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Ann’s father was a long-time investor in South Carolina timberland. Last year, Ann inherited a third of all the property and is now inundated with managing multiple Limited Liability Companies (LLCs), tracking down what her CPA calls “basis,” property valuations, and figuring out why she is taxed differently depending on whether she sells timber versus selling firewood: It’s just the same wood, right?
Fitting your timberland into your financial plan can be difficult. In your mind, the 270 acres by the river will be your kids’ college fund. Or maybe you want the grandchildren to inherit the family cabin where the annual summer vacation takes place.
Some considerations for including timber ownership in your financial plan include:
Build a Net Worth Statement
While most investors view their real estate separately from their stock and bond portfolio, it helps to list them together. Create four categories on a spreadsheet: cash, stocks, bonds, and real estate. In many cases, the value of the land, or the “dirt,” has now become more valuable than the trees that grow on the land.
Ideally, there would be a logical balance among the four groups. Do you have four times as much illiquid real estate as you do liquid assets? Do you have sufficient cash to manage expenses? Are you what is commonly referred to as being “land rich, cash poor?”
Liability Protection: Keep Business and Personal Separate
If a logger loses a hand while working on your property, or a hunter is shot in the leg, there is a good chance you will find yourself named in a lawsuit. It is vital to use entities to separate your personal assets from your business ones.
Liability protection often involves forming an LLC and putting the property in the name of the LLC. You will also want to open a bank account from which you transact all the LLC’s business. However, you will want to balance cash levels in the account to fund LLC expenses (while not maintaining too much cash in the event of a lawsuit).
Commercial liability insurance also provides a means of liquidity to pay for lawsuits. If you have a hunting organization leasing your land, do not sign a lease until you see proof of their own hunting lease liability policy.
Planning For Taxes on Timber Income
An expert accountant will help you keep track of the basis in your property, walk you through the mechanics of a 1031 exchange, and explain the difference between selling timber and selling firewood: selling firewood is considered a business activity and creates ordinary income taxes, while selling timber most often creates long-term capital gains.
Keeping clear records of the basis and valuation of your timber will save you headaches and taxes down the road. If you inherit land, ensure you obtain a date-of-death appraisal from a qualified appraiser. An appraisal often requires a timber cruise where a qualified forester conducts an analysis of the timber on the property to determine its fair market value. A good accountant will also help you understand how to make quarterly tax payments based on the timber income you received throughout the year. You may even want to take special distributions from the entity account for the sole purpose of covering the tax bill. You do not want any penalties or surprise tax bills in April.
Leaving a Legacy
If your goal is to leave the land for future generations to enjoy, you may want to consider conservation easements. A conservation easement is a legal agreement that permanently limits how land can be used to protect its natural, scenic, or historic value while the owner keeps the property. There can be significant tax benefits to placing your property in a conservation easement. But fair warning, the IRS heavily scrutinizes conservation easements and levies heavy penalties. Ensure you work with advisors who are experienced and qualified so that you do not run afoul of the IRS.
If your desire is for the grandchildren to enjoy the land long after you are gone, you can create an estate plan that allows them to be members of the entity owning the property. Having a formal operating agreement for the entity would govern the rules around managing the property, providing a structure for the next generation to work with.
For owners of timberland, integrating your timber plan into your personal financial plan can affect your family for generations. Whether funding a college education or making summer memories hunting from the family cabin, building a financial plan that includes your timber is crucial to achieving your goals.
Frequently Asked Questions
If you’ve owned the timber for more than a year and hold it as an investment, income from selling standing timber is generally taxed as a long-term capital gain. Income from cutting and selling products yourself, such as firewood or pine straw, is generally considered business income and taxed as ordinary income. A tax professional can confirm how the rules apply to your sale.
The basis of inherited land and timber is its fair market value on the date of the previous owner’s death. An appraisal or timber cruise from around that date helps document it, which lowers the taxable gain when you later sell timber or land.
Many landowners hold timberland in an LLC to help separate the property’s liabilities from their personal assets. Using a dedicated bank account, carrying commercial liability insurance, and having a written operating agreement are also important. An attorney can help you decide whether an LLC fits your situation.
A conservation easement is a legal agreement that permanently limits how land can be used to protect its natural, scenic, or historic value, while the owner keeps the property. Donating an easement may provide tax benefits, but the rules are complex and should be reviewed with qualified advisors.
Land held for investment or business use, including timberland, can generally be exchanged for other like-kind real property under Section 1031, which defers the capital gains tax. Exchanges have strict timelines and rules, so plan them with your accountant before you sell.
