Tax Considerations for Forest Landowners Mike Jacobson School of Forest Resources Penn State Nov 11, 2008 PSU Webinar

Facts Taxes are a major cost of doing business Taxes are a major cost of doing business Proper tax planning is every bit as important as the silvicultural techniques used to grow profitable forest crops. Proper tax planning is every bit as important as the silvicultural techniques used to grow profitable forest crops. Congress has provided several favorable advantages and elections to STIMULATE INCREASED PRODUCTIVITY from the nation’s private forest lands. Congress has provided several favorable advantages and elections to STIMULATE INCREASED PRODUCTIVITY from the nation’s private forest lands.

Caveat Its complicated stuff Its complicated stuff “the hardest thing in the world to understand is income tax” “the hardest thing in the world to understand is income tax” Albert Einstein This information and discussion should be treated as EDUCATIONAL, not legal advice. This information and discussion should be treated as EDUCATIONAL, not legal advice. Every situation is different Every situation is different Discuss with professional tax team Discuss with professional tax team

Types of Forest Taxes Types of forest taxes Types of forest taxes Income taxes Income taxes 2005 changes 2005 changes Timber sales and capital gains (631b) Timber sales and capital gains (631b) Reforestation deductions Reforestation deductions Estate taxes Estate taxes $2 m credit $2 m credit Property taxes Property taxes Clean & Green (in PA) Clean & Green (in PA)

Topics Establishing basis Establishing basis Expenses Expenses Timber Income Timber Income Other tax considerations Other tax considerations Estate planning Estate planning Conservation easements Conservation easements

Establishing a “basis” A capital investment in income-producing property A capital investment in income-producing property The law usually requires that basis be capitalized – held in a capital account – until the property is sold The law usually requires that basis be capitalized – held in a capital account – until the property is sold Tax rule: any expenditure of asset with life of greater than 1 year must be capitalized Tax rule: any expenditure of asset with life of greater than 1 year must be capitalized Basis is the book value of asset Basis is the book value of asset determined by how much you paid for it determined by how much you paid for it Recover basis with timber sale Recover basis with timber sale Use Form T Use Form T

Original Basis Purchase—Total cost to acquire the property, NOT just its purchase price and NOT its fair market value Purchase—Total cost to acquire the property, NOT just its purchase price and NOT its fair market value Inheritance – Property’s fair market value on the date the decedent died OR the alternate valuation date (earlier of 6 months after death or date any estate asset is sold) Inheritance – Property’s fair market value on the date the decedent died OR the alternate valuation date (earlier of 6 months after death or date any estate asset is sold) Usually results in a “step-up” in basis Gift—Lower of donor’s basis (carry-over basis) or property’s fair market value Gift—Lower of donor’s basis (carry-over basis) or property’s fair market value

Original Basis Ideally, determine original basis immediately after you acquire timber or forestland Ideally, determine original basis immediately after you acquire timber or forestland If you postpone process for several years, you may need the help of a forester to determine the trees’ original volume and value If you postpone process for several years, you may need the help of a forester to determine the trees’ original volume and value Allocate original basis proportionately among your capital accounts – for example, Land Account, Timber Account Allocate original basis proportionately among your capital accounts – for example, Land Account, Timber Account

Adjusted Basis Adjust capital accounts Adjust capital accounts Up by the amount of new purchases or investments Up by the amount of new purchases or investments Down as you recover your investment Down as you recover your investment Adjusted basis – The balance left in a capital account after one or more changes have been made to the original basis Adjusted basis – The balance left in a capital account after one or more changes have been made to the original basis

Expenses - Advantage of being in the ‘business’? Profit motive Profit motive The term “profit” also includes appreciation in the value of the assets. The term “profit” also includes appreciation in the value of the assets. Expensing Expensing Expenses, property taxes, interest, etc are fully deductible against income from any source. Expenses, property taxes, interest, etc are fully deductible against income from any source. Expanded Section 179 deduction Expanded Section 179 deduction New law effectively increases the limit to $250,000 and the phase out threshold to $800,000 for 2008 New law effectively increases the limit to $250,000 and the phase out threshold to $800,000 for 2008 Reverts to $125,000 and $500,000 phase out in 2009 Reverts to $125,000 and $500,000 phase out in 2009 Bonus depreciation – 50% of adjusted basis Bonus depreciation – 50% of adjusted basis

