I recently learned from a reliable source that only about 15 percent of taxpayers in the Northeast who report income from timber sales do so correctly. Although my source was coy about the exact nature of errors, implying that he was as stumped as anyone about the findings of this preliminary study, the facts are that when 85 percent of any population is misreporting income and expenses from transactions, something is amiss. It is too soon to speculate if the IRS is going to pursue the circumstances behind these data, but it is entirely possible that forest owners are paying too much rather than assuming that errors are intentional and in favor of the taxpayer.

One fairly common oversight of woodland owners who report timber sale income is not recovering the cost basis of timber. These owners pay taxes on gross income from timber and not just on profits from the sale. Failing to subtract the original cost of timber means more tax is due.

What is the cost of timber? It is that portion of the original purchase price of forest that can be reasonable and fairly attributable to timber resources on the date of acquisition. How does one divvy up a purchase price from 10 or 20 years ago and allocate to the cost of different assets? The rules say allocations must be "...according to the separate fair market value of each asset independent of the others on the date of acquisition." When the subject is forestland, this means being able to evaluate the cost of timber independent of land, and the cost of bare land independent of timber. This may sound like a ridiculous proposition, but it can be done, and it is the only way to offset income from the sale of timber with its original cost.
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In tax jargon, the cost of an asset is known as its "basis" or "cost basis," and when the asset is timber the process of recovering cost basis is known as "depletion." In other words, a woodland owner figures taxable gain by depleting the cost of timber to figure profit. The concept of depletion is to timber what depreciation is to a truck used for business purposes. That is, the IRS allows a taxpayer to recover the cost of capital, or the cost of business-use equipment, as the assets are used. Land is never depleted until it is sold outright.

Most people acquire forestland and other assets, such as a house, pastures and a barn, all for one price: the purchase price. The IRS says that if you can "reasonably and fairly" allocate a portion of that purchase price to timber, you can recover the cost of timber as it is harvested and sold. The trick is to figure out how to allocate the original purchase price to each of the assets independent of the others. Even those who purchased forestland with no improvements need to figure the proportion of the original purchase price that is reasonably and fairly attributable to just the timber, and the proportion that is attributable to bare land (interpreted as the same land, but without timber).

It is tempting to assume that forestland sans timber is actually a liability (since you pay taxes on it, but probably can't sell it) and, therefore, most of the original purchase price is allocated to timber--but on numerous occasions the IRS has taken the position that even completely cutover forestland has value, primarily on the grounds that land is scarce. The purchase price of timber, bare land and other assets must be allocated according to the fair market value of each asset independent of the other and reflecting the circumstances on the date of acquisition.

For many woodland owners, the cost basis of land and timber is attributable mostly to the original purchase price of the property. However, any carrying charges--such as taxes, interest and insurance--that were not taken as a deduction in the year they were incurred can be added to the cost basis. Furthermore, a woodland owner can allocate purchase price and other unused carrying charges of forestland at any time, so long as the allocation reflects the circumstances on the date of acquisition and any subsequent costs added to the basis are allowed.

So, what do you do if you purchased forestland 10 years ago and you're contemplating a sale this year? Obtain a current inventory and an estimate of growth rate, then "grow the stand in reverse" to reflect harvestable volumes on the date of acquisition. Next, obtain local historic information about stumpage to figure fair market value of timber and locate a real estate broker who is willing to offer an opinion on bare land values in the area. Both fair market value of timber and an opinion about the fair market value of bare land are used to estimate the total fair market value of the forest on the date it was acquired. Confused? Consider the following case study:

A young couple acquires 100 acres of forestland in the fall of 1995. They paid $95,000, or $950 per acre. In November of 2005 they hire a consulting forester to develop a forest management plan in anticipation of a timber sale early in 2006. As part of the plan, the consultant estimates the current inventory of timber, including both sawtimber from the main stem and fuelwood from cull trees and tops.

The consultant estimates there are 3,960 board feet (bf) plus or minus 500 bf, and 12.6 cords (cds) plus or minus 1.6 cds per acre. Since the inventory is only an estimate of actual volumes, the "plus or minus" values tell the reader something about the accuracy of the consultant's estimates. In this case, the consultant has estimated volumes to within 13 percent of actual, and thus the numbers are good enough for calculating the cost basis of timber.

An estimate of standing timber volumes should have an accuracy of not less than plus or minus 20 percent, except in low value or defective stands where higher errors are tolerable. Generally, the more valuable the timber the more accurate an estimate should be, even to as little as 5 percent or less. Unless stands are uniform, the cost of added accuracy can be prohibitively expensive.

While completing the inventory, the consultant also estimates average annual growth rates (using a tool called an increment borer to obtain growth ring counts). This tells the client the rate at which the stand is changing in volume, but more importantly, this same estimate is used to grow the stand in reverse so as to estimate timber volume on the date of acquisition. In this case, average annual growth rate is 2.6 percent (plus or minus 0.4 percent).

Using average annual growth rate, the forester deducts the equivalent of 10 growing seasons of forest growth to arrive at an estimate of total volume when the land was acquired: 306 thousand bf (Mbf) of sawtimber and 975 cds of fuel-quality wood. In the terms of financial calculations, the forester is discounting the current inventory: 396 Mbf and 1,260 cds at a rate of 2.6 percent per year.

The discounting formula is:

where "i" is the growth rate, in this case 0.026, and "n" is the number of growing seasons. We will assume that the volume immediately before the sale in spring 2006 is about the same as when the volume was measured the previous fall since the stand is dormant. When compounding or discounting growth in forest stands it is necessary to know the seasons that begin and end the period in question. For forestry calculations, the value of "n" is actually the number of growing seasons, not years.

With 1995 timber volumes in hand, the forester then obtains information about stumpage values on the date of acquisition. If her clients own land in Vermont, they're in luck: 24 years of stumpage data for 12 product classes reside on theExtension Forestry in Vermont website. For this example, let's assume that sawtimber stumpage in 1995 had an average value of $165 per Mbf and cordwood stumpage sold for about $7 per cord. Using these figures, the value of the timber inventory on the date of purchase was: 306 Mbf x $165 per Mbf + 975 cds x $7 per cord for a total fair market value of $57,315.

We have just estimated that the 1995 fair market value of timber is about 60 percent of the total purchase price of land and timber combined ($57,315/$95,000). This may seem like a fair and reasonable allocation, but without supporting information on fair market value of bare land, the allocation is apt to be questioned by a revenue agent during an audit. Remember, the IRS stipulates that the cost basis of assets must be allocated according to the separate fair market value of each asset independent of the other.

The forest-owning couple now investigates the value of their property as bare land. After much prodding, they get a realtor's estimate of what their land would have sold for in 1995 without the timber on it. The realtor believes the property might have brought $550 per acre for the tract as bare land. Using this figure, the fair market value of bare land is: 100 acres x $550 per acre, which is equal to $55,000. Thus, the total fair market value of bare land and timber, in 1995, is $55,000 (land) + $57,315 (timber) = $112,315.

With information on the fair market value of each asset (independent of the other), the couple is able to allocate their cost basis to separate land and timber accounts as follows: