A pay-as-cut timber contract is an agreement in which a buyer pays the landowner a set price per unit of wood as each tree is harvested, rather than paying a lump sum up front for all the timber on a tract. Because the landowner only gets paid when trees actually come off the stump, the arrangement creates what tax law calls a “retained economic interest,” and that qualifies the proceeds for long-term capital gains treatment under Internal Revenue Code Section 631(b).1Office of the Law Revision Counsel. 26 USC 631 – Gain or Loss in the Case of Timber, Coal, or Domestic Iron Ore The tax difference is real money: federal rates on the gain can drop from as high as 37 percent to 15 or 20 percent, and the income escapes self-employment tax entirely.
How the Contract Works
The buyer pays a set price per unit of timber as it is cut. Ownership of every standing tree stays with the landowner until the moment the buyer actually fells it. If a tree never gets cut, the landowner never gets paid for it, and the buyer has no obligation to harvest anything beyond what the contract’s minimum terms require.
Volume shown on mill tickets or scale slips controls the settlement between the parties. Two measurement approaches dominate. The first is log scaling, where each log is measured by diameter and length and run through a log rule to estimate board feet of lumber. The U.S. Forest Service authorizes three primary log rules: the Scribner Decimal C rule, a diagram-based method that estimates how many one-inch boards a log will yield; the International ¼-Inch rule, a formula-based method that generally tracks closer to actual lumber output; and the Smalian Cubic Volume rule, which measures raw cubic footage instead of board feet.2USDA Forest Service. National Forest Log Scaling Handbook The second approach skips board-foot scaling and weighs loads on certified mill scales, converting the weight to tons. Which method your contract uses matters, because the same pile of logs can produce different volume numbers under different rules.
This structure sits opposite the lump-sum sale, where the buyer pays a fixed dollar amount for all designated timber before harvest begins. In a lump-sum deal, the buyer absorbs the risk that actual volume falls short of estimates. In a pay-as-cut deal, that risk stays with the landowner. If a section of the tract produces less marketable wood than expected, the landowner’s check shrinks. The tradeoff is that the landowner also captures the upside when volume or grade exceeds projections, and the per-unit price can be renegotiated if market conditions shift during a longer contract.
What Belongs in the Written Contract
A handshake timber deal is a recipe for a lawsuit. Several provisions need to be nailed down before the first tree falls:
- Unit prices by species and product. Sawtimber pine, sawtimber hardwood, chip-and-saw, and pulpwood should each have their own price per unit. Lumping everything into one rate almost always shortchanges the landowner on higher-grade wood.
- Measurement method. Specify the exact log rule or weight conversion factor. Switching from International ¼-Inch to Scribner after the fact can change reported volume by 10 percent or more.
- Contract duration and extension terms. Open-ended contracts let buyers cherry-pick the best timber and leave the rest.
- Boundary marking. Identify who marks the boundary, who marks the trees to be cut, and what happens if unmarked trees are harvested.
- Performance bond. A bond posted by the buyer before harvest protects the landowner if the buyer damages roads, culverts, or standing timber outside the sale area. Bonds typically start at a few hundred dollars for small sales and scale up to around 10 percent of the estimated sale value on larger tracts. The bond is returned after the work is finished to the landowner’s satisfaction.
- Payment schedule. Weekly or biweekly settlements tied to mill receipts are standard. Longer gaps give the buyer more of your money as float.
- Insurance requirements. The buyer should carry general liability and workers’ compensation coverage. If a logger is injured on your land and the buyer is uninsured, the claim may land on you.
A consulting forester can draft or review these provisions and oversee the harvest on your behalf. Their fees generally run as a percentage of gross sale proceeds, so their incentive aligns with getting you the best price.
Why the Tax Treatment Is So Favorable
The tax benefits hinge on one concept: the landowner must retain an economic interest in the standing timber. In practical terms, your income has to depend entirely on whether trees actually get cut. A guaranteed minimum payment regardless of harvest volume breaks the link between severance and income, and the arrangement starts to look like a lease or an ordinary sale rather than a disposal with a retained interest.1Office of the Law Revision Counsel. 26 USC 631 – Gain or Loss in the Case of Timber, Coal, or Domestic Iron Ore
This requirement also means the risk of physical loss stays with you throughout the operation. If a wildfire, ice storm, or beetle infestation destroys standing timber before the buyer cuts it, you absorb the entire hit. That continuous exposure to loss is what makes the economic interest “retained” in the eyes of the IRS. It is not just a technicality; it shapes how you think about insurance, contract duration, and how much timber to leave exposed at any given time.
Section 631(b) says that when you dispose of timber you have held for more than one year, either through an outright sale or under a contract where you retain an economic interest, the difference between what you receive and your adjusted depletion basis is treated as gain or loss on the sale of the timber. That gain qualifies as a Section 1231 gain, which is taxed at long-term capital gains rates rather than ordinary rates.
