Wooden You Know Timber Speech (Powerpoint)

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Money Does grow On Trees! Owners of timberland can face a number of tax issues and opportunities, some of which …

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.

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  • 1. WOODEN YOU KNOW: IMPORTANT TAX TOPICS FOR TIMBER AND OTHER LAND OWNERSDavid 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 2
  • 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. 3
  • 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. 4
  • 5. ExamplePaul Bunyan sells a 100 acre timber tract ownedby his forest products business at a gain of$10,000. The same year, Paul sells an adjoining50 acre timber tract at a loss of $5,000. Becausethe section 1231 gains exceed section 1231losses, the net $5,000 gain is treated as capitalgain. 5
  • 6. ExampleAssume the same facts as set forth in theprevious Example, except that Paul Bunyanclaimed an ordinary loss of $5,000 on section1231 property in the preceding tax year. Underthe recapture provision of section 1231(c), theentire amount of gain is recharacterized asordinary income. The effect is that Paul has$5,000 of ordinary income. 6
  • 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. 7
  • 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 8
  • 9. ExampleSmokey the Bear bought 100 acres of timberland in 2010 andpaid $400,000 for the property. There were 1,000 cords oftimber on the property at the time of purchase. The fair marketvalue of the timber (separate from the land) at the time ofpurchase was $20,000. Smokey cuts and sells 500 cords oftimber in 2012 for $12,000 when the property has 2,000 cords oftimber. 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 9
  • 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. 10
  • 11. ExampleSmokey the Bear grows timber for sale or use inhis business. The fair market value of the timberis $12,000 on January 1 of the tax year andSmokey’s basis in the timber is $2,000. Smokeycuts that timber from business property that hehas held more than one year and then sells theresulting logs to a saw mill for $15,000. Smokeymakes a section 631(a) election and reports$10,000 of capital gain ($12,000 - $2,000) and$3,000 of ordinary income. 11
  • 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. 12
  • 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. 13
  • 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. 14
  • 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. 15
  • 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. 16
  • 17. ExamplePaul Bunyan gives a rare oriental tree to a stateuniversity in 2012. The tree has a cost basis of$100 and a fair market value of $2,000. The treewill be used by the university’s botanydepartment for classroom display. Because suchuse is directly related to the university’s exempteducational purpose, Paul may take a charitablededuction for $2,000. 17
  • 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. 18
  • 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. 19
  • 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. 20
  • 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. 21
  • 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. 22
  • 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”. 23
  • 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. 24
  • 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. 25
  • 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). 26
  • 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. 27
  • 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). 28
  • 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. 29
  • 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. 30
  • 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. 31
  • 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. 32
  • 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 owners home.• The tax is not imposed if the taxpayer sells the entire tract of land with the timber. 33
  • 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. 34