Timber Investments for Foreigners and the New Component of Section
631(b)
By Professor Richard A.
Westin
University of Kentucky Law School, Lexington, KY
Nonresident alien investors who are physically present in the
United States for 183 days or more in the taxable year are subject to
capital gains taxation at a rate of 30% according to §871(a). If
they are in the United States for less than 183 days, their capital
gains are exempt. The exception is for real property. FIRPTA generally
requires 10% withholding on the sale by a foreign person of any U.S.
real property interest, which includes interests in mines, wells and
natural deposits, but not timber. Assume a foreign person owned a
large tract of heavily forested land. Can she sell the standing timber
apart from the land and claim a nontaxable gain, given that, absent
FIRPTA issues, foreign persons are not subject to taxation on their
capital gains, including short term gains? Would it matter if the
standing timber were held for sale in the ordinary course of the
foreign individual's business?
It would appear that the answer is “yes.” In order to
achieve this result, the taxpayer will have to sell the timber apart
from the land on which it is located, either by a separate agreement
or by a clause or clauses in the sale contract identifying the timber
as a separate asset, with a separate valuation. Prudence dictates
getting a professional appraisal in order to substantiate the claim,
both to satisfy the buyer as to how much he must withhold and to
successfully conclude an IRS examination.
The same favorable result would appear to be true even if the sale
were of trees that were on an urban lot. The reason is simply that
under a recent change to §631(b), sales of standing timber are
per se sales of capital assets if held for over a year (and assuming a
gain in all hotchpot assets). This, however, poses a trap because
§631(b), as amended by the Jobs Act, treats §631(b) sales as
sales of “hotchpot” (§1231) assets if the timber is
held over a year and, in turn, §871(a) imposes the 30% tax on
gains realized on disposing of timber if those sales are reached by
§631(b).
So, it seems that for the private foreign investor in U.S. timber,
the solution to avoiding FIRPTA and capital gains taxation is to
report short-term capital gains. That is fine in theory but trees
usually require long holding periods to assure a financial gain. One
solution would be to obtain a long-term option to buy the timber. The
timber will get a new holding period on exercise of the option. The
option path gives the investor the choice of selling the option or
closing it and selling the timber. The caution here is that the option
price should not be so high that the investor could be viewed as being
under an economic compulsion to exercise it. In such a case, the IRS
can fairly argue that the investor held the timber for the period that
included the option's term.
For more information, in the Tax Management Portfolios, see
Rubin and Hudson, 912 T.M., Federal Taxation of Foreign Investment
in U.S. Real Estate, and Edwards, 610 T.M., Timber
Transactions, and in Tax Practice Series, see ¶2650, Taxation
of Timber, ¶2640, Miscellaneous Natural Resource Issues, and
¶7120, Foreign Persons' U.S. Activities.
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