New Rules: Form 1099, Casualty Losses, and Errata
Tree Farmer Magazine: May/June 2008 - Volume 27 No. 3
This column deals with the new IRS rules that will be finalized by this summer concerning Form 1099, the information return businesses use to report certain transactions with their customers. An update on casualty losses to timber is also provided, i in light of the "unsettled" weather that has hit many parts of the country. I also need to let you know of a mathematical error in my last column.
IRS Form 1099 Required For All Timber Sales
There has been rampant confusion for many years about whether timber buyers are required to file information returns with the IRS, that is, IRS Form 1099. The issue came to a head when IRC Sec. 631(b) was amended by the American Jobs Creation Act of 2004 (P.L. 108-357, Sec 315(a)), which now allows owners of timber held primarily for sale to customers in the ordinary course of a trade or business to get long-term capital gains treatment for lump-sum stumpage sales. Previously only pay-as-cut sales qualified for capital gains treatment. And, if this were not enough to justify a change in the rules, the IRS has known for years that a significant portion, perhaps as much as 50 percent, of timber owners who sell timber don't report if on their tax return. Some owners assume that if they did not get a Form 1099 on their timber sale then the transaction was not taxable. Aside from violating the law, this underreporting reduces the significance of the timber economy in the official statistics compiled by the IRS.
Regulations under Internal Revenue Code (IRC) Sec. 6045 previously provided that filing of the 1099 by buyers was not required for the purchase of standing timber for a lump-sum amount since such transactions came under the Uniform Commercial Code of most states and, as such, were not real estate transactions. When timber was acquired under any form of so-called pay-as-cut contract, the payments were considered royalties since they were tied to the severance of the timber. Royalties are generally reported on IRS Form 1099 Misc. and are taxed as ordinary income. However, timber royalties are subject to capital gains treatment under IRC Sec. 631(b) and, as such, Form 1099S is to be used, not 1099 Misc. Timber royalties under IRC Sec. 631(b) are generally reported on Form 4797. Note that these provisions reflect current law.
On November 28, 2007, the IRS issued proposed changes to Reg. 1.6045-4 that classify all lump-sum sales as real estate transactions under 1.6045-(4)(2). This would make these transactions subject to the same reporting requirements as other real estate transactions. The effective date would be when the amendments to Reg. 1.6045-4 are adopted. Most likely this will not be for several years. Until then, given the clarity of the intent of the IRS, firms would be well served by adopting the proposed regulations and filing Form 1099 for all timber purchases.
Casualty Losses to Timber
The worst news tree farmers can get is that their timber has been decimated by a tornado, hurricane, fire, or other sudden, unexpected, and unusual event. The second worst news is how little financial help you get on your federal income tax return. Changes in the law during the last several years have helped somewhat, but only if a small portion of your timber is destroyed. Here's an overview of steps you should take if you are subject to a casualty.
Update your timber accounts. The first step is to update your timber accounts to reflect balances as of the beginning of the tax year in which the casualty occurred. The accounts are based on your original basis in the merchantable timber and premerchantable timber when your timberland was acquired. Adjustments must be made for changes since the date of acquisition. If you never established your original basis, it's imperative that you do so. Quite simply, without being able to document the basis in your timber, you will have no loss to deduct. Determination of the original basis and its allocation among the assets acquired can be done some time after acquisition, but since the volume and values on the date of acquisition must be used, this means hiring a professional forester to work backwards from current conditions. Obviously, the mess left after a casualty makes this more difficult.
Salvage timber if possible. The next step is to make a reasonable effort to salvage damaged or destroyed timber, as needed, to returns stands to full productivity. "Destroyed" is a relative term, and depending on the markets in your area, it may be possible to make a sale by including damaged timber. The goal may be to reduce the cost of cleanup, to reduce the risk of fire and prepare sites for regeneration. If a sale isn't possible, the cost of cleanup becomes a site preparation activity that may be deductible as a reforestation expense. If you do have a salvage sale, you determine the gain or loss as for any other sale by subtracting the basis for the timber sold - the depletion allowance - from the revenue from the sale. The gain or loss is reported as an involuntary conversion on Form 4797. Any gain can be postponed by the purchase of qualified replacement property.
Recover basis in timber destroyed. The forester that helps with your salvage sale, if any, should also provide you with an estimate of the volume of timber destroyed. This volume is used to determine the depletion allowance for the timber destroyed. It's also referred to simply as the basis of the timber destroyed. You need this to adjust your timber volume accounts. This depletion allowance, however, is not necessarily your casualty loss deduction. The forester also needs to provide you with an estimate of the fair market value of this timber immediately before the occurrence of the casualty. Your loss is the lesser of the fair market value of the timber destroyed and the basis of the "single identifiable property" (SIP) subject to the casualty. The SIP is no longer your depletion unit for each unit of timber destroyed. Your SIP is the "block" of which the destroyed timber is part. If all of your timber is in one set of timber accounts, including subaccounts for premerchantable timber, and perhaps different stands, then the SIP is the basis of this entire block.
If only a portion of the timber in the block is destroyed, it's possible that the fair market value of the timber destroyed is less than the basis of all the timber in the block. In this case, the amount of the casualty loss is determined by the fair market value of the timber destroyed, instead of the depletion allowance for the timber destroyed. If all the timber in the block is destroyed, the casualty loss is determined by the depletion allowance for the timber.
Properly reporting casualty losses generally requires the assistance of a professional forester and a qualified tax advisor. Issues such as how best to handle damaged timber are complicated, and professional advice based on your specific circumstances will be worth the cost.