Are you a timber company that’s recently purchased timberland, plans to make significant investments in timberland ownership, or has significant timberland holdings that produce taxable income?
If so, your approach to timber depletion is one of the more significant planning areas to garner potential tax savings or deferrals. Various methods can be used to recover the cost basis of your investment in timber assets. The recognition of these expenses for accounting and tax purposes occurs as the timber is harvested.
At the end of the day, the goal is to establish a method that increases current cash flow on the front end by reducing your current tax liability, which ultimately frees up cash to reinvest in your operations.
Purchase Price Allocation
Depletion methodology starts with the original purchase price allocation of a timberland acquisition to timber, land, and other identifiable property. Finding the appropriate balance of complexity within your approach and ascertaining the benefit provided can often be a detailed but flexible process. Here are some things to consider:
- Initial allocation of purchase price. Look at allocations of value to timber and other timberland-related assets, such as land, roads, and timber age classes.
- Determination of depletion pools. After allocating a portion of your cost to timber, you can not only divide that timber asset into merchantable and premerchantable timber, but also establish any number of viable depletion pools. Many factors can come into play when allocating cost basis to these pools, which are used to determine the expense recognized upon harvest of the timber within a pool. Examples of considerations are species, geographic boundaries or accessibility, restrictions of rights or lack thereof, harvest plan, even or uneven age management, or surrounding economic conditions. This can be an interesting process with varying degrees of complexity.
As you think through an initial purchase price allocation and the creation of timber depletion pools, here are some factors that might impact your decision:
Carbon credits. There may be different ways to think about how monetization opportunities reflect the ability of standing timber to sequester carbon. Consider any future emission reduction projects that might impact an initial purchase price allocation.
Riparian zones. These are ecological, restrictive areas of land along the banks of rivers, streams, creeks, or other bodies of water.
Conservation easements. An easement can be timberland that’s voluntarily donated or sold by the landowner. It constitutes a legally binding agreement that limits certain types of uses or prevents timber harvesting or development from taking place on the land.
Accessibility of timber. Consider road systems and logging methodologies. Also look at how you might allocate cost basis differently to various components, including timber, depending on accessibility.
Other considerations. Restrictions related to political agenda, timber stand boundaries, proximity to urban and other geographic areas, and ecological constraints—such as set asides for owl management circles or other wildlife protection—may also have an impact on initial allocations.
As you determine whether assessing depletion alternatives might be beneficial to your company, ask these questions:
- Are you actively seeking investment in timberland property?
- Are you engaging in regular timber purchase and sale transactions?
- Does your timberland property include multiple species?
- Does the timber on the property have a variety of age classes?
- Do you plan on having an aggressive harvest plan or do you have a long-term holding mindset? (Or perhaps you’re somewhere in between.)
- Does the ultimate taxpayer generate net taxable income, and would that taxpayer benefit from alternative depletion methodologies or strategies?
The last question is of particular importance because a large purchase with long-term prospects has more value if you speed up the depletion, freeing up cash flow you can reinvest in timberland acquisitions or other business investments. These timberland owners are more likely to benefit from analyzing the allocation of cost basis to various depletion pools. On the other hand, you’re less likely to find value if your plan is to purchase and harvest timber in the short term or if there’s no taxable income to offset (for owners with passive loss carryovers or tax-exempt owners, for example).
Timber depletion is limited to your total cost basis in timber. You wouldn’t deplete your timber in full until you’ve harvested all of the applicable standing timber. Here’s a very simplified example: If you have $1 million of cost basis in your merchantable timber and you have 5,000 MBF (thousand board feet) of standing merchantable timber, you would deplete $1 million of cost over that 5,000 MBF of timber. For every MBF of timber harvested, you would deplete $200 of merchantable timber cost basis.
The goal is to optimize your cost allocation process between merchantable timber and other asset categories in order to create the most appropriate economic result that accomplishes your business’s financial and tax objectives. With that goal in mind, this thought process is often meant to reduce your current tax liability and increase current cash flow. It’s important to remember that you may be able to change your depletion method at a later date if the situation warrants it—you aren’t necessarily locked in.
Many timber companies take the simplest approach, which might not be the wrong approach in their circumstances. However, in some situations, it may be advantageous to look at alternative ways to bifurcate timber depletion pools to achieve the best financial results.
There are typically two reasons companies evaluate alternative depletion options:
- Motivation from a tax perspective. A company wants to influence its deductions for tax purposes by depleting timber cost basis in a way that either accelerates deductions to minimize tax liability, optimizes capital gain income from timber harvesting, or a combination of both objectives.
- Financial statement perspective. It’s possible for a company to recognize less expense on its financial statements than on its tax returns by using different methodologies to report depletion. This may create book-tax differences, but for financial statement purposes it presents higher remaining assets and stronger operating results. The policy for financial statement reporting would be part of the footnote disclosures.
It’s difficult to understand the value of this thought process until you’ve taken some time to analyze your alternatives. While selecting a depletion methodology is an opportunity for thoughtful analysis, it may also require additional commitment, due to additional administrative and record-keeping requirements.
The complexity of the process can be driven by the targeted benefit. It does generally require a tax appetite in order for the benefit to be worth the commitment of cost and time.
We’re Here to Help
There are multiple factors to consider depending on your company’s particular situation when it comes to depletion. It’s important to note any methodology you choose will hinge upon your company’s tax and financial goals—and those goals can oftentimes be different. Contact your Moss Adams professional if you’d like to assess your situation to see if an alternative depletion methodology will better address your financial goals.