Passive Loss Rules: The Three Categories Timber held for the production of income, such as an investment but which is not part of a trade or business. Timber held for the production of income, such as an investment, but which is not part of a trade or business. Timber held as a part of a trade or business in which you do not “materially participate” (i.e., one in which your activity is “passive”). Timber held as a part of a trade or business in which you do not “materially participate” (i.e., one in which your activity is “passive”). Timber held as part of a trade or business in which you “materially participate” (i.e., one in which your activity is “active”). Timber held as part of a trade or business in which you “materially participate” (i.e., one in which your activity is “active”). Tests for material participation See questionnaire See questionnaire

Operating expenses and carrying charges Engaging in timber-growing for profit, these expenses can be deducted in the year they occur. Engaging in timber-growing for profit, these expenses can be deducted in the year they occur. Examples Include: Examples Include: Labor costs, consultant fees, timber stand improvement, precommercial thinning Labor costs, consultant fees, timber stand improvement, precommercial thinning Carrying costs - property taxes, interest Carrying costs - property taxes, interest Can be capitalized in years your tract produces no income, but it usually is more beneficial to deduct them Can be capitalized in years your tract produces no income, but it usually is more beneficial to deduct them

Timber Income Both the amount and type of income received are important Amount: Price – Expenses – Timber Basis Amount: Price – Expenses – Timber Basis Type: Ordinary income or capital gain Type: Ordinary income or capital gain Your primary purpose for owning timber (passive loss rules apply) Your primary purpose for owning timber (passive loss rules apply) How long you have held it (how acquired) How long you have held it (how acquired) How you dispose of it (3 methods) How you dispose of it (3 methods)

Type of Income is Important Long-term capital gains - 15% and 5% for the bottom 2 brackets (0% for ) Long-term capital gains - 15% and 5% for the bottom 2 brackets (0% for ) Highest ordinary income rates – 35% Highest ordinary income rates – 35% Ordinary income you earn from timber is subject to self-employment taxes, at rates up to 15.3% Ordinary income you earn from timber is subject to self-employment taxes, at rates up to 15.3% If you have large capital losses, apply them against any amount of capital gains If you have large capital losses, apply them against any amount of capital gains If you are retired, capital gains do not count toward the amount of income you can earn before your Social Security benefits are cut If you are retired, capital gains do not count toward the amount of income you can earn before your Social Security benefits are cut

Qualifying for capital gains How disposed of: By a lump-sum sale or exchange By a lump-sum sale or exchange 1099 will be required 1099 will be required A Section 631(b) disposal, through a pay-as-cut contract or outright sale A Section 631(b) disposal, through a pay-as-cut contract or outright sale A Section 631(a) transaction, by cutting the timber yourself, converting it to products for sale, A Section 631(a) transaction, by cutting the timber yourself, converting it to products for sale,

Reforestation Amortization and Deductions The American Jobs Creation Act of 2004 changed the nature of the incentives The American Jobs Creation Act of 2004 changed the nature of the incentives Two tax incentives reduce or eliminate the need to hold reforestation expenses in a capital account until you sell timber or timber products: Two tax incentives reduce or eliminate the need to hold reforestation expenses in a capital account until you sell timber or timber products: You can deduct reforestation expenses – up to $10,000 per year of qualifying reforestation You can deduct reforestation expenses – up to $10,000 per year of qualifying reforestation And for those expenses over $10,000 you can amortize – write off over an 8 year period And for those expenses over $10,000 you can amortize – write off over an 8 year period

Cost-share Payments Generally, you are required to report government cost-share payments as part of your gross income (1099G). Generally, you are required to report government cost-share payments as part of your gross income (1099G). However, under Section 126 of the IRS Code, all, or part of, certain government cost-share programs MAY be excluded from gross income. However, under Section 126 of the IRS Code, all, or part of, certain government cost-share programs MAY be excluded from gross income. ‘Substantial’ increase in annual income ‘Substantial’ increase in annual income Nevertheless, even if you choose to exclude an approved government cost- share payment, YOU MUST REPORT IT! Nevertheless, even if you choose to exclude an approved government cost- share payment, YOU MUST REPORT IT!

