Income Taxes and Private Forest Landowners
Douglas Long and Alan Long1
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1995 SS-FOR-9
Contents
Since the Boston Tea Party, Americans have been quick to voice their discontent with paying taxes. In a recent survey, over 45% of private forest landowners in Florida and Georgia said taxation affected their management decisions. The objective of most taxpayers is to pay only the smallest amount that is legally owed. A basic understanding of the tax rules that apply to forestry practices can help you achieve this objective. Even if you do not understand the specifics of these rules, your awareness of regulations that apply to your practices allows you to prompt an accountant into investigating potential savings. The few minutes it takes to read this publication and familiarize yourself with tax laws and other business considerations may save you many dollars and hours of frustration.
We will focus on income tax concerns, although landowner decisions may also be influenced by property and sales taxes. This paper is divided into three major sections that address recordkeeping, land acquisition and timber sales, and tax requirements for other forest management activities. Gift and estate taxes will be discussed briefly at the end. Although we hope to provide useful information, each and every situation is different, and you are strongly encouraged to seek the assistance of a tax accountant. Compounding our disclaimer is the likelihood of tax law changes in the near future. We trust that such changes will only require a revision, rather than a complete rewrite, of this publication.
Taxpayers bear the burden of proving that their returns are correct, so good records are extremely important. Recordkeeping is probably the easiest but most neglected task of the forest landowner. Maintaining current and complete documentation of forest assets, income, and expenses is easy if done consistently, and the results will be essential in the event of an Internal Revenue Service (IRS) audit. If you have well documented records to back up your return, using the tax laws to your advantage will not be a ticket to an audit as many landowners fear, and if an audit is requested you will be prepared for it.
You should record and keep all invoices, receipts, canceled checks, contracts, meeting agendas and maps that pertain to your land and forestry practices. Ordinarily, the IRS has up to 3 years to perform an audit on a tax return, so you should keep these records for a minimum of 3 years. Even after selling the property, you should maintain the records for at least 3 years. Beyond the potential use for an IRS audit, these records are an important source of information for future decision-making.
At a bare minimum, you should keep a journal of expenses and income along with evidence of transactions in the proverbial "shoe box". A wiser and often more advantageous method of recordkeeping is the establishment of a simple accounting system which contains separate accounts for capital expenditures, capital income, ordinary income and normal expenses.
A CAPITAL EXPENSE account should be established for each asset that contributes significantly to the value of your investment. The three most common capital accounts of private forest landowners are (1) land, (2) timber and (3) equipment. A critical component of each of the expense accounts is the original cost-basis of your forest land or other assets. The basis of an asset is how much it actually costs. We will come back to the "basis" a little later.
The land account is subdivided into nondepreciable and depreciable subaccounts. The nondepreciable subaccount includes expenses for items that have an indeterminate useful life, such as the land itself, permanent roads, impoundments, and all other permanent improvements to the land. These represent values that cannot be considered in tax computations until the property is sold. Entries in the depreciable subaccount represent costs for real property items that wear out in a definable period of time, including buildings, fences, temporary roads, culverts, bridges, fertilization in established stands and similar improvements to the land. Costs for these items are recoverable by depreciation under the Modified Accelerated Cost Recovery System (MACRS) established by the IRS. The depreciated costs are deducted from income over a period of years that varies according to the type of asset.
The timber account is divided into merchantable and premerchantable timber subaccounts. Each of these subaccounts should include two entries--one showing the quantity of timber or land and the other its dollar basis. The merchantable timber subaccount initially includes the merchantable volume of standing timber that could have been harvested at the time of acquisition using prevailing utilization standards and the fair market value of this timber. Volumes are recorded in a common unit of measure such as cords or cubic feet. Merchantable timber subaccounts can be established by property, management unit, product, or species depending on which is best to meet your objectives. The most common type of account is an average value of all merchantable timber on the property. Volumes in this subaccount are periodically updated as the stands grow and as inventory information is updated. Note that only volume, and not timber value, is revised when inventory information is revised. Costs are only adjusted when new capital costs are incurred or timber is sold, as described later.
