afa income tax chapter 4

Forestry Operating, Management Forestry Operating, Management and Protection Expensesand Protection Expenses

Chapter 4Chapter 4

Forestry Operating, Management Forestry Operating, Management and Protection Expensesand Protection Expenses

• Deductions – expensingDeductions – expensing

• Hobby farm rulesHobby farm rules

• Forest management and protection costsForest management and protection costs

• Passive activity loss rulesPassive activity loss rules

• Reporting timber expensesReporting timber expenses

DeductionsDeductions

• A taxpayer may claim current deductions in A taxpayer may claim current deductions in computing “computing “taxable incometaxable income””

• Deductions from gross income are referred to as Deductions from gross income are referred to as ““above the line deductionsabove the line deductions” – e.g., business ” – e.g., business deductions or amortizationdeductions or amortization

• Deductions from adjusted gross income are Deductions from adjusted gross income are referred to as “referred to as “itemized deductionsitemized deductions””

ExpensingExpensing

• Itemizing deductions is advantageous only when Itemizing deductions is advantageous only when they exceed the standard deductionthey exceed the standard deduction

• Expenses are deductible only if authorized by Expenses are deductible only if authorized by statute, and may not be deducted twicestatute, and may not be deducted twice

• Certain expenses have been made non-deductible Certain expenses have been made non-deductible by “at-risk” limitations, passive loss rules, and by “at-risk” limitations, passive loss rules, and other public policiesother public policies

CapitalizationCapitalization

• Amounts paid for permanent improvements or Amounts paid for permanent improvements or restorations that have a useful life of more than restorations that have a useful life of more than one year are capital expendituresone year are capital expenditures

• Expenditures to establish or create an asset are Expenditures to establish or create an asset are capital in naturecapital in nature

• Examples include:Examples include:– ReforestationReforestation– permanent roads, buildings, fences, impoundmentspermanent roads, buildings, fences, impoundments

ExpensesExpenses

• Corporate and non-corporate businesses are Corporate and non-corporate businesses are allowed to deduct all allowed to deduct all “ordinary and necessary“ordinary and necessary” ” expenses incurred for the production or expenses incurred for the production or collection of income collection of income

• Investors may deduct expenses for Investors may deduct expenses for management, conservation, or maintenance of management, conservation, or maintenance of property held for the production of incomeproperty held for the production of income

• E.g., cost of prescribed burning, timber stand E.g., cost of prescribed burning, timber stand improvement, chemical release, and fertilizationimprovement, chemical release, and fertilization

Forestry Expenses Are Deductible Forestry Expenses Are Deductible If:If:

• Expenditures are for managing, maintaining, Expenditures are for managing, maintaining, and/or protecting timberlandand/or protecting timberland

• Activity is presumed for profit Activity is presumed for profit – IRC IRC § 162 for businesses and § 162 for businesses and – IRC § 212 for investorsIRC § 212 for investors

• Costs are “ordinary and necessary”Costs are “ordinary and necessary”

• Passive loss rules are satisfiedPassive loss rules are satisfied

Average Tax DeductionsAverage Tax DeductionsBased on AGI for 1999 (WSJ 3/20/02)Based on AGI for 1999 (WSJ 3/20/02)

AGI ($M)AGI ($M) Gifts ($)Gifts ($) Taxes ($)Taxes ($) Interest ($)Interest ($)

50-6050-60 1,8831,883 3,9193,919 6,8846,884

60-7560-75 2,1802,180 4,6334,633 7,4267,426

75-10075-100 2,6502,650 5,9125,912 8,3148,314

100-200100-200 3,7163,716 9,2769,276 11,00511,005

200-500200-500 8,4478,447 20,26120,261 17,74917,749

500-1,000500-1,000 20,82820,828 47,72047,720 29,32329,323

1,000+1,000+ 149,945149,945 187,792187,792 84,29884,298

Hobby Farm RulesHobby Farm Rules

• A timber activity is presumed to be for profit if A timber activity is presumed to be for profit if net income (profit) is earned from the property net income (profit) is earned from the property in any 3 of 5 consecutive yearsin any 3 of 5 consecutive years

• The converse is not conclusive; however, The converse is not conclusive; however, because profit includes appreciation in value, because profit includes appreciation in value, and expenses may still be deducted, if there is an and expenses may still be deducted, if there is an expectation of profitexpectation of profit