Involuntary Conversion If you lose timber in an involuntary conversion, you may be entitled to an income tax deduction, if not reimbursed by income or otherwise If you lose timber in an involuntary conversion, you may be entitled to an income tax deduction, if not reimbursed by income or otherwise Casualty loss, Casualty loss, Noncasualty loss Noncasualty loss Theft loss Theft loss Condemnation Condemnation

Court cases – last 10 years Have management plan Have management plan Keep good records Keep good records Get expert forestry advice Get expert forestry advice Show how improvements/expenses contribute to profit motive Show how improvements/expenses contribute to profit motive Be careful about deducting travel/meal expenses Be careful about deducting travel/meal expenses Absentee owners need to separate work been done for income or pleasure Absentee owners need to separate work been done for income or pleasure Differentiate between personal and income activities, especially if live on the property Differentiate between personal and income activities, especially if live on the property

Record Keeping Form T Form T Records consist of many things: Records consist of many things: Timber management plan Timber management plan Receipts for business transactions Receipts for business transactions Odometer readings, diaries, time recording for the time spent managing the trade or business Odometer readings, diaries, time recording for the time spent managing the trade or business Agendas to training meetings Agendas to training meetings Membership records in business related associations Membership records in business related associations Contracts Contracts Invoices Invoices

Estate planning - forestland issues Explosive land values Explosive land values High estate tax rates (unexpected values) High estate tax rates (unexpected values) Families don’t realize need (unexpected heirs) Families don’t realize need (unexpected heirs) Reasonable planning horizon exceeds lifetime Reasonable planning horizon exceeds lifetime “land rich, cash poor” “land rich, cash poor” Uncertainty – law will change Uncertainty – law will change

Three common phrases “we don’t need a will’ “we don’t need a will’ ‘we have a will – we’re all set” ‘we have a will – we’re all set” “we want to treat our children fairly, so we will divide everything equally among them” “we want to treat our children fairly, so we will divide everything equally among them” Communication is the key: Dying is as much as part of living. To die well is to do so in consideration of the people you leave behind.” Dying is as much as part of living. To die well is to do so in consideration of the people you leave behind.” Its not just about the taxes Its not just about the taxes

Federal Estate Tax Applicable Exclusion 26 U.S.C Deaths in : Applicable Exclusion Amount = $2,000,000 Deaths in : Applicable Exclusion Amount = $2,000,000 Year of Death Applicable Exclusion 2009 $3,500, tax repealed 2010 tax repealed (but carry over basis) 2011 $1,000,000

PA Inheritance Tax Rates 0%:Spouses; Charities, gifts to government 0%:Spouses; Charities, gifts to government 4.5%: Lineal Descendants; 4.5%: Lineal Descendants; 12%: Siblings 12%: Siblings 15%: All others 15%: All others Transfers Not Subject to Tax Transfers Not Subject to Tax Transfers to Spouses; Transfers to Spouses; Life insurance proceeds regardless of where they are paid; Life insurance proceeds regardless of where they are paid; Family exemption of $3,500 to designated beneficiaries who satisfy the conditions Family exemption of $3,500 to designated beneficiaries who satisfy the conditions

Tools and strategies Utilize unified credit Utilize unified credit Marital deduction Marital deduction Trusts Trusts Life insurance Life insurance Installment payments Installment payments Special use valuation Special use valuation Business transfers Business transfers Lifetime gifts ($24,000/year) Lifetime gifts ($24,000/year) Gift tax does not end in 2010 Gift tax does not end in 2010 Carry-over basis Carry-over basis Conservation easements Conservation easements

Tax Planning Opportunities with Conservation Easements Real estate taxes on easement property should be reduced. Real estate taxes on easement property should be reduced. Income tax benefits (IRC 170(h)) to individual landowners who donate or “bargain sale” Income tax benefits (IRC 170(h)) to individual landowners who donate or “bargain sale” A Qualified Real Property Interest A Qualified Real Property Interest to a Qualified Organization to a Qualified Organization Exclusively for conservation purposes Exclusively for conservation purposes

Tax benefits from donation of easement Charitable deduction in 50% of AGI (was 30%) Charitable deduction in 50% of AGI (was 30%) Excess deduction amounts can be carried forward for 15 additional tax years (was 5 years). Excess deduction amounts can be carried forward for 15 additional tax years (was 5 years). Additional exclusion of up to $500,00 (IRC 2031c. Additional exclusion of up to $500,00 (IRC 2031c.

Summary Part of forest management Part of forest management Timber is long term Timber is long term Be in the timber growing business Be in the timber growing business Capital gains Capital gains Expensing Expensing Reforestation incentives Reforestation incentives Establish “profit motive” Establish “profit motive” Recordkeeping Recordkeeping Plan your estate now! Plan your estate now!

Further information Timber tax website Timber tax website Penn State Forestry Extension Website Penn State Forestry Extension Website Mike Jacobson – Mike Jacobson –