The premerchantable timber subaccount should include the quantity as the number of acres of young natural growth or plantations. The dollar basis for these young stands on purchased tracts is the value attributable to the young timber's accumulated growth on the date of acquisition. If you are establishing a new plantation, the cost of this establishment (site preparation and planting) must be entered in this subaccount for value. As the young trees reach merchantable size, their portion of the pre-merchantable subaccount is transferred to the merchantable timber subaccount. This transferal would commonly occur--for pines in Florida-- when the trees are 10 to 20 years of age.
The equipment account includes the costs of depreciable real property that has a determinable useful life, such as trucks, tractors, planting machines and fireplows. Purchase costs for these items are also recoverable by depreciation under MACRS.
The CAPITAL INCOME account primarily consists of the capital gains or losses incurred from the sale of timber. Income from the sale of standing timber, stumps, and Christmas trees that are greater than 6 years old when cut is considered to be a capital gain if these assets were held for more than one year and meet other IRS requirements to be considered as capital gain income.
The ORDINARY INCOME account includes revenue from logs, cordwood, fuelwood and other products of felled trees or logging slash. Entries in this account differ in that once the owner cuts down a tree that felled tree becomes a product. The sale of logs or cordwood from this felled tree are considered ordinary income. If the owner were to sell the same logs or cordwood as standing timber and allow the purchaser to harvest the trees, the revenue would be considered a capital gain. Other common sources of ordinary income are Christmas trees less than 6 years old, pine straw and hunting leases.
The NORMAL EXPENSE account is established for handling the expenditures for continuous, ordinary and necessary, short-term practices. Entries in this account include property taxes, timber stand maintenance practices not related to a sale (e. g. weed control in established stands, prescribed burning, precommercial thinning, consultant, and other management fees); vehicle and equipment maintenance; minor supplies; travel expenses; and mortgage interest payments.
Landowner Designations for Tax Purposes
Your opportunities to utilize various expenses as deductions against income depend on how you use and participate in the management of your forest land. The IRS categorizes forest landowners into three classes relative to the use of their land: (1) personal use or hobby, (2) investment, or (3) business. The IRS will classify your landholdings as "personal use" if you do not use the land to produce income. Forest property that is used primarily for recreation or a vacation home fits within this category. You are considered an "investor" if timber production is not your primary form of income, but your management of the timber resource is profit motivated. Property that is held as a "business" is managed for profit on a more regular basis than an "investment". The two characteristic elements of a business are regularity of activities and transactions, and the production of a profit.
The "business" classification is further subdivided into "material participant" or "passive participant" based on your involvement in the business. A "material participant" is actively involved in the management of the land in a regular, continuous, and substantial manner. A low level of activity is adequate if that is all that is needed to sustain the business and you are the person primarily involved in the management decisions. Similarly, the landowner should generally be considered as materially participating even if they use the services of a consultant, provided the taxpayer reserves the final decision-making authority. While the consultant may offer management recommendations, the taxpayer must make the management decisions to retain material participation status.
"Material participants" have the greatest tax breaks, so records documenting your active role in the management of the land are crucial. To justify yourself as a "material participant", you should maintain records of all business transactions related to management and sales of timber, landowner meetings, related travel expenses, canceled checks from registration fees for seminars, and copies of meeting agendas. The effects of these different classifications on income taxes will be described in the following sections.
LAND ACQUISITION & TIMBER SALES
With a good accounting system in place, you are now ready to use that system to track all your expenses, income, and related information for income tax purposes. Let's begin with your acquisition of a parcel of forest land and look at the tax consequences of various activities.
The original cost-basis of forest land or other assets is the sum of the cost of the land including roads and buildings, timber, surveyors, realtors, foresters, attorneys, and other activities associated with acquisition of the forest land. If you acquire the land as a gift, the asset will usually retain the donor's original basis plus any adjustments to that cost prior to the gift. You will add to that adjusted basis the portion of the gift tax that applies to the difference between the donor's adjusted basis and the property's fair market value at the time of the gift. If you acquire the land through an inheritance, your original basis usually becomes the fair market value at the date of the decedent's death, or if an extension has been filed, six months after the date of death.
If the initial basis is unknown for a piece of property, it can be estimated through retroactive allocation . The retroactive method of establishing the original basis only includes the past value of the land and timber; other acquisition costs such as realtors and surveyors cannot be included without documented evidence of theircosts. You must obtain from an appraiser, realtor, or past tax records the prevailing fair market value of similar land and improvements at the date of purchase. An estimate of the original value of merchantable and premerchantable timber can be obtained by having a forester project the current inventory back to the date of purchase and then use stumpage prices from the year of acquisition.
