November 2005 - 1031 Tax Exchange Newsletter

1031 Exchange Newsletter
November 2005

AN EXCHANGE – AND A PROFIT

A recent Private Letter Ruling demonstrates an interesting way in which related parties may exchange timberlands and also take cash out of the overall transaction.

A timber company (“Company”) which owns, manages and harvests timber and wood products is owned by our Taxpayer, his son, and trusts for Taxpayer’s lineal descendents.  Therefore, Company and Taxpayer are related parties.

Over the years, Taxpayer and his now deceased wife acquired timberland acreage for investment, upon which there is a large amount of old-growth timber.  Taxpayer wants to continue to hold timberland for investment.  Company, of course, wants to cut up and sell all of that wonderful old-growth timber.  Taxpayer and Company propose to enter into a 1031 exchange in which Taxpayer’s 100% interest in the old-growth timberland will be exchanged for company’s 100% interest in reproduction timberlands of equal value.  The exchange will allow Taxpayer to accommodate the business needs of Company, while continuing to allow Taxpayer to hold timberlands for investment.

The first issue discussed in the ruling is whether old-growth timberlands and reproduction timberlands are like-kind under section 1031.  The Service found that the age, quality and species of the timber growing on the land may influence the grade or quality of the timberland involved in the exchange, but it does not change the class or kind of the property being exchanged, which is land.  Accordingly, the Service found that the exchange between Taxpayer and Company of old-growth timberland for reproduction timberland constitutes a valid exchange under section 1031.

The second issue discussed is whether cutting the timber by Company within two years will trigger recognition of built-in gain, since the parties to the exchange are related parties.  Normally, a disposition of the property exchanged between related persons within two years will cause recognition of gain under section 1031.  Past rulings held that timber rights (conveyed by a timber deed) are akin to personal property and not like-kind to a fee.  The service pointed to an earlier revenue ruling which held that the cutting of timber does not trigger recognition of built-in gains.  Therefore, the service determined that the cutting of timber after the exchange is not a disposition that causes recognition of built-in gains.

After the exchange, and after cutting and disposing of the timber, Company will still own the underlying land that was exchanged in the transaction.  Cutting the timber will not trigger recognition of gain.  Therefore, both Taxpayer and Company enjoy the benefits of the 1031 exchange, and Company enjoys a profit from the disposition of the timber.