Timberland Investment and Section 1031 Exchange
As a general rule, when you sell property and realize a profit from the sale, the gain is subject to capital gain taxes by the federal government as well as by many state governments. One way to avoid the immediate payment of capital gains taxes is to defer the payment through a Section 1031 exchange. In order for a transaction to qualify as a 1031 exchange, the transaction must be for “like-kind” property. When the property in question involves a timberland investment, the definition of “like-kind” can become less than clear.
Contract Right To Cut
Section 631(a) of the Internal Revenue Code covers the sale or exchange of timberland in general stating that it “allows a taxpayer who owns, or has a contract right to cut timber to elect to treat the cutting of timber as a sale or exchange of the timber in the year the timber is cut, provided the timber or the contract right to cut the timber is held for more than 1 year.”
One of the first important decisions regarding the use of a 1031 exchange for timberland investment was in Oregon Lumber Co. v. Commissioner, 20 T.C. 192 (1953). In that case, the taxpayer made an exchange of timberland for the rights to cut and remove standing timber from other timberland. The court held that “It is our conclusion that the right to cut and remove standing timber is so intrinsically different from a fee in land that an exchange of one for the other is not an exchange of like property within section 112(b)(1).”
More recently, however, in D.G. Smalley v. Commissioner, 116 T.C. No. 29 (2001), the court looked at a similar case wherein the taxpayer exchanged the rights to cut timber on his land for two years for a fee simple interest in three parcels of real estate. Based largely on the State of Georgia’s case law regarding timberland investments which holds as the prevailing view that “a conveyance of standing timber, to be severed by the buyer, generally constitutes a transfer of real property”, the court held that the taxpayer had a bona fide intent to complete a 1031 exchange and upheld the exchange. Although the court upheld the exchange, the court fell short of actually determining whether the transaction was a transaction for like-kind property, instead basing its decision on the taxpayers intent to enter into a like-kind exchange.
Whether or not an exchange of timberland will qualify for a Section 1031 exchange depends largely on how the applicable state law views timber and/or rights to timber. Where timber is viewed as real property, an exchange for a fee simple may qualify. In other states, however, where timber is not viewed as real property, an exchange for a fee simple is unlikely to be upheld.
To learn more about the benefits of a 1031 exchange for forest landowners, download the complimentary eBook by clicking on the button below.