Introduction
The Type of Gain or Loss
Capital Gain Status Important
Qualifying for Capital Gains
Lump-Sum Sales
Pay-as-Cut Contracts
Cutting Timber and Selling Logs
Summary
Introduction
Most timber sales by nonindustrial woodland owners
involve standing timber. The purchaser, in other words,
cuts the trees. Less often, the trees are cut by the
owner, who then sells the logs. In either situation, the
correct tax treatment of the money received is sometimes
difficult to determine. Are the proceeds to be treated as
a capital gain or as ordinary income? Does it matter?
Does self employment tax have to be paid? What other
problems are involved? This article will focus on these
and related questions.
The Type of Gain or Loss
Standing timber may be treated for income tax
purposes as either a capital asset or a non-capital
(ordinary) asset. The distinction is essential in
determining whether a woodland owner's gain or loss
from selling timber is considered "ordinary" or "capital"
in nature, and for deciding how to report the transaction
on the tax return.
Several changes in tax rates have occurred since
enactment of the 1986 Tax Reform Act. Today, non-corporate taxpayers
are taxed at five rate levels for
ordinary income, with a maximum of 39.6 percent, as
shown in Table 1. Long-term capital gains however, are
taxed at no higher than 28 percent. On the other hand,
ordinary income and long-term gains are taxed at exactly
the same rates for corporate taxpayers. The range is
from a low of 15 percent to a high of 35 percent.
Capital Gain Status Important
Proceeds from a timber sale could easily move a non-corporate owner
from the 28 percent ordinary income
tax bracket to a higher level, thus making capital gain
status a critical consideration from a tax rate standpoint.
There are also other reasons why the distinction may be
important, even for those whose rate does not exceed 28
percent.
Capital losses, for example, may be used to offset
only $3,000 of ordinary income per year, but there is no
limit on using such losses to offset capital gains. This
means that woodland owners who have large capital
losses from any source may be able to deduct a greater
proportion of those losses during any year in which there
are timber capital gains.
Also, taxpayers who are sole proprietors or members
of a partnership with respect to their timber ownership,
and whose woodlamd holdings are considered to be a
business, are subject to the self-employment tax on
ordinary income from the business. If timber sale
proceeds qualify for and are reported as capital gains,
however, they will be exempt from this tax. Self-employment income
is an important consideration,
particularly for those timber owners who are retired or
semi-retired and who have little or no income from
wages or salary. The rate of self-employment tax is
currently 15.3 percent on the first $62,700 of self-employment income,
plus 2.9 percent on all amounts
over that level. In addition to the tax itself, receipt of
self-employment income can lower the amount of Social
Security received by woodland owners who are between
62 and 70 years of age.
| Taxable Income | Maximum Marginal Rate | ||
| Married Filing Jointly | Single | Ordinary Income | Long-term Gain |
| $0 - 40,100 | $0 - 24,000 | 15% | 15% |
| $40,100 - 96,900 | $24,000 - 58,150 | 28% | 28% |
| $96,900 - 147,700 | $58,150 - 121,300 | 31% | 28% |
| 147,700 - 263,750 | $121,300 - 263,750 | 36% | 28% |
| $263,750 + | $263,750 + | 39.6% | 28% |
A sale for a lump-sum is the outright sale (usually by means of a timber deed or sale contract) of standing timber for a fixed total amount agreed upon in advance. The sale may cover all timber on a specified tract or only certain species, diameter classes, or individually marked trees.
Capital gains treatment will apply to the proceeds from a lump-sum sale if the timber was a capital asset in the hands of the seller. This means, as explained above, that it cannot have been held for sale to customers in the ordinary course of business. Rather, the primary purpose for holding the timber in question must have been for personal use or as an investment.
Whether standing timber is being held primarily for sale as part of a business is not always easy to determine. There is no applicable definition of the term "trade or business" in either the Internal Revenue Code or the Income Tax Regulations. Also, no broadly applicable definition has evolved from court decisions despite the fact that many reported cases on this point exist involving timber sales. Thus, the question can be answered only by weighing all the facts and circumstances of each particular situation.
Although no single factor is determinative, the following are all important:
In general, if a woodland owner makes only an occasional lump-sum timber sale that is unrelated to any business activity, the timber will qualify as a capital asset. Capital gains and losses from a lump-sum sale are reported directly on Schedule D of Form 1040. If long-term, the transaction is entered in Part II; if short-term, in Part I.
Pay-as-Cut Contracts
If you intend to sell standing timber and are in doubt
about whether it is a capital asset, you should consider
entering into a "pay-as-cut" contract. This is the only
way to absolutely ensure capital gain status for the
proceeds from the sale of standing trees, i.e., a stumpage
sale. This type of contract requires payment at a specific
rate for each unit of timber actually cut and measured,
rather than as a lump-sum amount of money agreed on in
advance. Authorized by Section 631(b) of the Internal
Revenue Code, it is technically termed "a disposal of
timber with an economic interest retained", but
commonly called a "pay-as-cut contract". It obligates
the purchaser to cut the designated trees and purchase
them at the unit price set in the contract.
