Federal Tax Treatment of Timber Investments

*Initially adopted by the Society on April 21, 1986, subsequently revised and extended by the Council on December 16, 1996, June 9, 2001, and June 8, 2002. It shall expire June 8, 2007 unless, after subsequent review, Council decides it otherwise.

Position

Many federal tax policies negatively impact forestry investments, often discouraging such investments. These policies lead to environmental degradation and the liquidation of existing privately owned timber inventories. The Society of American Foresters (SAF) advocates federal tax policies that encourage sustainable forest management, enhance the application of sound forest management principles, and address the unique nature of timber management programs. We strongly support the retention of forest land as forest land. Research and experience have shown that landowners may sell or convert their land to other uses due to tax issues. They should treat forestry investments fairly in comparison to other capital ventures.

Issue Statement

The federal income tax code is in conflict with the public interest objectives of sustainable private forest management and, in fact, discriminates against private forest ownership relative to other forms of investment with regard to treatment of income as ordinary (as opposed to long-term capital gains), restrictions on deductibility of forest management costs, and the low ceilings on reforestation costs eligible for rapid amortization and the reforestation tax credit.

With respect to the federal estate tax, the current provisions --- although greatly improved during the last several years --- still present a great burden to many individuals who inherit forest land. The tax ranges from 39 to 50 percent of the taxable estate and is due nine months after the owner's death. To pay the tax, landowners often have to resort to the conversion of forest land to other uses or the harvesting of timber that is inconsistent with forest management plans. The special use provisions of the law and the provision for paying the estate tax in installments are of little help. Although technically applicable, they can only be used by timber estates with great difficulty.

Background

Congress responded to growing forest liquidation problems prior to the 1940s by enacting Section 117(k) of the Internal Revenue Code in 1943. This legislation placed owners who cut their timber themselves or who disposed of it under a pay-as-cut contract, in the same capital gains status as non-managing forest owners who sold their timber outright in infrequent lump-sum transactions, or who disposed of their entire property at once. Section 117(k) was subsequently reenacted in 1954 as Section 631.

Section 631 remains in the federal tax code today and currently offers forestland owners two methods of selling timber: a pay-as-cut method or a lump-sum sale. Under the first option, the landowner retains title to the standing timber until it is cut, after which the purchaser gains title. Thus, the landowner bears the risk of physical loss until the timber is harvested and has great interest in the treatment of the trees because the amount of money received is dependent upon the volume of timber harvested and its merchandising. This option allows the timber owner to receive capital gains treatment for gains from the sale of his or her timber.

The lump-sum sale is an outright sale of the standing timber under a deed in which the buyer takes immediate ownership of the timber and assumes all the risk of loss during the period from the date of the sale to time of harvest. This option allows for a sealed bid sale such that the owner can receive the highest price possible for his or her timber. The difficulty with this method is that repeated lump-sum sales may result in the loss of capital gain eligibility for the sale proceeds and cause them to be taxed as ordinary income. This tax treatment difference between the two methods results in some disadvantages due to the way timber owners must market their timber in order to assure capital gains tax treatment.

The 1986 Tax Reform Act

The 1986 Tax Reform Act greatly affected the long-term commitments of forestland owners by eliminating the tax rate differential between ordinary income and capital gains. Although preferential long-term capital gains rates have since become part of the tax code, the benefit is not as great as before the 1986 Act. Prior to the 1986 Act, forest landowners could deduct forest management expenses in excess of timber income against other income with few problems. Since the 1986 Act, however, the ability to do so has been greatly curtailed by the passive activity loss rules which do not lend themselves to the unique aspects of timber investments. Many private woodland owners made significant long-term forestry investments on the premise that the timber capital gains and management cost deduction rules would remain in place during the lifetime of their investments.

Rapid amortization of annual reforestation and related stand establishment costs, and allowance of an investment tax credit for a portion of such expenditures as exist under current law, is particularly important to nonindustrial private owners of small forest properties. Although the amortization and credit provisions have been in place since 1980, Congress has not increased the eligible dollar amount, $10,000 per year, since that time.

