Timber Casualty Losses

Timber refers to trees valued primarily for the commercial utilization of their wood content. Timber in this context also refers to trees held for the production of income as a business or investment. Since timber is an appreciating asset, the depletion unit is usually less than its fair market value per unit volume. Also note that unless a separate cost basis has been established for the timber it may not be possible to claim any loss. It wouldn't be possible to determine which is lower, the basis or the decrease in the fair market value.

Determining a Timber Casualty Loss

Before a deductible loss can be determined you have to first decide whether to define the "single identifiable property" (SIP) as the individual units of timber, or the timber block. And second, whether to include just the timber destroyed, or the timber damaged and destroyed.

It is usually to your advantage to use the entire block as the SIP. This usually results in the change in fair market value being less than the basis. This means keeping all of your merchantable timber in one account. You should compare the results with the two approaches before making a decision. The IRS is not likely to allow you to change the method used after the casualty event has happened.

The decision on whether to include damaged timber in the casualty loss calculation is up to you. The impact of Rev. Rul. 99-56 on how IRS auditors will treat returns claiming a loss for damaged timber is unclear. Indications are, however, that unless unusual circumstances are involved you will be allowed to do so. Make this decision on on the basis of whether or not you will be able to conduct a salvage sale and how much of the damaged timber can and should be salvaged.

Basis of timber destroyed - Timber is destroyed if it has no salvage value. The basis of timber that has been destroyed is determined by adjusting the relevant timber accounts (to reflect any changes that occurred up to the casualty event), determining the depletion unit and multiplying the number of units destroyed by the depletion unit. It may be necessary to have a timber cruise to determine the amount of timber actually destroyed.

Basis of timber damaged - Timber is damaged if the productivity or quality of individual trees is reduced. Common forms of damage are broken tops and limbs from ice or wind, and leaning trees resulting from wind storms. A professional forester should be employed to estimate the volume and change in value of timber subject to damage.

Change in FMV of timber destroyed - The FMV of timber destroyed is its fair market value immediately before the casualty. By definition its FMV after the casualty is zero because it can not be salvaged.

Change in FMV of timber damaged - The value immediately before the casualty and immediately after must be estimated. It is necessary to do this only for those trees that will not be salvaged. Value may be reduced by changes in the quality of the products that could be cut from a tree. Value may also be reduced by a reduction in the rate of growth resulting from the loss of photosynthetic area (tops and limbs). An experienced forester should be consulted to make this determination.

Unmerchantable timber - A deductible loss may be claimed for unmerchantable timber if the following conditions are met:

  1. Separate accounts are maintained under the heading of young growth or plantation,
  2. Costs have been allocated to these accounts,
  3. These costs have not already been transferred to the merchantable timber account.

The basis of unmerchantable timber destroyed is computed by dividing the total cost shown in the account by the number of acres in plantation or young growth, and multiplying this amount by the number of acres destroyed.

Other Considerations:

Salvage must be attempted - If the timber is not rendered totally unmerchantable a reasonable effort must be made to salvage as much as possible. This means contacting potential buyers and soliciting offers. You should keep a record of buyers contacted and their responses. It is also advisable to make a photographic record of the damage. If you can't complete the salvage process in time to report the loss, use an estimate of salvage value. If the actual amount received is different than the estimate, an adjustment is made on the tax return for the year when the actual amount is finally determined.

Applicability of Passive Loss Restrictions - If a timber activity constitutes a business in which the owner doesn't materially participate, losses are deductible only to the extent of passive income from any other passive activity. The passive loss rules don't apply to activities carried out as an investment. In Treasury Decision 8290, 2-23-90, the IRS amended the passive loss regulations to clarify that the restrictions do not apply to losses form fire, storm, shipwreck, or other casualties or from theft. Thus, a timber loss resulting from an ice storm or tornado is deductible even if the timber is held for use in a business in which the owner doesn't materially participate.

Reporting a Timber Casualty Loss

The deduction should be claimed for the tax year in which the casualty 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. The deduction claimed should reflect any offsetting compensation, even though the compensation may not have actually been received as of the filing date. Adjustments can be made in later tax returns for differences between the anticipated and actual compensation. Any excess is simply included as income in the year in which it is received. It is not necessary to recompute the tax for the year in which the deduction was claimed.

The amount of any gain or loss from a timber casualty is determined in the same manner as for timber sales in general. However, the amount of the gain or loss is reported as an involuntary conversion, a section 1231 transaction. Losses are reported of Form 4684, Section B. The amount claimed is carried over to Form 4797.

The tax affect depends on any other section 1231 transactions or other capital gains or losses you may have for the year. In the case of timber held for use in a trade or business any loss reduces your net income on a dollar for dollar basis. In the case of timber held for the production of income the loss is reported on Schedule A, Form 1040, as an itemized deduction not subject to the 2 percent of adjusted gross income limit.

Adjustment of timber accounts - The timber accounts are adjusted to reflect the loss. If a nondeductible loss occurs the timber volume account is adjusted; however, no adjustment is made in the timber value account (cost basis) since none of the basis was recovered.

Additional Information in Case of Audit - If your return is audited for some reason you may be asked to provide additional information to support your casualty loss claim. The additional information would be provided on Form 4748. You would be well advised to maintain in your records the information included on this form in case of an audit.

Treatment of Gains From Involuntary Conversions:

The gain on an involuntary conversion should be reported as income for the year in which it is received. You may qualify to postpone recognition of the gain buying replacement property. An involuntary gain is realized when the insurance, award, or other compensation received for property involuntarily converted is greater than the basis of the property.

For additional information please refer to IRS Publication 547 (Sales and Other Dispositions of Assets) and 549 (Casualties, Disasters, and Thefts).