The tax code allows timber income to be reported as a capital gain, or as ordinary income. As the landowner, you are always better off to report this income as a capital gain, which eliminates both the 15.3% self-employment tax and the possibility of raising ordinary income to a higher bracket.
In order to receive the more favorable tax treatment allowed under Section 631(b), you must have held the land/timber for more than one year prior to cutting, unless you inherited the land/timber. For inherited property, there is no holding period required to qualify for long term capital gain status.
You can further increase your tax savings by creating and maintaining a depletion account. The depletion is a tax free return of how much your timber cost you at the date you acquired the property. The price you paid must be allocated to the various components of value on the property, such as bare land, merchantable timber, immature timber, and improvements, such as a cabin. For simplicity, the following example uses only bare land and merchantable timber as items of value:
Assume you paid $40,000 for a 40 acre parcel, of which 40% is determined to be for the “bare land” and 60% is for the “merchantable timber”. Your allocation would be as follows:
Land Account: $40,000 x 40% = $16,000.
Timber Account: $40,000 x 60% = $24,000.
The land account cannot be used for depletion or a tax deduction until you sell the property. However, the timber account of $24,000 is your basis for depletion whenever you sell timber.
Using the same example, assume you contracted with Northern Timberlands to cut the stumpage for $22/cord, 500 cord were cut this year, and the forester determines that there is a total of 1500 cord of stumpage on the property. (Note that this is for example only…your stumpage may be worth more or less that this example)
Stumpage Sale Amount ($$ you received):
Less: Depletion Deduction($24,000 basis : 1500 total cord = $16/cord depletion)
$16/cord x 500 cord cut
Gain for Tax Purposes:
Keep in mind that expenses such as attorney fees, surveys, or other closing costs are included in your cost basis when you purchase or otherwise acquire property. Any subsequent capital expenses are also added to your costs basis.
We hope this helps, and must make you aware that we do not advise on, or prepare general income tax returns – we specialize in timber. In this manner, we can help assess your potential tax savings, but you should certainly consult your tax preparer for more specific information.
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