Katrina Timber Casualty Losses
Review of Casualty Loss Deduction Rules for Timber
TIMBER CASUALTY LOSSES
No Special Relief for Hurricane Katrina Victims
Presidential Disaster Area Designation and Katrina-Related IRS Announcements
Go to http://www.irs.gov/newsroom/article/0,,id=147055,00.html for a list of the counties in the disaster area designated by the President. This site also provides details on many administratively designated tax relief provisions, but none deal specifically with the casualty loss deduction for timber in the disaster area.
Additional information on the tax relief provisions as well as other IRS publications and related materials on casualty losses can be found on the Forest Landowners Tax Council website at: http://www.fltc.net/hurricane_help.html
Natural disasters that destroy and/or damage timber don't result in a significant tax loss deduction for most taxpayers when their timber bases are low, which can be a suprise for these taxpayers. In these cases, decades of work and expenditures for planting (if already recovered through the reforestation tax incentives) and management of timber are reduced to splinters in an instant with little tax deduction as the deduction is limited to the smaller of the timber basis or the fair market value loss.
What Victims Need To Do As Soon As Possible
(1) Recover whatever tax records you can find. IRS guidance on reconstructing records is at http://www.irs.gov/businesses/small/article/0,,id=147164,00.html For timber you need any records that will help you determine the basis of your timber.
(2) Contact a professional forester. A private consulting or industrial forester will assist in making decisions about what courses of action are available to you. If all or some portion of your timber is destroyed (not salvageable) ask the forester for a letter so stating for your tax files. Specify the volumes and locations of the destroyed timber. Then, you'll need to decide what if any timber can be left to grow to its planned rotation age. Finally, identify any timber that was damaged and needs to be salvaged.
(3) Salvage the damaged timber not worth holding to rotation. The damaged timber that needs to come out should be offered for sale as soon as possible, even at depressed prices. Do so before insects and fungus make the timber worthless. Unless you have a high basis in the damaged timber whatever salvage income you generate will most likely be better than what you can claim as a casualty loss deduction.
(4) Work with your tax preparer or other advisor, if any, to decide whether to file an amended 2004 tax return to claim losses, or wait until your 2005 return is filed. This assumes you have property in the designated disaster area.
(5) Calculate your loss for destroyed timber, and the involuntary gain or loss on any salvage of damaged timber. Here's a summary of how these are done.
Basic Rule
Determine which of these two values is smaller: (1) the decrease in the fair market value of "single identifiable property" (SIP) and the adjusted basis of the SIP reduced by any insurance, salvage, or other compensation. For timber held for the production of income as a business or investment "the property" is the "block" in which the timber destroyed is located for accounting purposes. The basis of the timber in a given block is the basis of all the timber in the block, not just the basis of the volume in the block that was destroyed. This is demonstrated in Example 2.
Rules for Timber
As an appreciating asset the cost basis of timber is usually less than its fair market value. The deductible loss is thus usually the cost basis. Note that unless cost basis has been established it's not possible to claim any loss since it's not be possible to determine which is less.
Salvage must be attempted - If some of the timber is not totally un-merchantable a reasonable effort must be made to salvage as much as possible. This means contacting potential buyers and soliciting offers. Keep a record of buyers contacted and their responses. Also make a photographic record of the damage. Example 1 demonstrates how to report a salvage sale.
Partial damage - Hurricanes may not completely destroy trees, but may broken off tops and limbs. This may reduce the growth rate and quality of the wood if the trees are left to grow. Despite a change in how "the property" is defined the IRS continues to disagree with those court cases allowing a deduction for damage and reduced growth. The IRS's position is that such values are very difficult to estimate and not amenable to standard timber valuation techniques. If you are an "aggressive taxpayer" you may want to claim a loss for damage, but if you do and are audited be prepared to defend this action in court.
How to Claim Casualty Loss for Timber
The gain or loss is reported as an involuntary conversion under Section 1231. Losses are reported on Form 4684, Section B. The amount claimed is carried over to Form 4797, and then to Schedule D of Form 1040. The tax affect depends on any other Section 1231 transactions or other capital gains or losses for the year. For timber held for use in a trade or business any loss reduces your net income on a dollar for dollar basis.
Amount of Gain or Loss - The amount of the gain
or loss is determined by reducing any salvage income received by the basis
of the timber sold at salvage and the basis of any timber totally destroyed.
