If you hold timber as an investment, you might want to make an election on your tax return to capitalize certain forest management expenses and carrying charges that would otherwise be wasted for federal income tax purposes. This provides a workaround to mitigate some of the adverse tax effects on timber investors arising from the 2017 tax law change.
Prior to the new legislation, forest landowners holding timber as an investment could claim itemized deductions for property taxes and interest expenses (limited to net investment income) related to the forest property. Additionally, you could claim deductions for ordinary and necessary forest management expenses via miscellaneous itemized deductions. Examples of these expenses include (but not limited to):
- Fees paid to consulting foresters
- Salaries of hired labor
- Costs of silvicultural practices such as prescribed burning and precommercial thinning, insect control, and disease control
- Costs of firebreak and road maintenance
- Travel expenses
- Costs of tools that have a short life or of small cost
Under the current tax law, timber investors are still allowed to deduct in full taxes paid on the forest property. If your aggregated itemized deductions exceed the standard deduction, you are better off itemizing property taxes and interest paid on the forest property. You can carry over any disallowed interest expense and use it in later years.
But in many cases, you may find it more beneficial to take the standard deduction rather than itemizing, since the standard deduction has almost doubled. Further, miscellaneous itemized deductions have been suspended from 2018 through 2025, meaning you can no longer deduct investment expenses via Schedule A.
Does this mean that you have to waste these deductions?
Fortunately, you can make an election under IRC Section 266 to add some of these timber-related expenses to the basis of your forest property. This will result in a smaller capital gain and lower taxes when you sell the property. You can get the benefit of the high standard deduction and still reduce taxes upon sale of the forest property.
You may elect to capitalize the taxes and interest expense on a year-by-year basis. But once you elect to capitalize necessary development-related expenses (e.g., costs for silvicultural practices and timberland stand improvement/maintenance), the election remains in effect until the development is completed. The election can be made only for years when you do not have income from the property (e.g., hunting lease, timber income, sale of pine straw etc.).
To make the election, you just need to attach a statement with your original tax return:
“For tax year 2020, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize property taxes, interest and other miscellaneous carrying costs on the property located in xxx county.”
The election cannot be made on an amended return. If you hold timber as an investment, we encourage you to speak with your tax advisor so you can fully understand your options and find the strategy that makes the most sense for your situation.