Some expenses incurred by forest landowners can be expensed annually or periodically as opposed to capitalized. It is generally more beneficial to expense operating costs since the tax savings are realized more quickly than when the expenses are capitalized.
Forest Management and Protection
Forest operating costs include consulting forester fees, hired labor, travel expenses related to property management and income potential, silvicultural activities (prescribed burning, precommercial thinning, timber stand improvement), tools of short life, and fees for educational workshops and tours. These expenses can be deducted annually as operating costs. Interestingly, fertilizer costs are not considered in this category of expenses. Under current regulations the costs associated with fertilizing a forest must be capitalized or amortized. The IRS determines this on an individual basis with each taxpayer.
Timber CruisesThe costs associated with timber cruises are treated differently depending on the reason for conducting the timber cruise:
(Optional Treatment of Certain Expenses)
Taxpayers may elect to treat taxes and other carrying charges on forested property as capital charges rather than expensing them in the current year. Property taxes, interest, insurance, and most other timber related costs may be treated as carrying charges (capitalized). When a current deduction would not result in a tax benefit, taxpayers should capitalize expenses. This happens when taxable income is less than the amount of a deduction in question. When a taxpayer takes a deduction in this case, taxable income drops below zero, and additional deductions have no benefit. Taxpayers can make the declaration to capitalize carrying charges by filing a statement with the original tax return for the year the election is made. The declaration must include a statement defining the cost of the activity and the desire to capitalize the expense. However, a taxpayer can not capitalize expenses during a year that the property is financially productive. Timberland is financially unproductive in those years when it produces no income.
Passive Activity Loss Rules and Timber Related Expenses
The amount of operating costs and carrying charges that can be expensed depends on how a timber owner is classified under the 1986 Tax Reform Act. Earlier, the definitions of active trade or business, passive trade or business, and investment were discussed and defined. The taxpayer’s treatments of operating costs and carrying charges depend on which category applies.
Active Trade or BusinessWhen a forest landowner qualifies as an active trade or business, all operating expenses and carrying charges related to timber revenues are fully deductible against income from any source, for each year the expenses are incurred.
All investment tax credits, such as the reforestation tax credit, can be applied to income generated from any source.
If a taxpayer’s total deductions from all sources of active trade or business exceed income for the year, then the excess can be recorded as a net operating loss (NOL). The NOL can be carried back to amend tax returns from the 3 years preceding the NOL, and carried forward up to 15 years ahead until the loss is negated.
As can be seen from this discussion, the classification of ownership as an active trade or business has significant benefits for the forest landowner.
Passive Trade or BusinessWhen a forest landowner qualifies as passive trade or business, deductions attributable to passively held forest properties are allowed only to the extent of total income from all other passively held activities for the tax year.
The reforestation tax credit can only offset income from passive activities.
If the taxpayer’s deductions (e.g., depreciation, amortization) or investment tax credits (reforestation tax credit) from passive timber ownership exceed passive income from all other sources for the tax year, then the excess is suspended, or carried forward until income is generated or the property changes ownership Investment
When a forest landowner qualifies for the investment category, deductions attributable to management costs are classified as “miscellaneous itemized deductions” on IRS form 1040. To result in a tax benefit, the forestry deductions plus other miscellaneous deductions must exceed 2% of adjusted gross income or be permanently lost.
Management costs can be capitalized as carrying costs. But they cannot be counted as part of the 2% of adjusted gross income (miscellaneous itemized de-duction) and also capitalized.
Property and other deductible taxes attributable to timber held as an investment are deductible in full each tax year against income from any source. They are not classified as “miscellaneous itemized deductions.” However, they can be capitalized at the taxpayer’s option. Tax credits can be applied to income from any source.
Interest payments can be deducted only from net investment income. But, a taxpayer can elect to capitalize all or part of his or her interest on investments (IRS Schedule A).
Reporting Eligible Expenses
All taxpayers engaged in a trade or business
should keep books that adequately show the continuity of business activities.
Revenues and expenses should be supported by receipts, vouchers, and work
sheets. Remember that it is easy to glean over-excessive detail, but difficult
to fill in missing information many years after the action is completed.
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