Money Does grow On Trees! Owners of timberland can face a number of tax issues and opportunities, some of which are unique to owning this type of property, and others of which have broad application to many property and business owners.

1. 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

2. 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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3. Capital Gain vs. Ordinary Income
• In general, the determination depends on whether
the property is personal use, investment, or
business property.
• Gains from sales of timber held for personal use or
investment are entitled to capital gains treatment
under section 1221.
• Proceeds from sales of timber held as inventory are
taxed as ordinary income, with certain exceptions.
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4. 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 taxable
year exceed “section 1231 losses”, the net gain is
treated as capital gain. If section 1231 gains do not
exceed section 1231 losses, the net loss is treated as an
ordinary loss.
• Section 1231(c) provides for recapture of section 1231
gain if the taxpayer has “non-recaptured losses” in any
of the preceding 5 tax years.
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5. 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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6. 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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7. Depletion
• The costs associated with acquiring timber must
be capitalized.
• With respect to the standing timber, costs are
recoverable over time through the rules of
depletion.
• Section 611(a) authorizes a depletion deduction
for a taxpayer holding an “economic interest” in
timber. The depletion allowance is computed
using the taxpayer’s adjusted basis in the
property.
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8. 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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9. Example
Smokey the Bear bought 100 acres of timberland in 2010 and
paid $400,000 for the property. There were 1,000 cords of
timber on the property at the time of purchase. The fair market
value of the timber (separate from the land) at the time of
purchase was $20,000. Smokey cuts and sells 500 cords of
timber in 2012 for $12,000 when the property has 2,000 cords of
timber.
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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10. Election to Treat Cutting as Sale
or Exchange
• Taxpayers who cut timber for sale or for use in their own
trade or business may elect under section 631(a) to treat
the cutting as a sale.
• The election is available to taxpayers owning timber, or
having rights to cut timber under a contract, for more
than one year.
• The taxpayer will have gain or loss equal to the difference
between the FMV of the timber on Jan. 1 of the taxable
year 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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11. Example
Smokey the Bear grows timber for sale or use in
his business. The fair market value of the timber
is $12,000 on January 1 of the tax year and
Smokey’s basis in the timber is $2,000. Smokey
cuts that timber from business property that he
has held more than one year and then sells the
resulting logs to a saw mill for $15,000. Smokey
makes 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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12. Sales of Standing Timber
• Section 631(b) applies to taxpayers who sell standing
timber under a lump sum or pay-as-cut contract where
they retain an “economic interest” in the timber.
• Timber sold under such a contract is allowed capital
gain (or ordinary loss) treatment as if it is section 1231
property.
• The section applies to timber held more than one year
prior to disposal.
• The gain is equal to the excess of the amount realized
over the timber’s adjusted depletion basis.
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13. 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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14. Like Kind Exchanges
• Section 1031 provides that no gain or loss is recognized
on the exchange of property held for productive use in
a trade or business or for investment if such property is
exchanged for “like kind” property.
• "Like kind" refers to the nature or character of the
property and not to its grade or quality.
• Exchanges of timber properties require special
consideration in the “like kind” analysis.
• Exchanges of timber property for timber rights
severable from the land may not always qualify for like-
kind treatment.
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15. Smalley v. Commissioner, 116 T.C. 450 (2001)
• A section 1031 case in which the taxpayer
exchanged 2-year timber cutting rights for a fee
simple interest in three parcels of real estate.
• The taxpayer argued that he exchanged standing
timber for standing timber with land attached,
both of which were characterized as real property
interests under Georgia law.
• The Tax Court agreed with the taxpayer regarding
the characterization of the exchanged property as
real property under Georgia law.
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16. 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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17. 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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18. Conservation Easements
• Although gifts of partial interests in real estate are
generally not deductible, there is an exception for
contributions of conservation easements.
• The property must be used exclusively for conservation
purposes:
– the preservation of land for outdoor recreation or for
the education of the general public;
– the protection of natural habitat for fish, wildlife, or
plants; and
– the preservation of open space.
