Section 631(b) Transaction (Pay-as-cut Contract)
NOTE: If your timber is held primarily for sale to customer in the ordinary course of a trade or business it is no longer necessary to qualify under this Section to qualify for capital gains treatment. Click here for more information!
This section should be used if you sold standing timber under a pay-as-cut contract, this means that you did not receive an up-front lump-sum for the timber but were paid for the timber as it was cut. A pay-as-cut contract is also referred to as a "disposal with an economic interest retained" or a Section 631(b) transaction. Economic interest is retained by the landowner because they are paid only for the timber that is actually cut, and as such is dependent on the cutting to realize an economic return. The payments are generally set up on a pre-arranged schedule (i.e. monthly, quarterly) and the landowner is paid for the amount that was cut during that period. Contracts for the disposal of timber with an economic interest retained are often characterized as leases even if no formal agreement is written up.
The proceeds from timber cut and sold under a pay-as-cut contract is treated as a "capital gain" even if that timber was held "primarily for sale to customers in the ordinary course of a trade or business." Another advantage to timber qualifying under Section 631(b) is that the timber is considered Section 1231 property which means that you are entitled to capital gains treatment when aggregate Section 1231 gains exceed aggregate Section 1231 losses.
Because of the uncertainty that may exist in some cases, it is recommended that taxpayers making "frequent" sales of timber dispose of it with an economic interest retained, thereby avoiding the potential of losing capital gains treatment if audited.
Contracts - Contracts for the disposal of timber with an economic interest retained are generally characterized as leases. Thus, the owner of the timber disposed of is referred to as the "lessor" and the party acquiring the right to cut and the obligation to pay for the timber cut, as the "lessee." In many cases, however, such contracts do not include the provisions necessary to create a lease. Most short-term cutting contracts, for example do not create a landlord-tenant relationship between the lessor and lessee. Most long-term contracts, however, are properly classified as leases. In any case the terms lessor and lessee are used to avoid any implication that a disposal with an economic interest retained constitutes an outright sale of the standing timber.
Warning: Disposals with an economic interest retained are generally more risky to the lessor (seller) than lump sum sales. The lessor usually doesn't get his money up front. Typically the lessor must depend on the lessee to accurately report the volume of timber cut. This usually means paying a forester or other party to spot check or otherwise verify the log scale.
Definitions - In order to apply the provisions of Section 631(b) it is necessary to understand some of the definitions associated with it.
Owner - The provisions of Section 631(b) apply to any form of timber ownership and not just the outright ownership of the timberland itself. It therefore applies to any person, including a sublessor and the holder of a contract right to cut, who owns an "interest in the timber" An "interest in timber" results from possession of the right to cut timber for sale on one's own account or for use in one's trade or business. "On one's own account" means that under the terms of the contract the lessee has the unrestricted right to sell the logs to others, use them in his own trade or business, or otherwise dispose of the cut timber as he sees fit.
Timber - For the purpose of Section 631(b) the term "timber" includes the parts of standing tress usable for lumber, pulpwood, veneer, poles. pilings, cross-ties, and other wood products. It also includes evergreen trees more than six years old when cut and sold for ornamental purposes, i.e. Christmas trees.
Date of disposal - The date of disposal is the date the timber is cut. Timber is considered to be "cut" at the time when in the ordinary course of business the quantity of timber felled is first definitely determined. The procedure used to make this determination will vary depending on what part of the country you are in. Some locations use roadside scaling stations, others scale or weigh the logs at the mill that's buying them, or at the landing by the logger or the hauler. The IRS frowns upon deviation from standard practice simply to obtain a tax advantage.
Economic Interest - You retain an economic interest in the timber if you are dependent on the cutting of the timber for the realization of income from the timber. Under a pay-as-cut contract (Sec 631(b) transaction) the buyer tallies the timber cut during a specified period (one month, three months etc.), and pays for that amount of timber at the agreed upon unit price within some specified period of time.
Determining the volume cut - The volume cut is usually determined by scaling or weighing the logs produced. But, you may also determine the volume cut by scaling the trees themselves. This is accomplished by cruising the timber before and after a stand is cut. The volume cut is the difference between the two cruise volumes. If a large acreage is involved the area is usually divided into cutting units and the timber paid for upon completion of cutting each unit.
"Day of Reckoning" - Many contracts include terms requiring an advance payment before cutting starts and regular payments for the amount of timber expected to be cut over the next payment period. These and similar provisions will meet the economic interest retained requirement as long as there is an eventual "day of reckoning." On this day the total amount due the lessor under the terms of the contract based on the amount of timber actually cut must be determined and any necessary adjustments made. If the lessee has paid for more timber than was finally cut the lessor must reimburse the lessee for any such over payment, or vice versa.
Reporting a Section 631(b) transaction
The gain or loss from a pay-as-cut contract (disposal with an economic interest retained) is figured the same way as a lump-sum sale. The gain or loss is then reported on Form 4797, along with any other Section 1231 transactions. The gain and losses from Section 1231 transactions are netted on Form 4797 to determine if your net gain or loss. If a net gain results the amount is reported on Part II of Schedule D, Form 1040. If the netting of gains and losses from Form 4797 results in a loss it is treated as an ordinary loss.
In order to receive the preferential tax treatment provided by long-term capital gains it is necessary to determine the exact amount of time the timber was held (holding period). If the holding period does not meet the requirements then the gain will be taxed at your marginal rate. If, however, the holding period has been satisfied then the gain may be taxed at a rate lower than your marginal tax rate.
Note: It is important to note that if you did not meet the holding period requirements when the timber was felled, but met the required holding period when the quantity cut is first determined then the transaction would qualify for long-term capital gains treatment.