ers, however, it may be more advantageous--as dis- 
cussed above--to retain capital gain status rather 
than revoke the election. 
Deduction of Forest Management 
and Related Expenditures 
All timber establishment costs must be capital- 
ized. These can be recovered (deducted) only when 
the timber is cut or sold except as described next 
under the reforestation amortization provisions. Es- 
tablishment costs include those incurred for timber 
purchase, planting, seeds and seedlings, site 
preparation and related costs, and all practices nec- 
essary to ensure seedling survival. Virtually every 
other management cost may be either capitalized at 
the taxpayer's option or expensed--that is, deduct- 
ed from income each year as paid. Deductible ex- 
penditures include those incurred for silvicultural 
practices in established stands, protection, prop- 
erty taxes, interest, salaries, and professional ad- 
vice. Any ordinary and necessary business or in- 
vestment expense is deductible. 
Tax Reform Act Changes--The 1986 Tax Reform Act 
made a number of significant changes in the proce- 
dures associated with the expensing of operating 
costs and carrying charges. The changes impose a 
number of limitations on deductions. 
The new law mandates a system of rules intend- 
ed to limit, in certain cases, the ability of taxpayers 
to use deductions and credits attributable to one 
activity to offset income realized from other sources 
or activities. These rules are referred to as the "pas- 
sive loss rules." They apply to individuals, estates 
and trusts, as well as to personal service corpora- 
tions (i.e., Corporations the principal activity of 
which is the performance of personal services), and 
to certain closely-held corporations that are subject 
to the corporate income tax ("closely-held C corpo- 
rations"). For this purpose, a corporation is closely 
held if more than 50 percent of the value of its stock 
is Owned, actually or constructively, by five or fewer 
individuals. Except for these two specified cate- 
gories of corporations, the passive loss rules do not 
apply to corporations generally. They will begin to 
take effect in 1987. For those types of taxpayers 
subject to the rules, the 1986 Tax Reform Act cre- 
ates three relevant classes of properties or activities 
for purposes of expensing, or currently deducting, 
such items as management costs, taxes, and inter- 
est. The rules for deducting such costs will vary, 
106 
depending upon the category in which the 
particular timber activity fits. 
Trade or Business--The first category concerns tim- 
ber held as part of a trade or business in which the 
taxpayer materially or actively participates. In this 
instance, all operating costs and carrying charges 
are fully deductible against income from any source 
each year as incurred. Credits can also be applied 
to taxes associated with income from any source. 
Individuals can take the deductions on either 
Schedule C or Schedule F of Form 1040. 
Investment--The second classification concerns tim- 
ber held as an investment rather than as part of a 
business, with the taxpayer being either a material 
or active participant in the activity, and is applicable 
only to individual taxpayers. In this situation all oper- 
ating costs and carrying charges except property 
and other deductible taxes, and interest, are de- 
ductible against income from any source as "miscel- 
laneous itemized deductions" on the tax return--but 
only to the extent that, when aggregated with other 
"miscellaneous itemized deductions," the total ex- 
ceeds 2 percent of adjusted gross income. Other 
types of miscellaneous deductions include, but are 
not limited to, expenditures for tax return prepara- 
tion, safety deposit box rental, professional journal 
subscriptions, and investment advice. Such costs 
not expensed can, at the taxpayer's option, be capi- 
talized and recovered when the timber is sold. If not 
taken as either an itemized deduction or capitalized, 
they will be permanently lost. One word of caution 
is in order, however. The same expenditure cannot 
be used to meet the 2-percent threshold and also 
be capitalized. 
Property and other deductible taxes, such as 
severance and yield taxes, paid by an active timber 
investor are deductible in full each year against in- 
come from any source. Interest on indebtedness 
associated with a timber investment, however, is 
now deductible by active investors only to the extent 
of net investment income from all sources--not just 
timber--for the year. This rule is being phased in 
gradually over a 5-year period. Any such interest not 
deducted in a particular year may be carried for- 
ward indefinitely and deducted in later years when 
investment (portfolio) income--of any type--is real- 
ized. It may also be capitalized against future timber 
income. 
It is possible that most timber ownerships with 
some type of management activity that do not qual- 
ify as a trade or business in the traditional tax sense 
