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Postponing Tax on Stumpage Sales?

Tree Farmer Magazine: May/June 1999 - Volume 18, No. 3

Wouldn''t it be nice if you could postpone paying tax when you sell timber on the stump? I keep hearing rumors that tree farmers are doing this by exchanging their stumpage for other property. For example, a logger wants to buy your timber but you don't want the cash and tax liability. So, the logger buys a tract of timberland equal to the value of the timber you're selling. Then, instead of giving you cash he exchanges this land for the right to harvest your timber. Sounds perfectly reasonable, but can the tree farmer postpone the tax if and until the land taken in exchange is sold? Lets look at the "tax-free" exchange rules first, then apply them to this situation. Cross your fingers and squeeze real tight on this one, folks.

Voluntary Like-Kind Exchanges

Unless specific non-recognition requirements of the Internal Revenue Code are met, the gain or loss on a sale or exchange of property is taxable and must be reported. In general, nonrecognition applies if business or investment property is exchanged solely for other "like-kind" business or investment property. The gain is postponed because the basis of the property given in exchange becomes the basis of the property received. Thus, any gain from the increase in value of the property given in exchange is carried over to the replacement property and not realized until the replacement property is sold. This could be never if the property received is passed through your estate.

The trick is making certain that only "like-kind" property is exchanged. Three classes of property are used in defining like-kind property: (1) depreciable tangible personal property; (2) other personal property including intangible personal property, nondepreciable personal property, and personal property held for investment; and (3) real property.

The exchange of virtually any parcel of real property for another parcel of real property should qualify as like- kind as long as the interests in the property given up and the property received are of a similar character or nature. In particular the ownership interests must be the same. The most common form of ownership interest is "fee simple." A fee simple interest is not limited to a certain period of time. A leasehold interest is not of the same character or nature as a fee simple interest because a leasehold interest is limited to a designated period of time. However, a lease with 30 years or more remaining is of like- kind to a fee- simple interest, and non-recognition treatment is available to the person holding the lease (lessee). Nonrecognition may not be available to the person granting the lease (lessor) because receipt of the fee simple interest may be treated as advance rental payment that has to be reported as ordinary income.

There are many other requirements that must be met to qualify for non recognition. These have to do with the timing of the exchange, receipt of additional payments (boot), and involvement of third parties. But these aren't central to the issue here. Our concern is the definition of like-kind as applied to timber. And, keep in mind that it's the laws of your state that determine the nature of an ownership interest in property, not any Federal law. The Internal Revenue Code defers to state law on such matters because the treatment varies among states.

Application to Timberland and Timber

Timberland and un-severed timber, also called standing timber or stumpage, are both real property. In most states it's possible to separate the title to the timber from title to the land; that is create separate ownership interests or estates in the land and timber. But this usually requires some form of lease arrangement because the timber has no value unless the owner of the timber has access to the land.

The right to cut and remove standing timber under the provisions of a timber contract or cutting contract is classified as "other personal property" in most states. Such an interest is not real property. This becomes apparent when you compare the legal requirements of a typical timber sale with those of a sale of land or buildings. Most states don't require timber sale contracts to be recorded to be enforceable, as required for reality. The sale of standing timber to be severed by the buyer within a reasonable period of time are subject to the provisions of the Uniform Commercial Code (UCC) in most states. The UCC covers a majority of commercial transactions. Applying it to timber sales facilitates commerce in timber, reducing the cost and complexity. There is, however, some variation among states.

Thus, if in your state timber to be severed by the buyer within a reasonable period of time is personal property, non-recognition will not apply if this interest is exchanged for real property such as land or other timber. It could be exchanged for other timber cutting rights of similar duration. There may be situations in which this is advantageous, but these would be unusual. It would be more advantageous if the timber rights could be exchanged for other personal property, say stocks or bonds. The rules are more restrictive, however, regarding personal property than for real property. The class of property that comes closest to timber contracts is nondepreciable personal property held for investment, but this category is limited to such things as antiques, collectibles, works of art, coin collections, and stamp collections. This category doesn't cover timber sales contracts.

There is no published precedent for exchanging timber contracts for anything other than other timber cutting contracts. Here's a list of exchanges that have been upheld by the courts or the IRS: timberland containing some virgin timber and substantial stands of second growth for timberland containing only virgin timber; timberland for bare land; improved land for unimproved land; real estate in a city for a farm or ranch; a Tree Farm in one state for timberlands in another state, rental property for farm property; and timberland with reservation of timber cutting rights for state-owned timberland of lesser value.

Approach with Caution

If you don't believe in ever saying never by all means seek out qualified legal counsel to assess the potential for a qualified exchange meeting your needs. But, I strongly advise against accepting at face value any deal offered to you by someone promising a tax free timber sale. You can uncross your fingers now and I'm sorry I can't be more optimistic.

The following article has been reproduced here from the "Tree Farmer" magazine with the permission of the American Forest Foundation, 1111 19th Street, N.W., Suite 780, Washington, D.C. 20036. (Telephone 202.463.2462)