From the desk of Neena Mishra, Director of Equity Research:

On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010, which includes a key provision that benefits public timber REITs.  The new law (1) enhanced and extended a number of tax incentives included in the original Economic Stimulus Act of 2008 and American Recovery and Reinvestment Act of 2009 and (2) shortens the holding period for S-Corp built-in gains from seven years to five for dispositions in any tax year beginning in 2011, if the fifth year in the recognition period precedes 2011.

This second provision was designed to benefit corporations initially structured as C-Corps, but elected to be taxed as S-Corps and had net built-in gains when they made the S-Corp election. This may provide some tax benefits to the timber REITs – Plum Creek (PCL), Rayonier (RYN) and Potlatch (PCH) – in the near-term.

A built-in gain is the difference between the fair market value of an asset and its tax basis at the time the election is effective. The built-in gains tax applies to gains recognized within the ten-year period following the merger date from asset sales. Built-in gains tax is generally not payable on dispositions to the extent the proceeds from the disposition are reinvested in qualifying like-kind replacement property (i.e. 1031 like-kind exchanges). Also, the built-in gains tax does not apply to income generated from the sale of timber pursuant to a stumpage sale agreement or timber deed. The 2009 Recovery Act temporarily shortened the traditional 10-year holding period to seven years for dispositions in tax years beginning in 2009 and 2010.

As a result of the enactment of 2009 Recovery Act, Plum Creek recognized a $3 million deferred tax benefit in 2009 and reversed $5 million of tax expense related to the built-in gains that accrued in 2008. Further, as a result of the Small Business Jobs Act of 2010, the company reduced its deferred tax liability by $1 million during the first nine months of 2010.

For Rayonier (RYN), this provision eliminated the built-in gains tax for 2011. The built-in gains tax was ~$9 million in 2008 and is expected to be ~$6 million in 2010.