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Tax tests for woodland owners.

Forest owners commonly incur costs in the day-to-day management of their woodland. Such expenditures include, but are not limited to, fees paid to consulting foresters and other professionals; travel expenses directly related to the income potential of the property; silvicultural operations such as prescribed burning and precommercial thinning; fire, insect, and disease protection; short-lived tools; and salaries for hired labor. These expenditures are usually called "timber operating costs.

Woodland owners also generally pay property taxes, and perhaps insurance premiums and interest on loans. Such costs, together with certain other expenses related to the development and operations of timber properties, are termed "carrying charges."

Operating costs and carrying charges that are considered to be ordinary and necessary" expenses of managing, maintaining, and conserving forest land may be wholly or partly deducted (expensed) each year as these costs are incurred-provided the woodland activity is done for profit and the expenditures are directly related to the income potential of the property. The extent to which deductions may be currently taken, however, depends on how forest owners are classified under the 1986 Tax Reform Act. This legislation made a number of significant changes related to deductions. These changes are called the "passive loss rules." Passive Loss Rules

The passive loss rules govern the extent to which an operating loss (the amount by which current expenses exceed income) from a particular activity, such as forest land, can be offset against income from other sources. They apply to individuals' estates, trusts, and to two categories Of corporations "personal service corporations" (whose principal activity is the performance of personal services which are substantially performed by employee owners) and "closely held C corporations" (those subject to the corporate income tax and in which more than 50 percent of the value of the stock is owned by five or fewer individuals). The passive loss rules also apply to deductions passed through from partnerships and Subchapter S corporations to these five types of taxpayers.

Woodland owners subject to the passive loss rules must first determine which of the following three classffications apply to them and their forest property:

1 timber held as part of a trade or business in which the taxpayer materially participates.

2 timber held as part of a trade or business in which the taxpayer does not materially participate (thus, a passive activity).

3 timber held for the production of income (that is, as an investment), but which is not part of a trade or business.

The significant point, however, is that only taxpayers in the first category can fully deduct all operating expenses and carrying charges related to their timber activity against income from any source each year as incurred. Also, only taxpayers in the first category can apply ply credits arising from the timber activity (such as the reforestation tax credit) against taxes associated with income from any source. Thus, "material participation" in the forestry operation is of critical importance.

Most woodland owners will obviously find it to their advantage to currently deduct forest-management and related costs to the extent possible, rather than postponing or losing them altogether, as would be the case under the second and third classifications (see March/April 1987 and January/February 1988). A dollar recovered today is worth more than one recovered tomorrow, and is also available for immediate use or reinvestment.

Material Participation

The law provides that a taxpayer, to be materially participating, must be involved on a "regular, continuous, and substantial" basis. On March 19, 1988, the Internal Revenue Service issued the first of several temporary regulations that address passive losses and credits. Seven separate tests are provided to measure material participation. Six are applicable to most woodland owners. A forest owner will be considered to be materially participating in his woodland activity if any one of the six applicable tests are satisfied during a particular tax year. They are:

The "Absolute" Test

You and/or your spouse participate in the operation of your woodland activity for more than 500 hours during the tax year.

The "Do Most of It Yourself" Test

You and/or your spouse's personal participation in the operation of your woodland activity constitutes substantially all of the participation (including that of all other individuals) for the tax year. This test is based on total participation, including that of individuals who do not own interests in the property. Therefore, the hours of participation by a consulting forester and hired workers are included.

The "100-Hour Majority" Test

You and/or your spouse participate in the operation of your woodland activity for more than 100 hours during the tax year, and no other individual participates more, including those not owning an interest in the property.

The "Significant Participation Aggregate" Test

You and/or your spouse's aggregate participation in the operation of all of your "significant participation activities, " including your timber activity, exceeds 500 hours during the tax year. An activity is a "significant participation activity" if it is a trade or business in which you participate for more than 100 hours during the tax year. Thus you as a forest owner can qualify under this test even if another individual or co-owner participates in the woodland operation more than you do during the tax year in question.

The "Five of Last 10 Years" Test

You and/or your spouse materially participated in the operation of your woodland activity for any five of the 10 tax years immediately preceding the tax year in question. For this purpose, material participation in pre-1987 tax years is counted, but only if you met the 500-hour test in such years.

The "Facts and Circumstances" Test

All the facts and circumstances of the situation indicate that you and/or your spouse participated in the operation of your woodland activity on a regular, continuous, and substantial basis during the tax year. The specific rules to be followed in applying this test were not part of the first set of regulations, but will be addressed in future regulations.

