are still required to capitalize as a reforestation expense the cost of fertilizer applied when trees are planted. This reforestation cost would also qualify for Sec. 194 Reforestation Amortization. Also note that if you are currently amortizing post-establishment fertilization expenses you are required to file IRS Form 3115 requesting an automatic change in accounting method.  Full Text...

Revenue Ruling 2003-123 is bad news for trustees of trusts owning land for which they wish to grant a qualified conservation easement and take a charitable deduction. Land is almost always part of the principal of a trust, usually referred to as corpus. A trust can claim a charitable deduction for donations made from the income of the trust, that is, income produced by the principal. Thus, if a trust donates an otherwise qualified conservation easement to a qualified organization it can’t claim a charitable deduction, unless the donation wasn’t from principal.

American Jobs Creation Act of 2004

On October 11, by a vote of 69-17, the Senate cleared a $137 billion corporate tax overhaul package and, since the House passed the bill last week, President Bush is expected to sign the bill (HR 4520, American Jobs Creation Act of 2004) into law. The measure repeals a current export tax break that has been deemed an unfair trade subsidy by the World Trade Organization, as well as modifying a number of timber-taxes, including Internal Revenue Code Section 631(b) and allowing landowners to expense of reforestation costs in an accelerated fashion.

Summaries of Timber Provisions

Effective Date: October 22, 2004. Some provisions are effective January 1, 2005

Warning: Until the IRS issues regulations to implement the provisions of the bill it is not possible to guarantee that these summaries will reflect actual law.

(1) Capital gains treatment for timber "held primarily for sale to customers in the ordinary course of a trade or business", or for use in a trade or business

Under current law timber "held primarily for sale to customers in the ordinary course of a trade or business," or for use in a trade or business, that is disposed of on the stump must be done so under a so-called "pay-as-cut" contract to qualify for long-term capital gains treatment. In tax lingo it must be "disposed of with an economic interest retained." The bill amends Internal Revenue Code (IRC) Section 631(b) to provide that the disposal of timber on the stump qualifes for capital gains treatment if sold with either a pay-as-cut, or a lump sum contract. Lump sum is the type of contract generally preferred by landowners because the total amount to be received from the buyer is fixed in advance, rather than depending on the volume actually harvested by the buyer. Effective date: Sales after December 31, 2004.

Example under current law. Mr. Jones has operated a 350 acre tree farm in Georgia since 1974. He uses Form 1040, Schedule C, Sole Proprietorship business form, to report his tree farm incomes and expenses. In November 2004 he offers 80 acres of sawtimber timber for sale. He has sold timber 7 times since 1974. Because he operates as a business and has made frequent sales, he tells buyers that he must use a pay-as-cut contract in order to receive capital gains treatment. This limits the buyers he accepts offers from because he must trust them to accurately scale the logs produced and report this volume to him. He is payed based on the volume cut and the price per unit specified in the contract.

Example under revised law: Assume the same circumstances as in the above example, except that Mr. Jones tells buyers that the sale will be closed January 2, 2005. He also tells them to offer him a fixed dollar amount for the timber on the 80 acres. He asks for 50% of the proceeds at the time of signing and 50% before logging starts. This "lump sum" sale qualifes for long-term capital gains treatment, even though the timber is part of a business.

(2) Expensing of up to $10,000 of reforestation costs

Under current law a qualified taxpayer can elect to amortize over an 84-month period up to $10,000 of qualifed reforestation expenditures. A 10% tax credit can also be claimed on up to $10,000 or qualified expenditures. The bill amends IRC Secs. 194, to allow expensing of up to $10,000 of qualified expenses, and amortization over 84 months of any qualifed expenses over $10,000 per year. The amortization schedule remains the same: 1/14th for the first and 8th years, and 1/7th for years 2 through 7. The tax credit is eliminated. This expense would be reported as a business expense for taxpsyers reporting their timber activities as a business.Likewise for the amortization deduction. It appears that taxpayers reporting their timber activies as an investment would still be able to report the expense as an adjustment to gross income. Effective date: Qualifying expenditures made after October 22, 2004.

