Forest Finance: What is Timber “Depletion”?

10 03 2013

Money does grow on trees.  Unfortunately, it grows in small denominations.  So we care deeply about managing costs and minimizing taxes.  Which brings us to a category of questions I get each tax season:  timber depletion.  What is it?

Depletion, like depreciation and amortization, is a cost recovery method for natural resources.  It comprises the costs we have in the timber we own and harvest.  We subtract depletion from timber stumpage revenues to arrive at taxable income.  (Therefore, we want depletion rates as high as possible!)

There are two general methods for calculating depletion: tax depletion and financial depletion.  Tax depletion is based on the actual cost of the timber, adjusted annually for additions (acquisitions), removals (harvests), annual net growth, and capitalized reforestation costs.  The depletion “rate” for a corporation is capitalized silviculture dollars divided by the merchantable forest inventory

Financial depletion, also called “normalized” depletion, sums all capitalized silviculture expenses plus merchantable timber accounts and divides this by the beginning inventory plus all growth over the rotation.  The idea is that this should represent the initial cost of the timber plus all ongoing capitalized silviculture expenditures (all capitalized costs associated with wood production) and all the wood that is grown.  This approach provides an “average rate” over the rotation rather than a rate that can change drastically over one rotation.  You will find this method in financial reporting by publicly-trade entities. Private entities (S-Corps, LLCs, Partnerships) generally do not keep a set of financial reporting books.

In summary, depletion reduces the taxes we pay on revenues produced from harvesting and marketing timber.  Publicly-traded firms generally report both tax depletion and financial depletion.  At the end of the day, the objective is to MINIMIZE taxes paid within IRS guidelines….