However, several general principles may currently be used as guides. The first is that a taxpayer's management of his or her timber activity isn't taken into account if a paid manager participates in its management or if the taxpayer's management services are exceeded by those performed by any other individual. And second, if the taxpayer doesn't participate in the timber activity for more than 100 hours during the tax year, he or she cannot satisfy the facts and circumstances test for the year.

As the tests indicate, both spouses are treated as one taxpayer in determining whether the material-participation requirement has been met. It doesn't matter whether both own an interest in the property or not, or whether they file joint or separate tax returns.

Any work that a forest owner does in any capacity in connection with the woodland counts, but it must be "customary work." Work not customarily done, but accomplished to avoid the passive loss rules, doesn't count. Investment work" doesn't count unless the taxpayer is directly involved in the day-to-day management or operations of the woodland. Investment work would include reviewing reports on operations of the property; preparing or compiling financial summaries or analyses for the taxpayer's own use; and monitoring the operations in a non-managerial capacity.

Formal recordkeeping is not required to prove the number of hours devoted to a timber activity. Any reasonable means may be used, including-but not limited to-appointment books, calendars, and narrative summaries.

The hourly requirements of the material-participation rules are proving to be a perplexing situation for many woodland owners. The time specifications generally bear no relationship to the ownership and efficient management of forest property. During some years, little or no activity may be necessary and still be consistent with a good forest-management program.

Although many nonindustrial owners have developed some knowledge of good forest-management techniques, most are not professional foresters. Therefore, a large number use consulting foresters to provide professional expertise. The arbitrary passive loss rules, however, will certainly make it difficult for many woodland owners to continue utilizing consultants. By so doing, they could easily jeopardize their eligibility to deduct forestry expenditures. How will nonindustrial timberland owners react to the material-participation rules? Although it is too soon to be certain, indications are that some will sell their property but most probably will not-the land-ownership ethic is too strong. Property taxes and interest will continue to be paid, even if not currently deductible. However, many owners who are not able to qualify as material participants will severely curtail discretionary expenditures relating to their forestry investments, such as those for silvicultural and protection practices. They will become landowners rather than land stewards. As a result, timber productivity on perhaps millions of acres will be adversely affected. It is difficult to believe that this detrimental impact on the nation's forest resources is consistent with the intent of the 1986 Tax Reform Act.

If a woodland-ownership interest was acquired after October 27, 1986, the rules discussed above are fully effective now. But if the ownership interest was acquired before then, a five-year phase-in of the rules is provided. During the phase-in, even if the taxpayer does not meet one of the seven material-participation tests and the woodland activity is thus considered to be a passive one, a limited percentage of losses (deductions) and credits associated with it may be off set against income and taxes from any source. The percentages are as follows:





1987 65

1988 40

1989 20

1990 10

As an alternative to currently deducting eligible timber-related expenditures, materially participating woodland owners may capitalize them if they so choose in years during which no income is produced from the property. This may be done on a year-to-year basis. The process of capitalization in general has been discussed in earlier issues (see March/April 1987 and January/February 1988).

The specific rules governing operating costs and carrying charges were not changed by the 1986 Tax Act. Strictly speaking, only carrying charges capitalized. Carrying charges are expenses related to the development and operation of timber properties that may be treated as either deductible expenses or capital costs. As a practical matter, however, virtually all deductible timber-related operating costs are also considered to be carrying charges. Capitalized carrying charges are added to the timber's basis and are recovered by offsetting gain realized upon the sale or cutting of the timber, as discussed in the February 1986 issue of AMERICAN FORESTS.

The regulations additionally provide that taxpayers may elect to capitalize necessary expenditures associated with development of real property up to the time the development is completed. Expenditures incurred for silvicultural treatments in established stands-such as noncommercial thinning and other timber-stand-improvement work-fall into this category. Such costs may be capitalized to the timber account only if done consistently from year to year.

The election to capitalize is made by filing a statement, on a plain piece of paper, with the original tax return for the year in which the election is to be effective. The statement should indicate the cost items that are being capitalized.

It will be to a timber owner's advantage to be directly and actively involved with the management and operation of his (her) woodland in order to ensure that it is considered a trade or business in which the owner materially participates. Qualifying as an active business may also serve to lower any alternative minimum tax that a woodland owner may be subject to with respect to tax benefits associate with nontimber activities. There are also several significant federal estate tax advantages associated with fores land deemed to be an active business.

It should be kept in mind, however, that if a timber-growing activity is considered to be a "trade or business" for purpose of the passive loss rules, it may under certain circumstances be more difficult for the owner to obtain capital-gain treatment for timber-sale proceeds. As explained in earlier issues, capital-gain status may still be advantageous for certain woodland owners.
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Author:Siegel, William
Publication:American Forests
Date:Jan 1, 1989
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