The modern-day federal estate tax dates to 1924, when the top rate on estates worth more than $10 million was set at 45 percent. Subsequent changes set the top rate at 55 percent and the minimum effective rate at 37 percent. Recent legislative changes have greatly increased the size of the estate value that is exempt from the tax. For 2002 and 2003, it is set at one million dollars and it will rise in steps to reach $3.5 million in 2008. Rates are also gradually being lowered. Despite these advances, however, the estate tax still often provides a disincentive for retention of family forestland or prevents continuity of sustainable management even if the property is not sold. This situation is made worse by the fact that special use valuation, intended to help alleviate the estate tax problem for farm and timber owners, is largely inapplicable as a practical matter to timber estates. Also, very few timber estates are able to qualify under the strict rules of Section 6166 of the Tax Code which permits estate taxes to be paid over a 14-year period by qualifying family businesses at a very low interest rate.  The overall problem is likely to become even more widespread in the near future because more than half of today's nonindustrial private forest landowners are of retirement age, and land and timber values, on average, continue to rise.

Concerns with Today’s Tax Treatment of Timber Investments

This brings up four points of concern: 1) the national role of private forests as a provider of forest goods and services; 2) the role of sound forest management in increasing forest productivity and maintaining environmental quality; 3) the unique nature of timber investments relative to other business ventures; and 4) the potential effects of current tax rules on sustainable long-term forest management.

The Private Landowner’s Role

Private forestry investments add significantly to the economic and social welfare of the nation. Private forests provide wildlife habitat, a variety of recreation opportunities, aesthetic benefits, and numerous environmental amenities including water and air quality. These lands represent the very core of America’s producers of timber, on whom we will rely for an ever-growing portion of our future timber needs.

Over 357 million acres, or 71%, of timberland in the US is privately owned. These lands accounted for 89% of growing stock removals in 1996 (USDA, 1997); they produced 82% of the nation’s wood supply in 1991 (Powell, et al, 1993); and over nine million nonindustrial private owners hold about sixty percent of the commercially productive forestland in the United States (Birch 1996). Skillful, sustained management of our private woodlands will increase the production of all such benefits.

The Role of Sound Management

Today there is increasing pressure to rely on regenerated forests established and maintained by direct private investment. Forecasts by the USDA Forest Service and by private analysts agree that demand for timber from U.S. forests will rise over several decades from 19.8 billion cubic feet roundwood equivalent in 1997 to 26.5 in 2050 (USDA 2000). This expanded demand will place an increasingly heavy burden on private woodlands since, as a group, they are the most productive.

Furthermore, although the amount of timberland in the U.S. rose by 4 percent between 1987 and 1997, the net effect of changes such as re-evaluation of site productivity, the reverting of farmland back to productive forest land that is occurring in the East, and the withdrawing of timberland for reserved uses, has led to a 1 percent (5.2 million acres) decline in the amount of land available for timber production between 1953 and 1997 (USDA 1997). Future predications indicate that timberland area will continue to decline in response to both conversion as well as the removal of land from timber production for other uses, such as recreation and wilderness preservation. Urban expansion, rural homesites, highway construction, and utility rights-of-way all continually reduce the total private acreage available for growing timber. Although thirty-three percent of all forestland is federally owned (USDA 1997), many federal forestlands have been withdrawn from timber production and have been designated as Wilderness and other special management areas. Declining budgets, environmental concerns, and greater demand for non-timber uses have further reduced the public sector contribution to the nation's timber harvest.

The increasing pressure on private forestlands, combined with a lack of forest management incentives in today’s tax system, leaves few options for private forest landowners to manage for long-term sustainability and environmental quality.