The benefit of using retroactive allocation to estimate the initial basis is the opportunity to use the basis as a tax deduction at the time of disposal of your assets. The costs are the time and effort necessary to reconstruct a basis that satisfies the IRS. The complexity of the assets and the further back in time a purchase was made will greatly affect these costs and the ability to satisfy the IRS. Therefore, you should weigh the benefits and costs of retroactively establishing your initial basis before going through the process.
One of the most significant rules about forest land is that a taxpayer's cost-basis in timber can be recovered as the timber is sold. The value of timber can often constitute up to 75% or more of the purchase price of unimproved land, so you can recoup a portion of your investment as a tax deduction without selling the land. Bare land, buildings, roads and other improvements are recovered only when sold outright or through depreciation.
Adjusting your basis to account for depreciation of capital assets, growth of timber, sales and depletions is necessary if you wish to maximize your tax advantages from recovery of the basis upon disposal of assets. If you own your forestland as either an investment or a business, you may take annual depreciation deductions on real property items in the depreciable subaccount of your land account. Property depreciation values can be found in the Class Life Asset Depreciation Range System published by the IRS. To claim depreciation you use the MACRS, and you subtract from your basis in the land account these yearly deductions. You may also choose straightline depreciation over MACRS if you are an active participant in a business. Instead of depreciating capital assets used in an active trade or business (not an investment), you may deduct up to $17,500 of their costs in the year incurred. This straightline (Section 179) deduction is limited to the amount of taxable income attributable to your business and is reduced one dollar for each dollar of investment in Section 179 property over $200,000 during the tax year in which the expenses are incurred. As young trees reach merchantable size, their portion of the premerchantable subaccount is transferred to the merchantable timber account. You should remember to subtract the cost-basis of these now merchantable stands from the premerchantable subaccount when you add it to the merchantable subaccount. Merchantable sized trees increase in volume as they grow, so you should adjust your timber volume basis to reflect this increased size. If you own a large number of stands in various ages of timber, it may be helpful to make these adjustments yearly. Smaller landowners may only need to make these adjustments in the year the timber is to be sold. The original value basis in the merchantable timber subaccount may also need to be adjusted with the addition of subsequent purchases, acquisitions or other capitalized costs, or deductions arising from gifts, casualty or other losses, or timber sales.
When timber is sold or lost to various causes, the timber account is reduced by subtracting from the basis the values and volumes of timber sold or lost to fire, disease, theft, etc. If half of the current inventory is harvested, half of the timber cost-basis is recoverable and must be subtracted from the basis upon sale. "Depletion" is a term commonly used to describe these adjustments to the basis. A depletion unit is the adjusted timber value basis before harvest divided by the total volume. Total depletion is the volume harvested multiplied by the depletion unit. The total depletion is important because it is subtracted along with sales costs from the gross revenue of the sale to determine net taxable income. The following example illustrates the allocation of expenses and income to a set of hypothetical accounts and the subsequent changes in these accounts over time.
Example 1. Timber purchase and sale.
Assume you purchase 100 acres of forestland for $103,000. Bare land values at the time of purchase are $400 per acre. Fifty of your acres are stocked with pulpwood averaging 30 cords per acre valued at $32 percord for a total of $48,000. The remaining 50 acres are a 10-year-old plantation of premerchantable pine valued at $300 per acre (in addition to the $400 bare land value), for a total of $15,000. Acquisition fees such as surveying, timber cruises, and legal fees are $5,000. Table 1 shows the allocation of the purchase price to a land account, merchantable timber account, and premerchantable timber account. Acquisition costs are prorated to each account based on the account's percentage of the total fair market value.
In the fifth year you conduct timber stand improvements at a cost of $90 per acre on the 50 acres of pulpwood. The merchantable timber basis would be adjusted by $4,500 (50 acres * $90/acre) to equal $54,830 (Table 2).
At the end of the tenth year the plantation has reached pulpwood size, so you transfer the $15,730 premerchantable timber basis to the merchantable timber account. The merchantable timber basis is now $70,560. A cruise of all 100 acres indicates that you now have 40 cords per acre in the original pulpwood stand and 20 cords per acre in the 50 acres moved from the premerchantable subaccount to the merchantable subaccount. The adjusted basis volume now equals 3,000 cords:
((50 original pulpwood acres * 40 cords/acre) + (50 transferred plantation acres * 20 cds/ac)).