     Election provisions. Pending regulations, we do not know how the election to expense up to $10,000 per year of qualified reforestation expenses is to be made and more importantly whether an election will be binding on all future qualified reforestation expenses.

Example under current law. Mr. Jones incurred $19,200 of reforestation expenses in 2004. He elected to amortize $10,000 of the expenses. The balance of $9,200 was capitalized to his deferred reforestation (plantation) account. He claims a $1,000 tax credit (10% of $10,000), and amortizes $9,500 over 84 months.

Example under revised law. Assume the same circumstances as above, but Mr Jones waits until 2005 to incur the $19,200 of qualifed reforestation expenses. He elects to expense $10,000 of the reforestation expenditures. He amortizes the balance of $9,200 over 84 months. On his 2005 business tax return he adds the $10,000 expense plus the $657 of amortization to his other business expenses to determine his net income.

Note for individuals filing as investors. Internal Revenue Code Section 62(a)(11) provides that an individual taxpayer's adjustments to gross income include deductions allowed under Internal Revenue Code Section 194. Thus, instead of reporting qualified reforestation expenses and amortization amounts as miscellaneous itemized deductions, they are reported as adjustments to gross income. Since Internal Revenue Code Section 62(a)(11) was neither revoked nor amended by the Amercan Job Creation Act of 2004, this treatment applies to both amounts expensed (up to $10,000) and the amount of amortization deductions.

(3) Revocation of existing election to treat a cutting of timber as a sale

Under current law timber owners who cut their own timber or have it cut under a logging services contract can receive capital gains treatment on the value of the stumapge cut by electing to treat the cutting as a sale under IRC Sec. 631(a). Once made this election is binding on all future timber cut by the taxpayer. The bill provides that an election by a corporation made for a taxable year ending on or before the date of enactment of the bill, to treat the cutting of timber as a sale or exchange, may be revoked by the taxpayer without the consent of the IRS for any taxable year ending after that date. The prior election (and revocation) is disregarded for purposes of making a subsequent election. This change apparently applies only to corporations. Effective date: October 22, 2004

(4) Modification of safe harbor rules for timber REITS

Real estate investment trusts (REITS) are a standard vehicle for investments in real estate. A majority of REITS generate ordinary income from rents received from leasing commercial real estate. The IRC treats the "operating income" of REITS differently than gains from the disposal of the underlying assets. Over the last 20 years or so there have been major flows of capital into timberland. This resulted from institutional investors such as life insurance companies and wealthy individual investors seeking to diversify their portfolios. These institutional investments were possible because the large supply of timberland on the market from divestitures of timberland by integrated forest products corporations. A timberland REIT obviously generates cash flow by selling timber, which means disposals of the underlying asset. The bill revises IRC Sec. 856 and 857 to provide the same tax treatment to timber REITS as received by REITS in general. Effective date: October 22, 2004

The Jobs and Growth Tax Relief Reconciliation Act of 2003

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), signed into law by President Bush on May 28, 2003,  will impact timber owners in many ways. The most direct is a lower long-term capital gains rate. However, lower marginal rates on ordinary income and increased deductions for capital investments by small businesses will also have an impact.  It’s tempting to suggest that the change in rate structure should impact how timber owners structure their activities for business and tax purposes. However, the temporary status of the changes because of the sunset provision, makes long-term planning difficult. Flexibility remains important, but difficult to achieve.

Here are summaries of the basic provisions. The implementation of some of the changes must be clarified by the IRS. We will revise the technical discussions in the website as soon as adequate details are available.

Lower Rates for Ordinary Income

For ordinary income the 10% and 15% rates stay the same. The 27% rate drops to 25%, 30% to 28%, 35% to 33%, and 38.6% to 35%. These reductions are effective retroactively to January 1, 2003.

