Harvesting Private Capital to Restore Forests
Evan Mills, Ph.D.
A Proposal for Greening Tax-deferred Real Estate Exchanges
Given the halting embrace of science-based forest management by public entities and politicians, refocusing tax-deferred “1031” real estate transaction proceeds on this cause could become a refreshing and efficient way to infuse cutting-edge forest restoration projects with private capital. Such flows could be pooled, professionally coordinated, and scaled far beyond current efforts, potentially turning the timber industry’s business model on its head, prioritizing resilience and sustainability over revenues but still within a market-based framework.
Refocusing Billions of Dollars
First some context. Many who own so-called “income property” — whether it be a rental cottage or a shopping center — face an unwelcome reality at the time of sale. If they are fortunate, and the value of the property has increased while they’ve owned it, Uncle Sam wants a slice of the gains. A big slice, like up to a third.
The conventional way to avoid this tax is to purchase yet another similar income property. Upon doing so, the tax on capital gains is deferred into the future. The tax is ultimately paid if subsequently exchanged properties are sold without reinvesting the proceeds, or the tax is avoided entirely if that property is inherited. Since 1921, such tax-deferred transactions have been allowed under Internal Revenue Code 1031, hence the moniker “1031 exchanges”.
Not surprisingly, the flows of funds through 1031s are substantial. One study estimated that between 2010 and 2020, about 6% of commercial real estate transactions across the United States were of the 1031 type, amounting to a whopping $241 billion (an average of $24 billion per year) in property values being liquidated and reinvested, with the highest-single-year value just over $37 billion. Another study put the value at $100 billion per year.
With trillions now being poured into stock-market funds claiming the high ground in terms of environmental, social, and governance (ESG), it seems only natural to ask whether investors engaging in 1031s might not also be interested in how their dollars are invested. Indeed, while ESG is relatively “weak sauce”, focusing on incremental improvements in behavior of “ordinary” companies, the far more proactive investment approach known as “Impact Investing” centers on companies addressing social and environmental problems.
Yet, if Google-search is any judge, remarkably little has been said about “Green” or “Socially Responsible” 1031s and it seems that even less has actually been done about it.
When it comes to environmental applications, an idea that initially comes to mind is to buy real estate that meets some sort of higher “green” standard, such as buildings with Energy Star or LEED ratings, or perhaps land on which renewable energy development or sustainable agriculture occurs and leasing to project operators. Interesting but I would call this a rather “light-green 1031”.
Financing Forest Restoration
There are more creative ways to go, especially if an investor has tired of being a landlord for humans and is game to try renting to trees.
One needn’t exchange into a form of real estate identical to that being sold. Indeed, in the eyes of the IRS, even forest land purchased as an investment is interchangeable with buildings. And so a particularly intriguing concept involves engaging in restorative forestry aimed at enhancing ecosystems, securing carbon storage, and other benefits. Less obvious, however, is how sufficient revenue would be generated to entice investors to pursue such a project.
The solution, it seems, lies in part in the fact that some trees often need to be strategically removed in order to materially restore historically over-harvested and otherwise mismanaged lands. In over-cut forests, trees of unnaturally similar ages become entwined in protracted dead-end competition, especially where fire is suppressed. For example, such lands today can be “stocked” with 1000 small trees per acre, compared to perhaps 10 significant monarch trees per acre in primeval old-growth forests. And, those sparser forests with larger trees are more effective at storing carbon and do so more reliably than younger trees, while being vastly more fire-resilient. The removed trees over 10 inches or so in diameter at their base can be sold in the timber marketplace to fund the restoration work.
A recent study chronicles two decades of restoration harvesting experiments in Sierra Nevada pine forests, and found net revenues (after expenses) up to $2,500/acre. Net revenues for redwood forests should be much higher.
Permitting can follow alternatives to the traditional guidance documents prepared to direct the work of loggers, commonly called a Timber Harvest Plan (THP). Examples, in the case of California, include Modified Timber Harvest Plan for Fuel Hazard Reduction Plans (MTHP-FHR) or Non-industrial Timber Management Plans (NTMP) are used for long-term, ecologically prioritized management. But just the presence of these acronyms hardly guarantees genuinely sustainable project.
Removal and sale of the smaller excess trees will favor the ones that remain, the most promising of which are being referred to as Potential Elder Trees (PET) by Cal Poly Humboldt professor Stephen Sillett and his colleagues.
In some cases, carbon-offset markets may also be used to generate further revenue from the remaining carbon stored in the forest. However, in what often appears to be a shell game, there has been considerable overselling, deception, and outright fraud in these markets, not to mention uncertainties as to the stability and durability of the retained carbon. An added opportunity for misbehavior is to sell carbon credits from lands already protected by conservation easements — essentially double-counting and achieving zero additional carbon reductions by the credit buyers claiming to have proportionately offset their own emissions. Efforts have been made to define correct practices, but the temptation to double-dip in terms of payments is high.
