will be categorized as such when the regulations 
governing deductions are written by the Internal 
Revenue Service. If that does occur, the restrictions 
outlined above for investment deductions will be 
largely inapplicable to forest properties. 
Passive Participation--The third situation involves 
passive participation in a timber "trade or business," 
which is defined to include not only a trade or busi- 
ness in its usual sense but also activities not rising 
to the level of a trade or business but nevertheless 
entered into for profit, such as timber investments. 
If passive involvement began after October 22, 
1986, management costs, property taxes, and inter- 
est can be expensed only to the extent that, when 
aggregated with all other passive activity expenses 
for the year, the total does not exceed total passive 
income from all sources for the year. Also, credits 
may be applied only to taxes associated with pas- 
sive income. Certain closely-held corporations are 
the only exception to this rule. In some situations, a 
closely-held corporation may offset passive ex- 
penditures and credits against both active and pas- 
sive income, but not against portfolio income such 
as dividends and interest. If passive timber activities 
began before October 23, 1986, they are subject to 
a 5-year phase-in period before the new rules be- 
come fully effective. During this time, some operat- 
ing costs and carrying charges will be deductible 
against nonpassive income. Passive expenditures 
and credits that cannot be expensed or used in the 
year incurred may be carried forward indefinitely 
(suspended) and deducted in later years when pas- 
sive income--of any type--will be realized. They may 
also be capitalized against future timber income. 
The passive interest rules will apparently apply to 
the reforestation amortization and credit. 
The Distinction Between "Material," 
"Active," and "Passive" Participation--For individu- 
als, the preferred tax status would seem to be as a 
material or active participant in a trade or business. 
Ostensibly, unless this status is achieved, the de- 
duction of some expenses attributable to the grow- 
ing and holding of timber will either be deferred or 
lost forever. 
There are many unanswered questions in trying 
to determine what "passive participation" means 
with respect to a timber investment or business. The 
new law indicates that the ownership of a timber 
stand will not constitute a "passive activity" if the 
owner "materially participates" in the operation of 
the property. 
With respect to material participation, the new 
statute provides that, 
A taxpayer shall be treated as materially partici- 
pating in an activity only if the taxpayer is in- 
volved in the operations of the activity on a basis 
which is -- 
(A) regular, 
(B) continuous, 
(C) substantial. 
The conference agreement which preceded 
passage of the new law discusses the concept of 
"material participation" in several respects relevant 
to timber owners: 
A taxpayer is likely held to be materially partici- 
pating in an activity, if he does everything that is 
required to be done to conduct the activity, 
even though the actual amount of work to be 
done to conduct the activity is low in compari- 
son to other activities. 
With respect to material participation in an agri- 
cultural activity, ... decision-making ..., if bona 
fide and undertaken on a regular, continuous, 
and substantial basis, may be relevant to mate- 
rial participation. The types of decision-making 
that may be relevant in this regard include, with- 
out being limited to, decision-making regarding 
(I) crop rotation, selection and pricing, ... (3) the 
purchase, sale and leasing of capital items, 
such as crop land, animals, machinery, and 
equipment, ... and (5) the selection of ... crop 
managers who then act at the behest of the 
taxpayer rather than as paid advisors directing 
the conduct of the taxpayer. 
Thus, based on this guidance, an individual 
owner who follows a sound timber management 
plan, whether through an agent such as a consult- 
ing forester or directly, should be viewed as "materi- 
ally participating" in the timber enterprise (whether 
termed a business or an investment)--and thus be 
entitled to deduct all property taxes, interest, and 
management expenses from all other forms of in- 
come of any type--subject to the specific rules for 
active businesses and the specific rules for invest- 
ments as outlined above. 
A limited partner by definition in the law will 
automatically fail to meet the "material participation" 
requirements. 
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