The Unique Nature of Timber Investments

Investments in private forest management are unique in many respects. Timber often must be held for long periods of time before it matures and can generate income.  During this time it is subject to substantial economic and physical risks (fire, windstorms, insects, diseases, etc.).  Nonindustrial private forest landowners who invest in timber management often do not own the forest land long enough to recover their investments through timber harvesting and simply deducting a cost does not fully recoup that investment.  Timber has a low degree of liquidity and almost no value until it reaches merchantable size many years after initial stand establishment.  Timber may yield rates of return that are low relative to other capital investment opportunities.  As noted earlier, many private woodland owners made long-term forestry investments on the premise that the timber capital gains provisions and the timber management cost deduction rules of federal income tax law would remain in place. But tax policy changes in 1986 uprooted these investments.

Potential Effects of Tax rules on Long-term Management

Capital Gains

Preferential treatment of long-term capital gain income stimulates capital formation, lessens the tax burden (under a progressive tax rate system) caused by the bunching of gains, decreases the tax deterrent to sale of capital assets, and compensates for the negative impact of inflation on capital gains taxes. Arguments among experts abound on how much these factors justify reduced taxes on capital gains, whether the effectiveness of a capital gains preference promotes a higher level of capital investment, and if such a provision would result in increased tax revenues.

Despite these and other uncertainties, the United States has had an enviable record of private forestry accomplishments since the enactment of Section 117(k) of the Internal Revenue Code in 1943. For example, annual forest plantings on private acreage have increased dramatically since 1944, from about 250,000 acres/year to more than two million/year. Timber growing stock on private woodlands, which had a downward trend prior to 1944, rose more than 50 percent. These and other significant steps in forestry investment and productivity parallel the existence of equitable tax treatment for woodland owners under the timber capital gains provisions.

Taxing timber income as a long-term capital gain since 1944 has enhanced investments in timber and encouraged long-term capital growth. Until 1987, when the long-term capital gain rate differential was eliminated for most taxpayers, it provided some compensation for the long periods of time, and the often substantial risks (e.g., insects, disease, fire) that are associated with such investments. Although long-term capital gain rates that are lower than the ordinary income rates are now once again available to all noncorporate owners, they are still considerably higher than pre-1987 capital gain rates. The corporate long-term capital gain rates today remain the same as the corporate ordinary rates. No differential has been restored as with noncorporate rates. Capital gains treatment of timber income in its pre-1986 Tax Reform Act form is essential to private timberland owners. Changes in federal tax policy should not adversely affect forest landowners who manage timberlands the most intensively and who have established investment regimes based on stability of tax policy.

Deduction of Forest Management Costs

Losing the opportunity to fully deduct costs in the year they occur has had serious consequences for nonindustrial private forestry where a significant management investment might not yield an offsetting return for 20 to 120 years. This is due to the passive-loss rule criteria used by the Internal Revenue Service and the restrictions on itemized deductions for timber. It discourages many forest landowners from investing in sound forest management and leads to decreased timber production, liquidation of timber inventories, and associated adverse environmental impacts.

The present tax code creates problems for forestry in two ways. First, while timber management income is earned primarily at the time of harvest, forest management costs are spread out over longer time periods. For example, many tree species require thinning which often yields little or no revenue to offset thinning costs. In addition, ongoing management efforts are needed to monitor, prevent, and control insects, disease, fire, and other threats. In addition to this, property taxes and interest on loans must also be paid. Thus, timber production is not a tax shelter type of activity that the passive-loss rules are, in part, intended to discourage.

Second, it is difficult for many forest landowners to meet the passive-loss criteria for material participation time requirements for deducting expenses against other non-timber income. The current criteria do not recognize the periodic nature of forest management activities or allow landowners to credit consultant and contractor time toward meeting the material participation requirements. Sound forestry knowledge is necessary to guide timber management and protect and improve environmental values that are increasingly important objectives to both landowners and the general public. These objectives often require the hiring of natural resource professionals and contractors to prepare management plans, provide advice on alternative management practices, thin stands or plant new seedlings after a harvest. As the vast majority of landowners are untrained or poorly equipped to do this type of work or do not have the proper information needed to make decisions about the needs of their forests, they must rely on professionals. The hiring of contractors enhances forest management and the benefits to society and should be recognized by the tax law as an appropriate activity to meet material participation requirements.