The term "economic interest" arises from the fact that
the owner has an investment in the trees and secures
income from their cutting, to which he or she must look
for a return of the investment. The seller retains legal
title to the trees until they are severed and thus bears the
risk of any damage or loss while they are standing.
With a lump-sum sale, on the other hand, title to the
timber passes to the buyer immediately upon signing of
the contract and payment of the sale price. Advance
payments are permitted under Section 631(b). However,
in such cases, the contract has to clearly stipulate that
upon completion of cutting, necessary adjustments are to
be made. This is required in order that the total amount
paid is determined by the volume of timber actually cut
multiplied by the specified unit price.
Scaling the cut timber is the usual but not the only
acceptable method of measurement. The volume also
can be determined by cruising the standing trees that are
subject to the contract. The amount actually disposed of
is the cruised volume before cutting begins minus the
cruised volume of any contract timber that was not cut.
Revenue Ruling 78-104 is the authority for this
procedure.
The date of disposal for measuring the one-year
holding period under a Section 631(b) contract is the
date the timber in question is cut. However, it is not
usually practical to measure felled trees in the woods.
Therefore, the trees are considered "cut" when, in the
ordinary course of business, the quantity felled is first
definitely determined, whether at a log landing, wood
yard or mill, or after a follow-up timber cruise. This
definition of "cut" could help in determining whether a
Section 631(b) disposal qualifies for long-term capital
gain status. The timber may not have been owned for
the required holding period at the time it was physically
cut. But, by the time it was measured, the holding
period may have been met.
Section 631(b) gains are first reported on Form 4797,
where certain other gains and losses are also reported.
All the gains and losses entered on the form are totaled.
If a net gain results, it is treated as a net long-term gain
and is transferred to Part II of Schedule D.
West Virginia landowners should be aware that a pay-as-cut contract for timber in West Virginia may result in
the landowner incurring liability for West Virginia
severance tax, since responsibility for the tax lies with
the party who has title to, or an economic interest in, the
timber at the time it is cut. West Virginia timber
severance tax currently is imposed at the rate of 3.22%
of the gross value of the timber at the point where the
tree has been severed, delimbed, and topped.
Cutting Timber and Selling Logs - Section 631(a) Transactions
When standing timber is cut by the owner and the logs
or other products manufactured from them are sold, the
entire proceeds must be reported as ordinary income
unless a written Section 631(a) election is in effect. By
making the election, however, timber may be cut for sale
or for use in a business with the gain from holding it
recognized as capital gain, just as if the standing trees
had been sold outright. The election is made by
answering the question in item 44 of Form T and
supplying the information requested in items 45 through
51. The election must be made on the original tax return
(including extensions) for the year to which it first
applies, and not on an amended return. Section 631(a)
transactions are reported in two parts, as follows:
1) Report as Section 631(a) gain or loss the
difference between the adjusted basis for depletion of the
timber that was cut and its fair market value on the first
day of the tax year (usually January 1) in which it was
severed. This amount is entered on Form 4797 as
previously discussed. If a net gain results from totaling
all gains and losses on Form 4797, the net gain is treated
as a long-term capital gain and transferred to Part II of
Schedule D. The trees must be valued as they existed on
the first day of the tax year regardless of any changes
that accrued to them between that date and the date of
actual cutting.
2) Report as ordinary income the profit or loss
resulting from conversion of the standing timber into
logs or other products. The profit or loss is determined
just as for any other business operation. The income
received for the logs or other products is reduced by the
cost of the timber plus the costs of converting it (such as
for cutting and hauling). The timber cost is the fair
market value discussed in item 1).
An attachment giving the details of the cutting and
sale should be included with the tax return. Use
Schedule F of Form T or give the details required by
Schedule F on a plain sheet of paper. Be certain to
include information as to how the depletion basis used, if
any, was determined. Also describe how the fair market
value was determined.
Summary
The income tax and self-employment tax aspects of
timber sales, particularly those made under the
provisions of Section 631(a) or 631(b), can be complex
and sometimes confusing. Proper planning and good
advice are essential if you are to realize maximum
benefits and avoid negative
consequences. This subject
is covered in greater detain
in "Forest Owners' Guide
to the Federal Income
Tax," Agricultural Handbook Number 708, published by
the USDA Forest Service.
William C. Siegel, J.D.
is an attorney in private practice specializing in timber
tax law and forestry estate planning. He is retired from the USDA Forest
Service. Mr. Siegel can be contacted by writing to:
9110 Hermitage Place, River Ridge, LA 70123
or by telephone at 504-737-0583.
Last modified Oct. 22, 1997
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