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19. Butler v. Commissioner, T.C. Memo 2012-72
• The taxpayer contributed conservation easements and
retained certain rights to the properties, including the right
to subdivide the property, build homes, clear timber for
agricultural uses, and commercially harvest timber.
• The Service argued that the easements failed to protect
conservation purposes due to these retained rights.
• The Tax Court found that the taxpayers provided credible
evidence that the conservation deeds served the
conservation purpose of protecting a significant habitat for
wildlife.
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20. 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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21. Captive Insurance Companies
• Many risks can jeopardize a timber business, some of
which may not be insurable at a reasonable cost.
• A Captive Insurance Company ("Captive") may be used
to manage the risk of a timber business while also
providing income tax benefits to the business and its
owners.
• Use of a Captive may be helpful when full, or even
adequate, outside coverage may not be available to the
business, outside coverage is so costly that the
business cannot or does not want to incur the expense,
and/or when the business is otherwise unable to
access the reinsurance market.
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22. 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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23. General Valuation Concepts
• Section 2033 provides that the value of an
individual’s gross estate includes the value of all
property in which the decedent has an interest at
the time of this death.
• Similarly, Section 2501(a) provides that gift tax is
imposed upon the value of property transferred
by gift during each calendar year.
• The measure of the value of the property is its
“fair market value”.
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24. 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 or
member of the decedent’s family for a qualified use on the
date of the decedent’s death and for a number of years
prior 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’s
qualified use.
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25. Determining Special Use Value
• Two methods are provided:
– Application of a specific formula that uses the average
rental income from comparable properties for the 5
years preceding the date of death; or
– Application of a subjective “five factor” method that
considers: capitalization of income, capitalization of
rents, assessed ad valorem values, comparable sales,
and other relevant factors that fairly value the land.
• The formula method must generally be used unless there
is no comparable land.
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26. Qualified Woodlands Election
• A "qualified woodlands" election may be made
under section 2032A(e)(13) with respect to
timberland which would allow any timber on the
property to be valued as part of the underlying real
estate rather than as a separate asset.
• "Qualified woodlands" is defined as an identifiable
area of land (such as an acre) which are normally
used for planting, cultivating, caring for, or cutting
trees, or preparing trees for market (other than
milling).
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27. Estate of Rogers v. Commissioner,
T.C. Memo 2000-133
• This case concerned the valuation of land under
section 2032A for which a qualified woodlands
election was made.
• The land was timber property subject to long
term timber leases.
• Tax Court agreed with the estate that there were
comparable properties available.
• The Court also held that the value determined
under the formula method included the value of
the timber.
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28. Family Limited Partnerships
• Fractionalized interests in timber property can
be particularly difficult to manage.
• A family limited partnership (“FLP”) can allow
centralized management and facilitate
transfers of ownership.
• For tax purposes, a partnership interest is less
valuable than its underlying assets (due to
applicable discounts for lack of control and
marketability).
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29. 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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30. Charitable Trusts
• Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts
(CLTs) are referred to as “split interests trusts” because they
have both a charitable beneficiary and a non-charitable
beneficiary.
• Donors make charitable gifts while retaining beneficial
interests in the donated property.
• Charitable Lead Annuity Trusts (CLATs) are particularly
attractive in 2012 for a number of reasons.
• If an interest in a timber business is being given to a charitable
trust, there are a number of issues and potential pitfalls that
should be considered.
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31. Estate Liquidity Issues
• Section 6166 allows the executor to make an election to pay
part or all of the estate tax liability in two or more (but not
more than (10)) equal installments. In general, such an
election is available if the gross estate includes an interest in a
closely held business worth more than 35% of the decedent’s
total adjusted gross estate.
• The election also allows a 5-year deferral for payment.
• An illiquid estate may also employ a “Graegin loan” to
generate an up-front interest deduction for the total interest
to be paid over the life of the loan.
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32. 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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33. 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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34. 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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