Table 1. Allocation of purchase price to capital accounts.
| Account | Estimate of FMV* | Percentage of FMV | Allocation of Acquisition Fees | Basis |
| Land | $40,000 | 38.8 | $1,940 | $ 41,940 |
| Timber | ||||
| Merchantable | $48,000 | 46.6 | $2,330 | $ 50,330 |
| Premerchantable | $15,000 | 14.6 | $ 730 | $ 15,730 |
| Total | $103,000 | 100.0 | $5,000 | $108,000 |
* FMV = fair market value
Table 2. Resulting basis in capital timber accounts with timber growth, transfer and sale.
Merchantable Premerchantable
| Year | Volume (cds) | Basis | Acres | Basis |
| 0 | 1,500 | $50,330 | 50 | $15,730 |
| 5 | 54,830 | |||
| 10 | 3,000 | 70,560 | 0 | |
| 14 (pre-sale) | 3,350 | 70,560 | ||
| 14 (post-sale) | 1,250 | 26,334* |
* $70,560 - $44,226 depletion = $26,334
In the 14th year you decide to sell the original 50 acres of pulpwood at $42 per cord. A new cruise of the entire property shows 42 cords per acre in the original pulpwood stand and 25 cords per acre in the younger stand. Total volume is 3350 cords. Sale expenses are $500. The depletion unit for the sale is computed by dividing the merchantable timber basis by the adjusted volume of this basis.
Depletion unit = $70,560 / 3,350 cords
= $21.06/cord
Gross revenue = 50 ac * 42 cds/ac * $42/cd
= $88,200
Total depletion =50 ac * 42 cds/ac * $21.06/cd
= $44,226
Net taxable gain = $88,200 - ($44,226 + $500)
= $43,474
The method you use to sell your timber can significantly influence your income tax obligations. The primary types of timber sales are lump-sum sales and per-unit sales. In a lump-sum sale the buyer pays a fixed total amount for the standing timber. The title passes immediately to the buyer, who then has a specific time period to harvest the timber. In a per-unit sale the buyer pays for the volume of timber, per unit of volume, that is cut. The owner retains title to the wood until it is cut, measured and purchased. If your forestland is held as an investment or for personal use for longer than one year, a lump-sum or per-unit sale may be considered a long-term capital gain. No holding period applies to inheritances.
If, however, you are considered a participant in a business, the per-unit sale is generally the only type of sale that qualifies for long-term capital gains status because you retain an economic interest in the timber until it is cut. Per-unit sales may help you avoid being taxed in the next higher tax bracket by spreading the sale payments over two or more tax years. Some landowners choose to have both lump-sum and per-unit sales paid in installment payments to reduce taxable income in a single year.
Generally, if you choose to harvest the timber yourself and convert it to logs, fuelwood, or other products, the income is taxable as ordinary income. Federal tax rates are now the same for ordinary income and long-term capital gains. Net taxable gain is taxed at your marginal rate: between 15% and 28%. Long-term capital gain status may still be advantageous because capital losses can offset capital gains in the same tax year without limit while the offset of capital losses against ordinary income has a limit of $3,000 per tax year. Finally, if your forest land is held as an active business, long-term capital gain status is important because you are not obligated to pay self-employment tax on income from timber sales. The self-employment tax for 1994 was 15.3%.
An expenditure that creates or improves an asset having a useful life greater than one year must be capitalized and cannot be totally deducted in the year it is incurred. The expenditure is recorded as the basis for a new asset or is added to the basis of an existing capital asset. Common forestland assets that must be capitalized (other than the land and timber discussed in the previous section) include buildings, equipment, site preparation, planting and fertilization. Capitalized costs are deducted from income at the time of sale, through depreciation, or by amortization.
Amortization is the process by which the basis of a non-depreciating asset, such as reforestation or fertilization, is recovered as a deduction from taxable income prior to the sale of the (timber) asset. Currently, you can amortize 95% of your reforestation costs up to $10,000 over the eight tax years after planting or seeding. Reforestation costs include site preparation, seedlings, some weed control after planting, paid labor, and equipment rental or operating costs. The cost for establishing plantations for purposes other than the production of wood fiber are not amortizable (i.e. Christmas trees, shelterbelts, landscaping, aesthetics, etc.). Reforestation costs greater than $10,000 should be capitalized and added to the premerchantable timber basis subaccount.