Lower Long-Term Capital Gains Rates

The maximum rate on net long-term capital gains drops from 20% to 15%, but at the price of increased complexity. The capital gains reductions are effective for sales and exchanges on or after May 6, 2003. The IRS estimates that this will add eight lines to Schedule D and its worksheet. If you receive installment payments from a disposal prior to May 6, 2003, the new rates will apply to any payments received on or after May 6, 2003.

The capital gains rate for taxpayers in the 10% or 15% ordinary income brackets falls from 10% to 5%.  And, in 2008 this 5% rate falls to 0%, but only for this one year. On January 1, 2009 the rate goes back to the 20% and 10% rates because of sunset provisions. If you plan on transferring wealth to individuals in a low tax bracket, you might consider transferring assets to be disposed of by the recipient in 2008. With a zero tax rate the carryover basis rule for gifts is moot.

Under certain circumstances gains on sales and exchanges of property held for more than five years was 18% instead of 20%, or 8% instead of 10%. These 5-year gains rates are eliminated. However, they will return in 2009 unless Congress extends the provisions of JGTRRA.

Deductions of capital losses against ordinary income are still limited to $3,000 per year for individual taxpayers.  Thus, it’s still prudent to balance capital losses against capital gains by timing disposals and exchanges.

The 28-percent maximum capital gains rate on gains from collectibles remains, as does the 25-percent rate on unrecaptured Code Section 1250 gains.

Expensing of Capital Costs

Small businesses can deduct currently instead of depreciating up to $25,000 worth of qualified property placed in service during the year, the Sec. 179 deduction. The amount decreased by $1 for each dollar of qualified expenses over $200,000, the “phase-out threshold.” The amount qualifying for deduction increases to $100,000 for years 2003, 2004 and 2005. These amounts will be indexed for inflation in 2004 and 2005. In addition, the phase-out threshold increases to $400,000.

Some Relief on Alternative Minimum Tax

Congress was expected to include major relief from the alternative minimum tax which is catching an increasing number of middle income taxpayers.  Relief was limited, however, to an increase in the amount of the alternative-minimum-tax taxable income exempt amount. It went from $35,750 to $40,250 for single taxpayers, and $49,000 to $58,000 for married taxpayers. These changes are only for tax years beginning in 2003 and 2004.

Tax on Stock Dividends Reduced

Dividends paid by C corporations to stockholders remain subject to double taxation. The corporation pays tax at the corporate rate and then pays dividends from after-tax income. These dividends are then taxed on the recipient’s tax return at their individual rate. Effective January 1, 2003 specific rates will apply to dividend income, 5 percent and 15 percent. Thus, long-term capital gains and dividends will be taxed at the same rate. The rate drop from 38.7 percent to 15 percent for the highest bracket taxpayers is substantial. This does not imply, however, that investors can be indifferent between capital gains and dividend income. Double taxation still applies to C corporations, as high as 38 percent to the corporation and 15 percent to the stockholder.

The reduced rates apply from January 1, 2003 to December 31, 2008. A zero-percent rate will apply to taxpayers in the 10- and 15-percent tax brackets for 2008 only.  All the reduced rates end after December 31, 2008.

The reduced rates do not apply to interest on saving accounts, certificates of deposit, and government bonds.  Also, note that distributions from tax-deferred retirement vehicles and deferred annuities receive no benefit from the rate reduction on stock dividends. Payouts will be taxed at ordinary rates even if the funds distributed were generated from stock dividends.

The definition of “dividends “ for purposes of the reduced rate is not defined in the bill, but, the common law definition is “a corporate distribution with respect to its stock paid out of current or accumulated earnings and profits.”  The reduced rates specifically do not apply to credit unions, mutual insurance companies, farmer’s cooperatives, stock owned for less than 60 days in the 120-day period surrounding the dividend date, among many others.  In the case of closely held C corporations, expect to see a reevaluation of the balance between payouts in the form of salary and dividends. The new dividend rate law has many other significant implications for investors.