There are three basic ways in which income can be realized from the ownership of timber property:
In the case of items 1 and 2 above the income is treated as ordinary income. In the case of item 3 above the income may qualify for capital gains treatment, and as such may be taxed at a lower rate than your ordinary income.
If you are not sure whether your timber sale qualifies for capital gains treatment Click Here! You will be asked a series of questions based on what was sold and how you treated the sale.
The substantial and unusual increase in income, which may occur when timber is sold, may put you in a higher tax bracket. Tree farmers are forced into such situations by the nature of the timber growing process, not by choice. Historically, the policy has been to provide relief from jumps in marginal tax rates if the income level for that one year is not representative of your normal income level. Congress felt that income averaging was no longer necessary because of the reduction in the number of tax brackets. Thus, income averaging was eliminated in 1986. It is no longer possible to spread the tax liability without spreading receipt of the income over more than one tax year. Also, note that tax liability can not be assigned to other taxpayers. The owners of the timber must pay.
Note: The Taxpayer Relief Act of 1997 restored income averaging for farmers. The growing of timber, however, doesn't qualify as farming for purposes of this provision.
Spreading Income - You should consider spreading income only if the additional income would put you in a higher tax bracket, or if the gain in a later year could be used to offset capital losses. Given your estimated taxable income, how much additional income can you receive before entering a higher tax bracket? This will depend on how you file.
If the income from your timber investment is to be used for the benefit of the family as a whole, after-tax income can frequently be increased by dividing the before-tax income among the family members. Methods for doing this include filing a joint return with your spouse, transferring title, forming a family partnership or S corporation, creating trusts and employing family members. Many of these arrangements are complex and should be undertaken with the guidance of competent legal counsel.
When deciding whether or not to spread income you should consider the opportunity cost of not receiving the entire amount immediately. What would the interest earned on the deferred payments be? Would you have to borrow funds to meet your needs while waiting for the payments? If so, what would it cost to borrow the funds. These "opportunity costs" need to be compared to the tax savings before making a final decision.
Passive Loss Rules -The passive activity loss restrictions apply to any form of business: sole proprietorships, partnerships, estates, trusts, closely held C-corporations and personal service corporations. The passive loss rules may restrict the extent to which operating losses can be offset against income from other sources. For a more in-depth review of the Passive Activity Loss Restrictions click here!
Types of Sales
The decision about how best to sell timber should focus first on what is best from a marketing standpoint, i.e. how to maximize the total revenue received for the timber. Then the tax consequences of the alternatives should be analyzed.
To learn more about the different types of sales, how they are treated for tax purposes, and how to report the income click here!