You also have the opportunity to take a 10% investment tax credit on the first $10,000 of reforestation costs. This tax credit and the amortization of reforestation are one of the best tax advantages available forlandowners who harvest timber and reforest that land, or previous non-forested land. Combined, they may reduce the present value of reforestation by 17% to 36% --depending on your marginal tax rate. Your amortization and tax credit are subject to recapture by the IRS if you dispose of the trees or property within 10 years.
Deductible forest management expenses include salaries, legal fees, travel costs directly related to management of the property, small tools, protection costs (e. g. prescribed burning), stand maintenance (e. g. weed control in older plantations), property taxes, and interest on loans. The amount you can deduct annually is dependent upon your IRS classification as either personal user, investor, or business. If you are considered to be a personal user, deductions are allowed only to the extent that aggregate expenditures from all passive activities do not exceed aggregate income from passive activities. Expenses that cannot be claimed in one year may be carried forward to offset passive income in the future.
If you are viewed as an investor, property taxes can be written off as an itemized deduction and management expenses not related to a timber sale that exceed 2% of your adjusted gross income can be deducted as a miscellaneous deduction. For either personal users or investors, forest management expenses not related to a sale, nor deducted from annual income, may be added to the cost basis of timber and are recovered as a deduction from gross revenue when the asset is disposed of or sold. If you are viewed as a material participant in a business, all management expenses, property taxes, and interest on loans are fully deductible against any source of income in the year they are incurred.
Expenses of sale such as advertising, cruising, marking, scaling, and professional fees are deductible from the gross price received from the timber sale for all three categories of owner. The net taxable gain of a sale is equal to the gross sale revenue minus total depletion and sale expenses.
Four federal cost-share programs have been available to provide financial assistance for private owners of forestland. Through the Stewardship Incentive Program (SIP), Forestry Incentives Program (FIP), Agricultural Conservation Program (ACP), and the Conservation Reserve Program (CRP), landowners can receive cost-share payments for up to 50% to 75% of the average cost of approved practices. Information about eligibility and assistance for these programs is described in the publication Forestry and Stewardship Assistance for Florida Landowners , available from County Extension Offices, County Foresters, or Forestry Extension, School of Forest Resources and Conservation, Gainesville, FL 32611 (904/846-0849).
All or part of cost-share payments from SIP, FIP, and ACP may be excluded from gross income at your discretion. Even if payments are totally excludable, they must be reported to the IRS as excludable under Section 126 of the Internal Revenue Code. The maximum amount excludable per acre is the greater of:
(1)the present value of $2.50 per acre, or
(2)the present value of 10% of the average annual income per acre for the past three tax years.
Generally, if you harvested the tract within the past three years, all of the cost-share payments received can be excluded. CRP payments must always be reported as ordinary income.
Excluding cost-share payments is not always advantageous because you must also exclude the portion of your reforestation costs covered by those payments during computation of tax credit and amortization. If you include a federal cost-share payment as income in the year of planting, the entire cost of planting including the cost-share payment can be used to calculate the tax credit and seven year amortization. Taxes on cost-share payments for reforestation are subject to full recapture--if you sell the property or cut the trees within 10 years of claiming the exclusion. The amount subject to recapture decreases 10% each year after that. If the cost-share payment is for timber stand improvement, you can include the payment as "miscellaneous income" and deduct the timber stand improvement expenses in the year incurred.
Calculations for reforestation expenses, cost-share payments, and tax obligations are illustrated in the following example.
Example 2. Reforestation cost-shares, tax credit and amortization:
Assume you reforested your 50 acres in 1994 at a cost of $80 per acre for a total $4,000. You received a 50% cost-share payment of $2,000. Your average annual income from these acres in the previous three tax years was $10,653 ($31,960 / 3 years). The interest rate is 7%.
The first step is to decide the maximum amount of the cost share that is excludable if you elect the option of excluding the cost-share payment from your income. This is the greater of:
Option 1. the present value of $2.50 per acre, or
Option 2. the present value of 10% of average annual income from the acres for the past three tax years.