A third potential revenue stream, and one completely consistent with the ultimate goal of restoration, is the sale of conservation and/or development easements to protect the remaining lands. Conservation easements are added to the property’s deed and stipulate specific management practices in a manner that is binding. Guidelines could range widely, from to recurring “sustainable” timber harvesting to prohibiting removal of any remaining trees for perpetuity — or a various of restrictions applying to different subsets of the property. According to one report, the majority of conservation easements on U.S. forestland involve purchase (not just gifting) by the recipient, and nearly three million acres were involved in such transactions between 2000 and 2009 alone. Separately, or in addition, if the land in question has the potential to be developed for housing or other purposes that would entail removal of trees or other ecological disturbance, those development rights also have value and may be able to be sold in lieu of development. Interestingly, proceeds frm the sale of a conservation easement may be eligible for an additional 1031 exchange.
A Potential Free-market Solution Not Dependent on Subsidy or Government Intervention
When one or a combination of these approaches is employed, the project generates revenue for the investor to replace that from the previous investment, while the forest is protected. The investor retains and can enjoy the property–and even pass it on to future generations for posterity–but they need not hold onto it indefinitely since protections are now part of the deed. Conservation organizations may subsequently purchase such properties to ensure proper management and stewardship, particularly if they are contiguous with other parcels also in conservation status. Tax-advantaged gifts of such lands can also eventually be made through the owner’s estate.
As always, the devil is in the details. For such projects to pencil, the net proceeds must exceed the costs of permitting, consultancy, timber operations, taxes, insurance, and legal fees. One challenge is that these projects may have negative cash-flow before harvest revenues occur. Particular investment risks pertain to forestland, including wildfire, insect infestations, changes in regulations, and fluctuations in lumber or carbon prices, endangered species identification or other factors that could impede tree removal even for restoration purposes, a host of regulatory uncertainties, and the difficulty in projecting long-term (post-harvest) costs of management and stewardship. I hear from landowners that the licensed timber operators doing the actual tree removal often resist instructions associated with restoration goals. There will be intrinsic tensions between the intensity of tree removal and revenues required (or otherwise desired) to make the project work for the investor. Meanwhile, uncertain restoration costs may include removal of old logging roads, stream recovery, prescribed burning, and abatement of invasive plant species. My initial financial modeling is promising, but more due diligence is needed to determine when and where such projects would work.
According to one source “over 50% of U.S. forestland is owned and managed by more than 10 million private owners. Most of this land is family and individually owned and the average parcel size is smaller than 25 acres.” A 2004 study put the number at 59%, classified as “Non-Industrial Private Forests (NIPFs)”. Pooling multiple investors and properties could consolidate expertise, improve buying power, and spread risks. Larger parcels are also far more suited to saleable conservation easements and potential public uses. Vehicles to do so include Delaware Statutory Trusts (DSTs) or Tenants-in-Common (TIC) structures, which are widely used to aggregate “beneficial” or “fractional interests” in conventional real estate projects … but certainly have their own complications. At least one such firm includes “Timber” investments in its portfolio, although these are most likely conventional industrial logging operations.
Redwood forests are perhaps the most promising for Green 1031s — they grow fast, store the most carbon, and the wood from even small, overcrowded trees is valuable. If the nuances and risks are kept in focus, there appears to be great potential for the channeling of tax-deferred private investment proceeds to forest restoration, but care must also be taken to avoid green-washing in such transactions. A key aspect of this is clearly defining “restoration”, and not relying on it as a feel-good buzzword that can be loosely interpreted and applied to profit-driven industrial logging projects.
As a case in point, a recent in-depth analysis of “restoration” projects in Northern California redwood forests found that their recovery was somewhat worse than in previously logged tracts that had not been “restored”. Upon closer look, one sees that the work involved very aggressive logging, with a whopping 40% of cross-sectional (aka “basal”) tree area removed compared to the previously logged comparison plots. This means larger trees were removed, unlike a true restoration approach, under cover of the word “restoration”. This presumably caused a lot of disruption to the canopy, allowing an excessive increase in light in the forest floor, in turn favoring the increase in invasive species tallied in the report.
These vagaries make it clear that there need to be clear definitions and standards for what constitutes “restoration forestry”. Attributes could include factors such as e.g., sizes of trees removed, change in canopy cover, mechanical/manual methods, new/removed roads length per acre, residual slash metrics, etc.
With a more disciplined approach, the result would be a bountiful harvest of ecological and economic value. For example, two percent of annual 1031-exchange flows could initiate restoration forestry projects on at about 200,000 acres each year. For perspective, this is on a par with the land area protected during the century-long campaign by Save the Redwoods League.
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Evan Mills, Ph.D. is an Affiliate and retired Senior Scientist at Lawrence Berkeley National Laboratory and a Research Affiliate with UC Berkeley’s Energy and Resources Group. He has participated extensively in the work of the Intergovernmental Panel on Climate Change (IPCC), which shared the 2007 Nobel Peace Prize with former Vice President Al Gore.