Timberland owners often engage in tax deferred exchanges for a number of reasons, including to align holdings closer to vendors or to acquire potentially higher yielding timber. Along with timberland, timber rights held for either business use or investment can also be exchanged and capital gains deferred for real property given proper conditions. Timber right holders willing to maximize their benefits through such exchanges should pay close attention to state regulations and transaction structures in terms of cutting time and timber quantity limits.
Exchanges of timberland are more common than exchanges of timber rights. According to The Nature Conservancy 2006 annual report, “About 44 million acres of privately owned forestland will be sold in the United States over the next 25 years.” Timber Real Estate Investment Trusts (REITs), such as Plum Creek Timber (PCL), Rayonier (RYN), and Potlach (PCH), replace lower yield timber holdings with higher yield timber properties. With each 1031 exchange, consideration is given to the nature and character of conveyed rights, likeness of physical properties and period or duration of interests. The Court has interpreted the “like kind” requirement liberally, meaning an interest in real estate, whether improved or unimproved is like kind to other interest in real estate as defined by state law.
Is timberland exchangeable for other real property? Yes, just like ranch land, farms, investment lots and tenants-in-common, timberland can be exchanged and the Federal and State capital gain deferred indefinitely or until the replacement property is sold. The steps of a timberland exchange follow the same 1031 exchange rules required for a forward 1031 exchange or reverse 1031 exchange.
Standing Timber vs. Perpetual Timber Rights
Can standing timber be exchanged? It depends upon whether the state recognizes timber as real property. Is the right to harvest timber unlimited and perpetual? The sale of standing timber over a limited period of time, viewed as a carve out, has been disallowed by the IRS in a 1953 tax court case known as the Oregon Lumber Company where the timber right was a thinly disguised timber sale contract. In TAM 9525002, the IRS also disallowed the sale of timber as a 1031 exchange.
Perpetual timber rights to harvest unlimited standing timber are similar to water and mineral rights classified as real property rights given state law. A deed for timber must be conveyed, not a contract and bill of sale. There cannot be a pre established cutting contract or the timber can be considered personal property which is not “like kind” to real property.
In many states it is possible to separate the timber interest from the title to the land. A timber deed and a land deed can be exchanged independently for a simple fee interest in real property. A 1031 exchange allows the conversion of a timber deed to real property while retaining ownership of the original land. Thirty-year leasehold timber rights, including the right to extract timber or an outright grant of timber rights, can be exchanged for other real property.
Depletion vs. Depreciation in a Timberland Exchange
Owners of natural resources, including timberland, mines and wells, would also benefit from understanding the difference between depletion and depreciation. Depletion is the cost recovery for accounting and tax reporting. Though similar to depreciation that allows the recovery of the cost of an asset over the “useful productive life,” it represents the accounting method of allocating the exhaustion of natural resource over the life of an asset. The natural resources owner can claim a depletion deduction to account for the reduction of reserves.
Depletion
The depletion allowance is based upon whether the taxpayer’s investment intent when acquiring standing timber is to generate income from cutting and selling standing timber. If so, then when the tract is first purchased, an estimate is made of the quantity of marketable timber units or square board feet. Next, a cost depletion per unit is determined by dividing the cost or the adjusted basis of timber on hand at the beginning of the year by the total units or square board feet. For each sale, the depletion cost unit is multiplied by the number of units or square board feet sold.
Example: How to calculate a depletion deduction?
The taxpayer purchases timberland and estimates the total quantity of marketable square board feet available for sale is 2,000,000 units. The adjusted basis for the standing timber is $160,000. The taxpayer cuts and sells 250,000 units. The taxpayer’s depletion for each unit for the year is $.08 ($160,000 / $2,000,000). His depletion deduction is $20,000 (250,000 x $.08).
The taxpayer files Form T with his federal annual tax return, claiming a $20,000 deduction for timber depletion, or for a sale of timber. The sale of timber is taxed as inventory or ordinary income rather than a capital asset and long term capital gains. Timberland sales not limited to time and cut quantity are taxed at the long term capital gain rate.
The cost basis of the timberland is reduced each year by the depletion amount for that year. The resulting basis is used to determine the cost depletion for the next year.
If you are considering a 1031 exchange of timberland, Atlas 1031 provides the accommodation services compliant with Internal Revenue Code Section 1031. Click below to begin a consultation or call our office at 1 800 227 1031.
