Timber real estate investment trusts (REITs) are a unique segment of the real estate industry that offers exposure to timberland investments. They combine aspects of real estate ownership with natural resource management. Timberland has long been considered a stable, inflation-hedged asset, but timber REITs bring these benefits to a wider pool of investors by providing an accessible vehicle to invest in timberland without the need to directly own or manage forests.
What Are Timber REITs?
A timber REIT is a special tax entity that owns, operates, or finances timberland properties. These properties are managed to produce and sell timber, a renewable resource used in various industries, including construction, paper production, and energy. Timber REITs typically generate revenue from two primary sources:
- Timber Gains: The cutting and sale of standing timber, which can be a mix of hardwood or softwood, depending on the region and type of forest.
- Land Appreciation: Timberland properties can appreciate in value over time.
Timber REITs allow investors to benefit from timberland investments without the need to actively manage forests, a trade that requires focused knowledge of land management and sustainable forestry practices.
Structure & Operations of Timber REITs
Timber REITs are structured similarly to other REIT types. REITs must elect to be treated as REITs for tax purposes. By law, they must distribute at least 90% of their taxable income to shareholders as dividends, making them an attractive option for income-seeking investors. The main difference between timber REITs and traditional REITs (which focus on properties like office buildings or shopping malls) is the underlying asset – timberland. Timber REITs are also subject to the special tax provisions relevant to the timber industry that interplay with the REIT rules under 26 U.S.C. 856, 857, 631(a) and 631(b).
Timber REIT Qualifications
Timber REITs follow many of the same qualification requirements as standard REITs. REITs are subjected to an asset requirement whereby at least 75% of a REIT’s asset value must consist of real property, cash and cash items, and government securities. With respect to timber REITs, qualifying real property includes raw land and unsevered natural products and deposits, i.e., trees.
Timber REITs may own non-qualifying assets and operate non-qualifying timber trades or businesses through taxable REIT subsidiaries (TRS), e.g., timber product manufacturing businesses. The value of the TRS securities held by a timber REIT cannot exceed 20% of a timber REIT’s total asset value.1
A timber REIT is subject to the same income requirements as its standard REIT counterpart. Ninety-five percent of a REIT’s gross income must consist of qualifying income (95% income) such as dividends, interest, rents from real property, and gains from the sale of real property that is not held for sale to customers in the ordinary course of the REIT’s trade or business. 2 Further, a REIT must derive at least 75% of its gross income from qualifying income (75% income) such as rents from real property and gains from the sale of real property that is not held for sale to customers in the ordinary course of the REIT’s trade or business.3
Timber Income Taxation – In General
When property is held by a taxpayer in the ordinary course of its trade or business, the gains from the sales of such property would normally be ordinary. Timber organizations benefit from special tax code rules regarding cutting and/or selling of their standing timber property.
Under §631(a), a taxpayer is entitled to make an election to treat, as a sale or exchange, the activity of cutting standing timber owned for greater than one year. The gain to be recognized under §631(a) is equal to the difference between the fair market value (FMV) as of the first day of the taxpayer’s taxable year and the adjusted depletable basis of the timber. The gain is recognized in the year in which the timber is cut (not sold). The FMV then serves as the cost basis to the taxpayer when the timber is eventually sold. Such gains qualify for capital gains treatment under §1231.
Under §631(b), timber owners who sell standing timber outright or with a “retained economic interest,” i.e., pay-as-cut contracts, the gains from such sales are treated as a sale or exchange of property, qualifying for capital gains treatment under §1231, so long as the timber was owned for greater than one year. It is important to note that the sale must be of standing timber, or in other words, the trees must still be on the stump. If the taxpayer cuts their own lumber, they must make the election under §631(a). No election is necessary to qualify for §631(b).
Timber Gains – REITs
REITs are subject to special rules that penalize them from engaging in certain transactions. The code4 imposes on REITs a 100% tax on the net income derived from their prohibited transactions.5 Gains from the sale of real property held for sale in the ordinary course of the REIT’s business qualify as one such prohibited transaction and subject to this tax. However, the code provides standard REITs with a safe harbor under §857(b)(6)(C) to test whether their real estate asset sales qualify as a prohibited transaction.
Timber REITs are provided with their own safe harbor under §857(b)(6)(D), as their assets are unique and operate differently from a standard REIT. Sales of standing timber by a REIT will not qualify as a prohibited transaction so long as it meets a six-part test:
- The REIT must hold the standing timber or timberland in its trade or business for under two years.
- Aggregate expenditures, includable in the basis made improving the timber or timberland or expenditures made directly related to operating property to produce timber or preserve timber, cannot exceed 30% of the net selling price of the timber or timberland. Such costs include land leveling, costs incurred establishing a stand of timber, fire prevention costs, and managing insects and diseases.
- Aggregate expenditures, includable in the basis made improving the timber or timberland or expenditures made not directly related to operating property to produce timber or preserve timber, cannot exceed 5% of the net selling price of the timber or timberland, e.g., interest, taxes, and overhead.
