Carrying charges are taxes, interest, and certain other expenses related to the development and operation of timber properties that may be treated as either deductible expenses or capital costs. Capitalized carrying charges are added to the timbers basis and are recovered by offsetting gain realized upon the sale or cutting of timber.
Under certain circ*mstances, expenses which would normally be deducted currently, can be capitalized. This treatment applies to the costs of holding property while it's being "developed" and the "development costs" themselves. This treatment is available cause while property, such as timberland, is being developed it generally is not producing income against which to offset expenses.
The election to capitalize carrying charges may be appropriate if you treat your activity as an investment. Some years your non-timber miscellaneous itemized deductions may not be sufficient to put you above the 2% of adjusted gross income floor. As such the benefit from your timber expenses would be lost in whole or in part. By electing to capitalize them as a carrying charge these expenses are added to the basis of your assets for eventual recovery. If not capitalized they could never be recovered for tax purposes.
How do they apply?
The regulations governing carrying charges don't specifically address timber, but they do provide general guidelines. Two classes of carrying charges are recognized by the regulations.
Holding costs - (those that can be elected on a year to year basis). Annual property taxes, interest on a mortgage, insurance premiums, and similar costs may be expensed or capitalized, as you choose, during any year in which your timberland is "unimproved and unproductive." Unimproved real property is generally defined as land without buildings, structures, or any other improvements that contribute significantly to its value. Forest land is unproductive in any year in which no income is produced from its use, such as from hunting leases, timber sales, or sale of forest products cut from timber. In any year your property is productive (income is received) you may not elect to capitalize these carrying charges.
Development costs - (those that must be treated consistently from year to year). The regulations also provide that the expenses for developing real property may be treated as carrying charges. This treatment is available whether the property is improved or unimproved, and whether productive or unproductive. However these cost must be treated the same each year. Non-commercial thinning and timber stand improvements (TSI) are classified as development expenses. Unless you are an investor who rarely meets the 2% floor, you would not want to lock-in and election to capitalize these costs. The lock-in of this treatment applies even if you neglect to formally elect this treatment on your return.
Making the election
Carrying charges are recovered by deducting them as operating expenses or by adding them to the appropriate capital accounts for recovery through depreciation, depletion, or allowable basis of stumpage disposed of. The items you elect to capitalize are listed in a statement filed with the original return for the taxable year for which the election applies. Include a statement to the effect that you are electing to capitalize these carrying charges and include information regarding the activity and associated project with which the charges are associated.
NOTE: If you did not deduct carrying charges in a particular year, it is not automatically assumed that you elected to capitalize these costs. Thus you are not permitted to go back and add to your capital accounts carrying costs which you did not deduct or elect to capitalize in previous years.
Carrying charges which you elect to capitalize are allocated to the capital accounts to which these costs apply. Non-commercial thinning and TSI costs are allocated in full to the timber accounts associated with the timber treated. Holding costs are allocated among all the assets held, land, timber, improvements, etc. A suggested procedure is to allocate the costs according to the bases of the accounts involved as of the beginning of the year.