Being able to currently deduct the cost of timber management activities such as silvicultural practices, forest protection, stand maintenance, property taxes, and interest on borrowed money, would afford timberland owners equal treatment with investors in other capital asset and income-producing activities. Elimination of the opportunity for many timber owners to deduct these costs since 1987 has had serious consequences for private forest investment. These consequences include: 1) the inability to recover any ongoing management costs until timber is harvested many years in the future; 2) unique discrimination against timber investments in favor of non-timber businesses where most management costs, including interest, are deductible; and 3) an added imposition on timber owners to maintain an expensive recordkeeping system over the life of the timber stand. The poorly designed changes in the deductibility rules have encouraged timberland owners to liquidate existing forest holdings and have discouraged future investments in timber production. These actions adversely impact their ability to protect and improve the health and productivity of a significant portion of the nation’s forest estates.

Amortization and Credit

Existing federal tax provisions for reforestation have been an especially important source of investment capital for nonindustrial forest owners. Elimination of the amortization and credit provisions of federal law would impede the flow of investment capital required by these owners to carry out reforestation activities that follow timber harvest. Reforestation costs, however, have increased significantly with inflation. Thus, the tax benefits associated with amortization and the credit are worth much less now than previously because of failure to increase the eligible dollar amount set when Congress incorporated these provisions into the Internal Revenue Code in 1980.

Estate Tax

A recent study has shown that 36 percent of forest estates owe the federal estate tax, while approximately 2 percent of estates in general owe the tax. This study further demonstrates that timber or land is sold to pay a portion or all of the estate taxes in 40 percent of the forest estate cases where the tax is due. These study results portray the enormity of the effects the estate tax has on the decisions of forest landowners regarding the activities on their forests (Green et al. 2000). They show that in response to the substantial tax that is due, and the short payment schedule, many estates are forced to disrupt forest management programs, prematurely harvest timber and otherwise engage in forest practices that can degrade the quality of both the environment and the land, thus limiting future forest management options. The tax may also force the estate to subdivide or sell all or portions of the family land in order to meet the estate tax obligation. The fragmentation and conversion of forestland to other uses or the harvest of its resources without consideration of the effects on current and future generations, is of major concern to the American people and professional foresters.

The special use valuation provisions of the federal estate tax law and the provisions permitting payment of the tax over 14 years at a very low interest rate are of little help to estates containing timberland. Although technically applicable to forestland and timber, they were written primarily to apply to agricultural production. The eligibility and valuation rules are largely incompatible with the reality of nonindustrial forest management and can only be used by timber estates with great difficulty, if at all. For example, specially valued timber cannot be harvested for 10 years after the owner's death, even if required as part of an ongoing forest management plan or for salvage purposes following insect, disease or fire damage. Even for those forest estates that qualify for special use valuation, the current $800,000 limitation on reduction below fair market value effectively excludes substantial acreages.

Recommendations

Establish Tax Policies That Improve U.S. Ability to Compete Internationally

Federal tax policies should allow U.S. private timber investors to compete fairly with other markets for timber products. Timber products are commodities traded in extremely competitive world markets. Virtually every major timber producing country in the world, to further its public policy, provides special tax treatment and other financial assistance for private forestry investments. These policies were enacted in recognition of the unique nature of timber growing and the special problems faced by timber investors. In many instances, the benefits far exceed those in the United States.

Modify §631(b) of the Tax Code to Encourage Investments in Forestry

Debate continues about the effects of capital gains tax policy on small nonindustrial landowners who may be more affected by limits on their ability to deduct timber management costs than are industrial forest landowners. The changes in the long-term gain rates have been much costlier to large private owners in terms of return on investment. In addition, taxpayers in states using federal adjusted gross income as the state income tax base have experienced substantial increases in state income taxes.

The Society of American Foresters supports federal capital gains tax policies that address the unique nature of timber management programs and thus treat forestry investments fairly in comparison to other capital ventures. SAF recognizes, however, that such policies need not necessarily encompass the exact provisions of prior capital gains law to be effective. Nevertheless, there is overwhelming circumstantial evidence that a substantial portion of the nation’s private forest owners have favorably responded to past capital gains policies that have encouraged private forest investment. Changes should be enacted that will be fair to forest owners, encourage the application of sound, professionally prescribed forest management practices on private woodlands, and contribute to the expected increase in national demand for timber in the years ahead.