Option 1 is $2.50 * 50 acres = $125
Option 2 is .10 * 10,653 = $1,065
Option 2 is the greater amount, so we determine the present value of the amount excludable by dividing by the interest rate of 7%:
$1,065.3 / .07 = $15,214.
Result: Since $15,214 is greater than the $2,000 cost-share payment, the entire $2,000 is excludable.
The tax credit and amortization can be taken on the remaining $2,000 of reforestation costs. The tax credit is calculated by multiplying $2,000 by 10% which equals $200. This $200 can then be subtracted directly from your income tax in the first year. In addition, the annual amortization deduction is calculated by multiplying the remaining $2,000 of reforestation costs by 0.95 and then dividing the result by 7 years.
($2,000 * 0.95) / 7 years = $271.43 / year
In the year of reforestation and in the eighth tax year (1994 and 2001 respectively), one half of the $271.43 ($135.71) can be deducted from your taxable income. The full annual deduction of $271.43 can be deducted in each of the 6 years from 1995 through 2000.
You may be charged the federal gift tax if you give property worth greater than $10,000 as a gift or sell land for substantially less than the fair market value. An annual gift tax exclusion allows you to give any number of people up to $10,000 in property or cash without you incurring a gift tax. If the gift exceeds $10,000, the excess is taxed to the donor as a gift. This annual gift tax exclusion allows you to reduce the size of your estate while alive. In addition, there is a one-time unified tax credit that may be applied against all gift taxes during a lifetime. If any of this credit is remaining at death, it can be applied against estate taxes. Estate taxes must be paid when property is transferred after death. In 1987, the $192,800 credit was equivalent to transferring $600,000 of the total estate to one individual tax-free (Feitshans & Hamilton 1991).
Any amount of property may pass between you and your spouse without being taxed either before or after death. If one spouse dies, the value of the property left to the survivor is deducted from the adjusted gross value of the estate before the estate taxes are calculated. The estate tax is normally due nine months after death. However, if there is reasonable cause, the IRS may grant a one-year extension up to 10 times--for a total of 10 years (Feitshan & Hamilton 1991).
Casualty Losses, Condemnation, and Timber Theft
Casualty losses are defined as being identifiable, damaging to property, sudden and unexpected, or unusual--such as forest fires and hurricanes. Southern pine beetle losses do not qualify as a casualty loss except in premerchant-able stands. Condemnation is the taking of private property by a government entity without the landowner's consent, but with compensation. Casualty losses, condemnation, and timber theft are all treated in the same manner. As a general rule, all losses are deductible from income in the year sustained. Claims for these involuntary conversions, however, can be no greater than the adjusted basis of the asset at the time of conversion minus insurance or other compensation in the year of discovery.
If a gain results from involuntary conversion, you can defer it for tax purposes if the money is used to replace the converted property. Otherwise, it must be reported as income in the year received. Replacementmust be within two years for personal property and within three years for real property. The IRS has provided a non-casualty loss for businesses and investors when abnormal drought causes the death of tree seedlings or when pine beetles kill merchantable timber.
CONCLUSION
This may be too late to help with your 1994 taxes, but you can hopefully use it as you prepare for next year. Now is not too early to start that recordkeeping and expenditure planning that you will wish you had done when the next April 15 rolls around.
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REFERENCES
Bishop, L. 1994. Tax tips for forest landowners for the 1994 tax year.
R8-MB 66. USDA Forest Service, Southern Region, Atlanta. 2 pp.
Hoover, W. 1989. Timber tax management for tree farmers. American Forest Council. Washington, D.C. 103 pp.
Hoover, W., W. Siegel, G. Myles, and H. Haney Jr. 1989. Forest owner's guide to timber investments, the federal income tax, and tax recordkeeping. USDA Agriculture Handbook 681. Washington, D.C. 103 pp.
Rivers, W. 1991. Tax options when pine beetles kill your timber . R8-MB51. USDA Forest Service, Southern Region, Atlanta. 2 pp.
1Graduate Assistant and Assistant Professor, School of Forest Resources & Conservation, University of Florida, Gainesville, 32611
University of Florida, Gainesville * Institute of Food and Agricultural Sciences * Florida Cooperative Extension Service * John T. Woeste, Dean