As a land broker, you have to understand the investment side of what you’re selling. I am not only a broker though; I am also an investor. I believe in the investment of land and actively participate in it as often as possible. A large part of both brokering and investing in timberland is understanding the many tax incentives of owning it, one of which is basis depletion.

Most investors understand cost basis, most commonly just referred to as “basis”, which is the fair market value of the purchase price allocated to different aspects of your property on the closing date. These include the bare land value, improvement values, equipment values, and of course timber value, which is what we will concentrate on in this post. One of the primary concerns of prospective buyers of timberland today is understanding exactly what their tax liability will be from any timber sales. They understand that land has historically been an extremely stable investment, but when it comes to timberland, they may not know how to quantify exactly what their tax liability might be. They’re always very surprised to learn that their tax liability from a timber sale may be ZERO.

How is that possible? Assuming any of the more standard ownership structures, when you sell timber, you are “depleting your basis” in timber. So while you are receiving income from the viewpoint that you are receiving funds and depositing them in the bank (or the coffee can be buried in the backyard), it is not a taxable gain, it is a recovery of capital, at least until you deplete that basis. Therefore, until you fully deplete your basis, you’re not making a profit, so your timber proceeds are not taxable. Once you deplete your timber basis and assuming you’ve owned the property for over a year, any future timber sale proceeds are taxed as a long-term capital gain. Compared to income from a rental property which is taxed as ordinary income from day one, this makes timberland a very attractive investment tool for diversification or for meeting your investment goals faster via the lower tax rate.

Also keep in mind that if you are purchasing land via a 1031 tax-deferred exchange, you typically bring the basis forward from your first sale that participated in the applicable chain of 1031 exchanges. As such, if you plan to sell the subject property and use a 1031 exchange to purchase another property, your original basis should carry forward to the next property and/or any other real property that is acquired within the chain of 1031 exchanges. Once you liquidate any of those properties, your taxable gain will be determined by using the original remaining basis.

Example

You bought a timber tract for $160,000 and the land was worth as much as the timber. Your basis for the timber is $80,000. Based on an estimated one million board feet (1,000 MBF) of standing timber, you figure your depletion unit to be $80 per MBF ($80,000 ÷ 1,000). If you cut 500 MBF of timber, your depletion allowance would be $40,000 (500 MBF × $80).

When to claim depletion.   Claim your depletion allowance as a deduction in the year of sale or other disposition of the products cut from the timber, unless you choose to treat the cutting of timber as a sale or exchange (explained below). Include allowable depletion for timber products not sold during the tax year the timber is cut as a cost item in the closing inventory of timber products for the year. The inventory is your basis for determining gain or loss in the tax year you sell the timber products.

Example

The facts are the same as in the previous example except that you sold only half of the timber products in the cutting year. You would deduct $20,000 of the $40,000 depletion that year. You would add the remaining $20,000 depletion to your closing inventory of timber products.

Electing to treat the cutting of timber as a sale or exchange. You can elect, under certain circumstances, to treat the cutting of timber held for more than 1 year as a sale or exchange. You must make the election on your income tax return for the tax year to which it applies. If you make this election, subtract the adjusted basis for depletion from the fair market value of the timber on the first day of the tax year in which you cut it to figure the gain or loss on the cutting. You generally report the gain as long-term capital gain. The fair market value then becomes your basis for figuring your ordinary gain or loss on the sale or other disposition of the products cut from the timber. For more information, see Timber in chapter 2 of Publication 544, Sales and Other Dispositions of Assets.

DISCLAIMER: This is not intended to be tax or investment advice by the author or National Land Realty. You should consult your accountant and/or investment advisor before making any decisions regarding taxes or investments.