For most landowners the federal rate on the gain is 15 percent. Taxpayers at the top of the income scale pay 20 percent on long-term gains.3Internal Revenue Service. Topic No. 409, Capital Gains and Losses Either way, the savings over the top ordinary rate of 37 percent are significant. Because the gain is classified as a capital gain rather than earned income, it is not subject to self-employment tax.4USDA Forest Service. Tax Tips for Forest Landowners 2025 Tax Year
Higher-income landowners face an additional 3.8 percent Net Investment Income Tax on the lesser of their net investment income or the amount by which their modified adjusted gross income exceeds $250,000 for married joint filers, $200,000 for single filers, or $125,000 for married filing separately.5Internal Revenue Service. Topic No. 559, Net Investment Income Tax Timber capital gains count as net investment income for this purpose, so a large single-year harvest can push a landowner into NIIT territory even when their ordinary income alone would not. Spreading harvests across multiple tax years is one way to manage this.
Holding Period and Depletion Basis
Section 631(b) requires you to have held the timber for more than one year before the disposal date. The clock starts the day after you acquire the timber, whether by purchase, inheritance, or gift. A tract bought on March 15, 2025 satisfies the one-year rule on March 16, 2026.
For pay-as-cut contracts, the date of disposal is the date the timber is cut. If you receive a payment before the trees are actually felled, you may elect to treat the payment date as the disposal date instead. The election can be useful for advance payments, but the holding period has to already be met on whichever date you pick. If it is not, the gain is short-term and taxed at ordinary rates.
Depletion is the timber equivalent of depreciation. Your depletion deduction for each harvest period comes from a per-unit rate that reflects how much of your original investment gets used up with each unit cut:
Depletion rate per unit = adjusted basis of the timber account ÷ total estimated merchantable volume
Multiply that rate by the volume harvested during the tax year, and you have your depletion deduction. The adjusted basis includes your original purchase price allocated to the timber (not the land), plus capitalized costs like cruising and boundary surveys at acquisition, minus any depletion claimed in prior years.
Getting the denominator right is the hard part. “Total estimated merchantable volume” is not what stood on the property decades ago; it has to reflect current inventory, including growth since acquisition and any prior harvests or losses. Most landowners hire a forester to conduct a timber cruise before each sale to update these numbers. Overestimating volume produces a depletion rate that is too low, meaning you pay more tax now and get a larger deduction later. Underestimating does the opposite. Neither error is free, so the cruise is worth the cost.
Reporting the Income
Landowners who claim a depletion deduction or report a disposal under Section 631(b) must complete and attach Form T (Timber) to their income tax return.6Internal Revenue Service. Instructions for Form T (Timber) Form T is where you track timber accounts, record changes in volume and basis, and calculate depletion. It is the IRS’s way of making you show your work.
The gain or loss from the disposal flows to Form 4797 (Sales of Business Property), not Schedule D, because Section 631(b) gains are Section 1231 transactions.7Internal Revenue Service. 2025 Instructions for Form 4797 That distinction matters if you have Section 1231 losses from other property, because losses and gains net against each other on Form 4797 before anything reaches your Form 1040.
Buyers who make pay-as-cut payments are generally required to file Form 1099-S reporting the amounts paid, since the payments are treated as royalties tied to the extraction of the resource. Keep every mill ticket, scale slip, weight receipt, and settlement statement. They are your primary defense in an audit, and they need to reconcile with the volumes and dollar amounts reported on Form T.
If Timber Is Destroyed Before It Is Cut
Because the landowner bears the risk of loss under a pay-as-cut contract, the tax treatment of destroyed timber matters. If a casualty like fire, hurricane, or ice storm takes out standing timber, the loss is generally deductible under Section 165. The deductible amount is based on the adjusted basis of the destroyed timber, not its fair market value.8Office of the Law Revision Counsel. 26 US Code 165 – Losses You calculate the loss using the same depletion-unit approach: per-unit basis multiplied by volume destroyed.
If insurance proceeds or salvage income exceed your adjusted basis in the destroyed timber, you have a gain rather than a loss. Section 1033 lets you defer that gain by reinvesting the proceeds in replacement property within two years after the close of the first tax year in which you realize the gain.9Office of the Law Revision Counsel. 26 US Code 1033 – Involuntary Conversions The replacement property must be similar or related in use, which for timber generally means other timberland or standing timber. You can apply to the IRS for an extension of the two-year window if you need more time.
Salvage sales after a casualty deserve careful handling. If you harvest damaged timber quickly and get paid for it, that income may still qualify for capital gains treatment under Section 631(b) as long as the retained-interest and holding-period requirements are met. Mixing salvage proceeds with insurance payments without proper allocation between the two creates headaches at tax time.