Cost Basis – What is It and How Do I Use It?

Cost Basis is a complex issue with numerous ramifications, pitfalls and planning opportunities. *

Generally, one of the primary deductions you can take against timber sale proceeds is your cost basis.  The original basis of property is usually its cost, along with any other expenditures incurred to acquire the property. The cost is the amount you pay in cash, debt obligations, or in other property. (National Timber Tax website – www.timbertax.org)

This cost basis is used to calculate the depletion unit needed to determine the taxable gain (loss) when you sell timber on the stump, cut timber, or dispose of it involuntarily, such as by a casualty, theft, or condemnation.

Although the calculations and what is included in basis may differ between investors in timber and those that hold it as a trade or business (discussed in a previous issue of the Woodland News) the overall thought process is similar.  For the purposes of this discussion we will focus on the investor, but much of this discussion would apply if you are in the trade or business of selling timber.

Your original cost basis depends on how you acquired your timber asset.

• If you inherited the property, the basis is generally the property’s value on the date of the decedent owner’s death.
• If you acquired the property by gift, the basis is generally the basis the donor had when giving it to you.
• Finally, if you purchased the property, the basis is the amount paid to the seller plus expenses.

While this may seem straight forward, without a good timberland appraisal at the time of acquisition it is often very difficult to estimate the portion that applies to the timber and ultimately to the timber sold.  In an ideal situation, you would have a timberland appraisal that identifies each of the components of value for a property and provides an allocation of the value to each of these components.  In this manner, you can readily see the allocated value for the timber and pulpwood on a property.  Without such an appraisal, the steps become much more difficult, however, the Internal Revenue Service seems willing to accept a reasonable approach to estimating the basis in your timber.

Let’s use an example.  Say ten years ago you bought a home and 100 forested acres for $100,000 and you do not have an appraisal showing the values of the various components that you acquired, but with hindsight and “growing” the timber backwards based on what is there today, and using values from ten years ago, you arrive at the following estimates:

A quick review of the assumptions, ten years ago at acquisition: the house was worth $50,000; the 100 acres of land was worth $300 per acre or $30,000; the property had 140 thousand board feet (MBF) of sawtimber worth $200 per MBF or $28,000; and the property had 2,000 tons of merchantable pulpwood worth $2,000, or an actual total component value estimate of $110,000.

However, you only paid $100,000 for the property. (Note it is often true in appraisals of real property with various components that the sum of the component parts exceeds the market value.)  Using the percent of component value we can estimate the share of basis for each of the components.  In this example, your original basis in the sawtimber is $25,455. So today, if you sold half of your timber your deduction for basis would be half of that or $12,727.

It is not often that simple, however. Let’s say that after you purchased the property you needed to do a title abstract.  It could be argued that this cost should be allocated to each of the components based on the percent of component value.  On the other hand, what if your woodlot required an herbicide treatment, then arguably this cost should be allocated only to the timber (or 93% to the sawtimber and 7% to the pulp in the above example).  Similarly, a new addition on the house would most likely only be added to the basis in the house.  A similar rationale can be made for other improvement costs, including surveys, internal roads, timber stand improvement work, etc.  The landowner / taxpayer should look to why the cost was incurred and which assets benefited.

Here’s one often asked question: If I spend 10 hours improving my woodlot and I am worth at least $20 per hour (ask your spouse) can I capitalize and later deduct this $200 of value? No, only if you pick up the $200 as income when you did the work.  So if you paid a forester $200 then you could.

Another twist to the numbers:  In our original basis calculation you purchased 140 mbf of timber with a total basis of $25,455 or $182 per MBF.  In ten years your timber may well have grown to

190 mbf but your basis is still $25,455 or $140 per MBF.  This is one of the issues encountered in Form T, discussed in an earlier issue of Woodland News.  Much of the units in Form T are in $/MBF – so – while your total basis may remain constant, your basis per MBF becomes lower as your timber grows.

In future articles on timber taxation we will discuss the timing of expenses, end of the year tax strategies and timber sale timing.  In the meantime, feel free to contact the folks at FORECON, Inc. for your forestry and timber related issues.

*Note, the following is merely an overview and professional tax advice is highly recommended.