Income Tax
Considerations of
Timberland Investments
Korey Collins, CPA, Partner, Sellers
Richardson Holman and West LLP
Income Tax Considerations of
Timberland Investments
May 21, 2013
Timber Tax Basics
Timber investments are very attractive from a
tax standpoint
 As long as certain requirements are met
(discussed in next few slides), then income can be
taxed at capital gains rates
 Cost of managing the timber can be deductions
against ordinary income
 One of a very few structures to allow a variance in
tax rates between income and deductions
© 2012 McGladrey LLP. All Rights Reserved.
Timber Tax Basics (cont.)
The attractiveness of a timber investment
hinges on the application of IRC §631
 §631(a) allows for the cutting the timber for use
in the taxpayers business or for log sales
 Difference between value of the standing timber
and basis on the first day of the year in which it is
cut is capital gain or loss; further gain or loss from
cut and haul, and from merchandising, is ordinary
© 2012 McGladrey LLP. All Rights Reserved.
Timber Tax Basics (cont.)
IRC §631
 §631(b) allows for the sale of standing timber to
be taxed at capital gains rates
 Timber must be held for one year or more in
order for §631(b) to apply
© 2012 McGladrey LLP. All Rights Reserved.
Tax Issues of Certain Investors
Foreign and tax-exempt investors may have some
unique tax issues with a timber investment

Tax exempt investors generally are concerned with
unrelated business income tax (UBIT)


Timber sales under 631(b) generally don’t create UBIT, but
could if there is debt
Foreign investors generally are concerned about the
Foreign Investment in Real Property Tax Act (FIRPTA)
and/or the concept of effectively connected income
(ECI)

Both timber and land sales could create FIRPTA and/or ECI
© 2012 McGladrey LLP. All Rights Reserved.
Tax Impact of Business Structure
There are three main vehicles for timber
investments
 A separate account usually structured as a single
member LLC
 A pooled fund structured as a limited partnership
or sometimes as a LLC
 A pooled fund structured as a REIT
© 2012 McGladrey LLP. All Rights Reserved.
Business Structure (cont.)
Separate accounts structured as a LLC
 A LLC with a single owner is disregarded as a
taxpayer
 The LLC owner will incur any tax directly as if they
owned the timber property outright
 LLC structure is primarily for legal protection
© 2012 McGladrey LLP. All Rights Reserved.
Business Structure (cont.)
Pooled fund as a limited partnership
 Taxed as a partnership (i.e. flow-through entity)
 Partners take on the tax attributes of the
partnership
 Usually can be very flexible, and usually not
difficult to operate from a tax standpoint
 No significant limitations on operations or assets
 Could be burdensome for foreign or tax exempt
investors (UBIT and FIRPTA)
© 2012 McGladrey LLP. All Rights Reserved.
Business Structure (cont.)
Pooled fund as a REIT
 Taxed a hybrid entity with some corporate
attributes and some flow-through attributes
 In many cases, the REIT structure is a logical
method to reduce U.S. federal income tax
expense (for both foreign and tax –exempt
investors) and thus increase investor value
 Can be complex and administratively burdensome
(see REIT slides)
© 2012 McGladrey LLP. All Rights Reserved.
Taxation of a Partner in a LP
A limited partner will be treated as a passive
investor in the partnership
 All income and loss passes through to the partner,
the partnership pays no entity level tax (except
for some state tax in certain states)
 Timber sales under 631(b) and land sales are
capital gains, management expenses are ordinary
losses
 For UBIT and FIRPTA, the partner is considered to
be in the business of the partnership
© 2012 McGladrey LLP. All Rights Reserved.
Taxation of a Shareholder in a REIT
A REIT shareholder is considered an owner of a
corporate entity, with no “real” flow-through



As long as a REIT distributes 100 percent of its
income, it will not pay tax at the entity level and only
its shareholders will pay tax
REIT distributions are characterized for shareholder
tax reporting purposes based upon the underlying
activities conducted by the REIT
The taxability of shareholder distributions is based
upon REIT earnings and profits, which is an economic
measure of operating activities
© 2012 McGladrey LLP. All Rights Reserved.
Requirements for Obtaining &
Maintaining REIT Status
Pursuant to IRC §856(c), at least 75% of the
total value of a REITs gross assets must consist
of these three items:
1. Fee and lease interests in land, timberland,
mortgages on real estate and shares in other
REITs
2. Cash and cash items
3. Government securities
Requirements for Obtaining &
Maintaining REIT Status (cont’d)
The limitations under IRC §856(c) as to what the
other assets of a REIT can be are:
1. Not more than 25% of the total value of a REIT's
gross assets may be in the securities of one or more
taxable REIT subsidiaries (TRS), and
2. Not more than 5% of the total value of a REIT's gross
assets may be invested in the securities of a single
issuer, and the REIT may not own more than 10%
(vote or value) of the securities of any one issuer,
excluding TRSs.
Requirements for Obtaining &
Maintaining REIT Status (cont’d)
There are two income tests provided by IRC
§856(c)(3)
1. 75% of a REITs gross income must be from the
following sources:
a. Pay-as-cut or lump-sum timber sales
b. Rents from real property (including hunting, cell tower,
and sign revenue)
c. Interest on mortgages secured by real property
d. Gain from sale of shares of other REITs/dividends from
other REITs
e. Gain from sale of non-dealer real property
Requirements for Obtaining &
Maintaining REIT Status (cont’d)
2. 95% of a REITs gross income must be from the
following sources:
a.
b.
c.
d.
Dividends
Interest
Gain on sale of stocks and securities
Sources qualifying under the 75% test above
What are Typical Timber Tract
Operations in a REIT?
The following timber tract activities are typical in a
timber REIT and generally produce qualifying REIT
gross income:
1. Pay-as-cut timber harvesting (viewed as a royalty from
real estate)
2. Lump-sum timber sales (also viewed as a royalty)
3. Rental income from land uses such as hunting leases,
cell tower and signage
4. Sale of timberlands held for productive timber or
investment purposes
5. Some miscellaneous income such as sale of carbon
credits
What are Typical Timber Tract
Operations in a REIT? (cont’d)
Some timber tract activities would likely not be
considered qualifying income for a REIT and should
be avoided:
1. Log sales
2. Sale of timberlands that could be classified as “dealer
activity”
Case Study Question
What facts in the Blue Devil case should be
considered from a tax standpoint when deciding the
structure?
What structure do you think works best if there will be
debt in the fund?