Section 631(b) of the Tax Code should be modified to permit either lump-sum or pay-as-cut sales, at the taxpayer’s option, to qualify for capital gains treatment by those forest landowners who are governed by Section 631(b).  The change is endorsed by the Internal Revenue Service and the Congressional Joint Committee on Taxation has determined that it will have no impact on treasury receipts.

Index the Tax Deductible Basis to Account for Inflation

Most economists agree that inflation increases the effective tax rate on real (non-inflationary) capital gains. No single income tax rate reduction accurately corrects for the highly variable effects of inflation. The percentage impact of inflation will vary with the holding period of the capital asset. It is often suggested that the most suitable way to ensure that inflation will not cause an extra capital gains tax burden is to index the tax-deductible basis for inflation. Under this proposal tax savings could be substantial for forest owners, many of whom often own timber for several decades or longer before harvest. At the same time, woodland owners in the aggregate would not benefit nearly as much from indexing as would investors in other capital enterprises. Basis indexing tends to benefit owners of capital assets held for relatively short periods of time more than it does those who hold capital assets for longer periods.

Modify the Material Participation Rules and Criteria

Policies that decrease after-tax returns from long-term forestry investments, such as the passive-loss criteria for material participation, will reduce such investments and may lead to reducing the health and productivity of privately owned timber inventories. The passive-loss rules should be modified to address the uniqueness of timber investments. The criteria should be changed to recognize that the periodic nature of many of the management activities required for timber production on nonindustrial private forestlands may not meet current material participation requirements. They should also permit professional resource management consultant and contractor time dedicated to long-term forest management to be credited to a landowner's material participation account. These modifications to the rules, however, should not impose unduly burdensome and time-consuming record keeping requirements on landowners.

Retain the Reforestation Tax Provisions

The $10,000 annual limit for reforestation expenditures should be increased to $25,000 and thereafter, indexed annually for inflation. Such action will enable woodland owners to stay on an even keel with respect to rising site preparation and planting costs.

Reform the Estate Tax

The federal estate tax should be completely revised and reformed for forest land estates. Until this is accomplished, Section 6166 of the Internal Revenue Code, which permits the estate tax to be paid over 14 years at a very low rate of interest, should be amended so that estates containing substantial amounts of forestland will easily qualify.

In the interim, the special use provisions of the Code that allow current use valuation of forestland and timber instead of highest and best use value should be amended to allow for a maximum reduction in fair market value assessment of $1.5 million as compared to the current maximum of $800,000. Additionally, the special use valuation eligibility rules pertaining to valuation procedures, material participation, and the harvesting of specially valued timber should be amended to be more compatible with forest management and timber production.

Literature Cited

Birch, T.W. 1996. Private forest-land owners of the Untied State, 1994. Resour. Bull. NE-134. USDA Forest Service, Northeastern Forest Experiment Station: Radnor, PA

Greene, J., T. Cushing, S. Bullard, and T. Beauvais. 2000. Effect of the federal estate tax on non-industrial private forest holdings in the U.S. In Proceedings of the Forest Fragmentation 2000 Conference: Sustaining Private Forests in the 21st Century, 142 - 144. Alexandria, VA: Sampson Group, Inc.

Powell, D.S., et al., 1993. Forest resources in the United States, 1992. General Technical Report RM-234. USDA Forest Service: Fort Collins, CO

USDA Forest Service. 2000. Resources Planning Act Assessment: Review Draft. Accessed on the World Wide Web at http://www.fs.fed.us/pnw/sev/rpa/index.htm. USDA Forest Service: Washington, DC.

Smith, W.B., J.S. Vissage, D.R. Darr, and R.M. Sheffield. 1997. Forest Resources of the United States, 1997. USDA Forest Service: Washington, DC.