This means that if no salvage income was received the loss is the basis of
the timber destroyed. You also reduce the gain or increase the loss by your
costs to find a buyer, estimate the volume of timber sold and destroyed, etc.
The basis of the timber sold and the timber destroyed is determined by multiplying the number of units sold and destroyed by the depletion unit for the timber.
The depletion unit is determined by dividing the adjusted cost or other basis
for the timber by the total volume of timber in your timber account at the
beginning of the year. Thus, it is necessary to know the adjusted basis of
your timber and the total volume of timber, as well as the volume of timber
sold and destroyed.
Year Reported
The deduction should be claimed for the tax year in which the casualty loss occurs. If, however, an area is designated by the President of the United States as a "disaster area" the deduction can be claimed in the year before the year in which the loss occurred.
Postponing Gains
Gains realized on an involuntary conversion should be reported as income for the year in which it is received. You may, however, qualify to postpone recognition of the gain by buying qualified replacement property, as discussed in IRS Publication 547, Casualties, Disasters and Thefts (Business and Nonbusiness).
Example 1. Partial destruction and partial damage.
The Browns own 130 acres of forestland. On December 31, 2004 their timber basis was $90,675. The total volume of merchantable timber was 585 MBF, 4.5 MBF per acre. This made their depletion unit $155.00 per MBF, determined as $90,675/MBF ÷ 585 MBF.
On August 29, 2005 a hurricane struck their forestland. They immediately hired a consultant forester to estimate the volume of timber destroyed, the volume that is damaged but salvageable, and the total volume of all merchantable timber prior to the hurricane. The consultant reported 60 MBF totally destroyed, 90 MBF damaged but salvageable, and 445 MBF unaffected for a total of 595 MBF.
The consultant contacts several buyers to gauge interest in salvaging the timber. He finds no buyers interested in salvaging only 90 MBF. Therefore, he marks an additional 100 MBF for sale, making the total 190 MBF. The best price offered is $310 per MBF.
The tax effect of these transactions is as follows. The basis of the timber destroyed is $155 x 60 = $9,300. The change in fair market value was estimated using the contract price for the salvage sale, $310 x 60 = $18,600. The lesser of these two is the basis of the timber, however, because they were able to salvage timber this comparison doesn't affect their tax calculation. Instead, they pay tax on a net gain of $18,950, determined as,
| Sale proceeds, 190 MBF * $310 per MBF | $58,900 |
| Allowable basis, 2501 MBF * $155 per MBF | (38,750) |
| Consultant forester and other sale expenses | (1,200) |
| Gain | $18,950 |
How to report this gain - This transaction is reported on Form 4797, Sales of Business Property, Part III; and on Form 4684, Casualties and Thefts the gain is reduced by any other losses. If there are no losses, the gain is reported on Form 4797, line 3, where it is added to any other long-term Section 1231 gains and losses. If the result is a net gain it is reported on Form 1040, Schedule D, line 11. However, the gain can be postponed if qualified replacement property is purchased.
Example 2. Partial destruction
Assume the same facts as Example 1. On August 29, 2005, a hurricane struck their forestland. They immediately hired a consultant forester. She estimates that 60 MBF was destroyed, none was damaged but salvageable, and the total volume was 595 MBF prior to the hurricane, and a fair market value of $310 per MBF.
The basis of the timber destroyed is $155 x 60 = $9,300 if each individual MBF is used as the single identifiable property (SIP). The basis is $90,675, if the block is used as the SIP. Since the Browns have always kept all timber in one account, they use $90,675 as the basis for determining their loss. The change in fair market value was estimated using the consultant's fair market value, $310 x 60 = $18,600. The lesser of these two is the change in fair market value, making the loss they can claim $18,600.
How to report this loss - Since no gain is involved Form 4797 is not used. They use Form 4684, Section B – Business and Income-Producing Property, Part I, Casualty or Theft Gain or Loss. On Form 4684, Casualties and Thefts, this loss is offset by any gains. If a net loss results the next step depends on whether the timber was business of investment property.
Timber held for use in a trade or business. The loss on Form 4684, line 38a, is reported on Form 4797, line 14, where it would be added to other ordinary gains and losses. If a net loss results on Form 4797 it is reported on Form 1040, line 14, as an adjustment to gross income. Thus, these losses are fully deductible against any other income.
Timber held for production of income as a investment. The loss from Form 4684, line 38b is entered on Form 1040, Schedule A, Itemized Deduction, not subject to the 2% of adjusted gross income limit.