- The REIT makes less than seven sales of property or;
- The total adjusted bases of the sold property during the tax year does not exceed 10% of the total basis of REIT property at the beginning of the tax year or;
- The total FMV of the sold property during the tax year does not exceed 10% of the total FMV of REIT property at the beginning of the tax year or;
- The total adjusted bases of the sold property during the “three-year average adjusted bases percentage”6 does not exceed 20% of the total basis of REIT property at the beginning of the “three-year average adjusted bases percentage,” or;
- The total FMV of the sold property during the “three-year average fair market value percentage”7 does not exceed 20% of the total basis of REIT property at the beginning of the “three-year average fair market value percentage.”
- If the REIT makes more than seven property sales, substantially all of the marketing expenditures with respect to the property were made by an independent contractor or a TRS, and
- The sales price of the timber is not based on income or profits.
As long as the prohibited transactions’ safe harbor under §857(b)(6)(D) is met, §631(a) and §631(b) permit timber REITs to account for these gains as qualifying income for the purposes of satisfying the §856(c)(2) and §856(c)(3) 75% and 95% income tests. However, a Timber REIT must conduct the cutting of the standing timber through a TRS to qualify its §631(a) gains as qualifying REIT income.
Gains recognized by the REIT under §631(a) and §631(b) and subsequently distributed to the shareholders qualify as capital gain dividends to those shareholders, so long as the REIT designates them as such pursuant to §857(b)(3)(A) and (B).
Finally, for the purposes of qualifying for the 75% and 95% tests, gains that would otherwise constitute gains under §631(a) and §631(b) but fail to meet the one-year holding requirement are also considered qualifying REIT income. However, these gains would not enjoy capital gains treatment.8
It is also important to note that a REIT cannot directly engage in the selling of “cut” timber or finished timber products, nor directly engage in trades or businesses conducting timber product manufacturing or other down-stream timber businesses. These types of operations would need to be conducted via a TRS of the REIT subject to the 20% test in §856(c)(4)(B)(ii).
Timber REITs & Carbon Emission Offsets
With the ongoing proliferation of environmental improvement initiatives in the real estate industry, carbon sequestration payments or carbon emission offsets have gained popularity in the timber REIT space. Recent IRS private letter rulings (PLRs) have addressed the question of whether certain carbon emission offsets issued by a greenhouse gas (GHG) registry to a timber REIT are considered “good” income for purposes of the REIT’s income tests under §856(c)(2) and (c)(3).
In PLR 202401011, a REIT’s LLC subsidiary (taxpayer) held title to a portion of the REIT’s timberland. The taxpayer would participate in a carbon sequestration program whereby a GHG registry would issue credits to the taxpayer based on the quantity of carbon that can be sequestered from the atmosphere at the site. The credits issued to the taxpayer would then be transferred to an intermediary, which would market them for sale to third parties. During such time, the taxpayer bears the benefits and burdens of ownership of the offsets. Income derived from the offsets serves to compensate the taxpayer for its loss in revenue and value stemming from the land-use restrictions placed on the standing timber. In the PLRs, the taxpayer intends to include the FMV of the offset in its gross income upon issuance. They further intend to treat any subsequent gain or loss from the ultimate sale of the offsets as non-qualifying income under §856(c)(2) and (c)(3).
In the ruling, the IRS states that the offsets are analogous to compensation received for the granting of an easement on real property for a stated term, as the taxpayer agrees to restrict the use of its land and real property (timberland) for a limited term of years. The IRS concluded that the taxpayer’s treatment of the offset income is qualifying income under §856(c)(2) and (c)(3) as it does not appear to violate Congress’ objectives in implementing the REIT tests under §856. Further, the IRS concluded that the income would be recognized at the earlier date the offsets are earned, received, or due.
In PLR 202404002, the facts are mostly like those in PLR 202401011, except that the taxpayer acquired timberland from a third party that already had an agreement with an intermediary for the sequestration of carbon and was subject to a carbon offset program. The IRS came to the same conclusion in PLR 202401011 for the offsets earned by the taxpayer. However, the IRS expressed no opinion on the income earned or issued to the site's previous owner, but later received by the taxpayer after coming into ownership of the site.
It is worth noting that the IRS also issued no opinion or guidance on whether the subsequent sale of the carbon offsets to third parties would qualify under the REIT income tests or if these sales would constitute a prohibited transaction under §857(b)(6)(D). As the REIT will have a tax basis equal to the value reported as income, any sale or taxable distribution shortly after receipt should result in little or no gain.
Insight From Forvis Mazars
Timber REIT taxation and qualification are complex, and certain transactions still carry some uncertainty. Uncertainty surrounds the treatment for cutting timber under §631(a) or selling the standing timber under §631(b) held for greater than one year but less than two. Would such a transaction fail the two-year holding under the §857(b)(6)(D) prohibited transaction safe harbor, or does the sale or exchange capital gains treatment in §631 override the §857 prohibited transaction tests? Further, it is unclear whether a carbon credit offset with long-term restrictions placed on timberland should be treated as a sale of the portion of the property restricted. Finally, is a carbon emission offset credit a good REIT asset under §1.856-10 for purposes of the asset tests? The carbon offset credits do not appear to meet the requirements to be treated as a real estate asset, as they seem separable from the real estate since they are transferable, and produce income from sales other than real estate income.
Timber REIT organizations should consult with their tax advisors on their transactions due to the many intricacies of the REIT rules and how they interplay with the timber industry. If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.