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Rev. Rul. 61-56, 1961-1 CB 243

REV-RUL, Gain or loss upon the disposal of timber under cutting contract., Rev. Rul. 61-56, 1961-1 CB 243, (Jan. 01, 1961)

SECTION 631.--GAIN OR LOSS IN THE CASE OF TIMBER OR COAL

26 CFR 1.631-2: Gain or loss upon the disposal of timber under cutting contract. An amount received by the fee-owner of certain timber from the default of a cash performance bond posted by a grantee under a contract involving the cutting and disposal of timber, is not an amount realized from the disposal of timber under section 631(b) of the Internal Revenue Code of 1954 and is taxable as ordinary income.

Advice has been requested whether income resulting from default of a performance bond posted by a grantee under contract involving the cutting and disposal of timber constitutes gain on the disposal of timber within the purview of section 831(b) of the Internal Revenue Code of 1954.

The fee-owner of certain timber entered into a contract under which a second party was granted the right, license and privilege to enter upon the timber lands and cut and remove all merchantable timber within a stated period of time. All the timber involved in the contract had been owned or held for more than six months before the contract was entered into. All timber cut and removed was to be paid for at a specified price per thousand board feet. The measurement of the logs after removal from the land was to be done by an independent scaling agency whose measurement report constitutes the basis for determining the amounts due the owner. Title to the timber was not to pass until the timber was actually severed and removed from the land.

The contract required the tender of a cash deposit as security for the performance by the second party, the grantee. This deposit was to indemnify the owner of the timber lands against a default by the grantee. If the grantee complied with all the covenants and agreements, the security deposit was to be repaid one-half upon the expiration of the third year of the agreement and the remaining one-half upon the expiration of the fourth year of the agreement.

In the event that (1) the grantee failed to make a required payment within a stated time, (2) default was made by either the grantor or the grantee in the observance or performance of any condition under the contract, or (3) either party became involved in financial difficulties evidenced by its making an assignment for the benefit of its creditors, or by the appointment of a receiver for all or a substantial part of its assets, or by the filing of a petition of bankruptcy, or by its being adjudicated a bankrupt, then the party not in default could terminate the contract.

In the instant case, the contract between the parties was a contract for the disposal of the standing timber with a retained economic interest in the grantor.

Section 631(b) of the Code provides that in the case of the disposal of timber held for more than six months before such disposal, by the owner thereof under any form or type of contract by virtue of which such owner retains an economic interest in such timber, the difference between the amount realized from the disposal of such timber and the adjusted depletion basis thereof, shall be considered as though it were a gain or loss, as the case may be, on the sale of such timber.

Section 1.631-2(a)(2) of the Income Tax Regulations states that, in the case of such a disposal as that provided in section 631(b) of the Code, the provisions of section 1231 of the Cody apply and such timber shall be considered to be property used in the trade or business for the taxable year in which it is considered to have been sold, along with other property of the taxpayers used in the trade or business so defined in section 1231(b), regardless of whether such timber is property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Whether gain or loss resulting from the disposition of the timber which is considered to have been sold will be deemed to be gain or loss resulting from a sale of a capital asset held for more than six months will depend upon the application of section 1231 to the taxpayer for the taxable year.

Under the foregoing facts and law, an actual disposal of timber would qualify for section 631(b) treatment. However, in the event of the grantee's default by reason of which the grantor would receive payment of an amount under the cash performance bond, such amount would not constitute payment for the disposal of timber and would be taxable as ordinary income to the grantor.