Hurricane Katrina and Rita Hit Timber Owners Hard, But No Tax Relief Expected For Timber Losses
Tree Farmer Magazine: November/December 2005 - Volume 24 No. 6
Estimated timber losses were over $5 billion for Katrina alone. Rita will raise the total. I hope I'm wrong by the time your read this, but as of this writing there was little chance of tax relief on timber losses. Please go to the IRS Newsroom On-line at http://www.irs.gov/newsroom/index.html for the latest update, including disaster area designations. We'll also keep the National Timber Tax Website (www.timbertax.org) updated.
Natural disasters that destroy and/or damage timber don't result in a significant tax loss deduction for most taxpayers. Decades of work and expenditures for planting and management of timber are reduced to splinters in an instant with little hope of a significant tax deduction. The upper limit on a loss deduction is your timber's basis.
What Hurricane 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 you can do with just the 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. You might also consider selling investments producing gains to offset losses.
(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 of timber in the block that was destroyed.
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.
Partial damage
Hurricanes may not completely destroy trees, but may break off tops and limbs.
This may reduce the growth rate and quality of trees 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. Thus, if
you are an "aggressive taxpayer" you may want to claim a loss
of 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 salvaged and destroyed.
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 549, Condemnations and Business Casualties and Thefts.
More Information
There is more detail and examples at www.timbertax.org