• The burden of proof shifts to the taxpayerThe burden of proof shifts to the taxpayer

Timber Operating CostsTimber Operating CostsEligibility For ExpensingEligibility For Expensing

• Property taxes – IRC Property taxes – IRC § 164 – deductible § 164 – deductible regardless of IRC §§ 162 or 212regardless of IRC §§ 162 or 212

• Interest – deductibility is limited to “net Interest – deductibility is limited to “net investment income” for the yearinvestment income” for the year

• Investment income is defined as gross returns Investment income is defined as gross returns from interest, dividends, annuities, and royalties from interest, dividends, annuities, and royalties plus net gain attributable to the disposition of plus net gain attributable to the disposition of timberland held for investmenttimberland held for investment

Forest Management Forest Management And Protection CostsAnd Protection Costs

• Operating costs include Operating costs include – Consulting forester’s and other professional feesConsulting forester’s and other professional fees– Hired labor, direct travel, and silvicultural costs Hired labor, direct travel, and silvicultural costs

E.g., timber stand improvement, prescribed burning, pre-E.g., timber stand improvement, prescribed burning, pre-commercial thinning, and cost of small toolscommercial thinning, and cost of small tools

• Business use of home office, if used as the Business use of home office, if used as the “principal place of business”, and there is no “principal place of business”, and there is no other fixed location where taxpayer conducts other fixed location where taxpayer conducts businessbusiness

Management Expenses Management Expenses (Continued)(Continued)

• Protection costs – from fire, insects, disease, and Protection costs – from fire, insects, disease, and timber trespass controltimber trespass control

• Timber cruises depend on purpose and timing:Timber cruises depend on purpose and timing:– If part of a purchase, it’s a capital expenditureIf part of a purchase, it’s a capital expenditure– If taken subsequent to acquisition, it is a business If taken subsequent to acquisition, it is a business

expenseexpense– If taken in conjunction with a sale, it is a cost of saleIf taken in conjunction with a sale, it is a cost of sale– But for investors who do not buy, it is not deductibleBut for investors who do not buy, it is not deductible

Carrying ChargesCarrying ChargesOptional Treatment of Forestry ExpenseOptional Treatment of Forestry Expense

• Taxpayers may elect to capitalize timber Taxpayers may elect to capitalize timber expenses, on a year-to-year basis, if property is expenses, on a year-to-year basis, if property is ““unimproved and unproductiveunimproved and unproductive” ”

• Election is made when deduction will not result Election is made when deduction will not result in a tax benefit by filing a statement with in a tax benefit by filing a statement with original returnoriginal return

• Caution: Elections on “developmental Caution: Elections on “developmental expenditures”, once made remain in effectexpenditures”, once made remain in effect

Passive Activity Loss (PALs) Passive Activity Loss (PALs) RulesRules

• Rules govern extent to which an operating loss Rules govern extent to which an operating loss from an activity for any year can be offset from an activity for any year can be offset against income from other sourcesagainst income from other sources

• Rules apply to individuals, estates, trusts, Rules apply to individuals, estates, trusts, personal service and closely held “C” personal service and closely held “C” corporationscorporations

• PALs do not apply to C corporations or directly PALs do not apply to C corporations or directly to partnerships and S corporationsto partnerships and S corporations

A Forestry ActivityA Forestry Activity

• A taxpayer must treat one or more business A taxpayer must treat one or more business activities, or one or more rental activities, as a activities, or one or more rental activities, as a single activity if it constitutes an “appropriate single activity if it constitutes an “appropriate economic unit” for measuring gain or losseconomic unit” for measuring gain or loss

• An AEU depends on ”all the relevant facts and An AEU depends on ”all the relevant facts and circumstances” – five factors are set forth for circumstances” – five factors are set forth for making this determinationmaking this determination

Reporting Timber ExpensesReporting Timber Expenses

• Non-corporate businesses are not required to Non-corporate businesses are not required to keep formal records, but adequate books are keep formal records, but adequate books are recommended as the business growsrecommended as the business grows

• Expenses are recorded on Schedule A, for Expenses are recorded on Schedule A, for investors; on Schedule C, for businesses; and on investors; on Schedule C, for businesses; and on Schedule F, for farmers of Form 1040, Schedule F, for farmers of Form 1040, Individual Income Tax ReturnIndividual Income Tax Return

• Passive activity is reported on Form 8582Passive activity is reported on Form 8582