Chapter 3 - Timber Casualty Loss Audit Techniques Guide
Publication Date: September 2005
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
3. IDENTIFICATION OF THE PROPERTY UNIT
A. In General--
As a first step in determining the property unit for a casualty loss claim, one must inspect the taxpayer's records to determine how the timber accounts are maintained. In forested landscapes individual trees are usually grouped in cohorts or units called stands. In timber stands the species composition, tree age, and site productivity are often similar. The volumes of individual trees are measured in units depending upon the location. Examples of common units are board feet, cords, cunits, and tons. Timber is grown in timber "stands" and is inventoried and harvested in timber units. Large timber owners usually account for their timber holdings in timber blocks and file Form T; these timber blocks may encompass large tracts of timber and many timber stands. Smaller timber owners may account for their timber holdings in timber accounts that are separated by tracts of land or by stand delineation. It is these various groupings that will determine the limits of the casualty computation and allowable basis deduction. A quick review of Part II of the Form T should identify the timber depletion blocks being used by the taxpayer for all purposes for which timber basis is a requirement.
Reg. 1.165-7(b) provides that in the case of any casualty, the amount of loss to be taken into account for purposes of section 165(a) shall be the lesser of either--(i) the amount which is equal to the fair market value of the property immediately before the casualty reduced by the fair market value of the property immediately after the casualty; or (ii) the amount of the adjusted basis prescribed in §1.1011-1 for determining the loss from the sale or disposition of the property involved.
Under Reg. 1.165-7(b) (2), business casualty losses shall be determined by reference to the "single, identifiable property damaged or destroyed."
Revenue Ruling 99-56, accepts the "depletion block" as the SIP in timber casualty loss cases, and acknowledges that partial damage may be sufficient for claiming a casualty loss. In general, a "depletion block" is an account for timber basis that may be defined as an operational unit or a logging unit, or may be established by geographical or political boundaries or logical management areas. (Section 611) As a consequence, most casualty losses are now measured by the diminution in value in the entire "depletion block", rather than being limited by basis in the units of timber actually destroyed.
Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value (of the SIP) or the adjusted basis, (of the SIP). Treas. Reg. 1.165-7(b) (2).
B. Accounting Records to Review
Form T Timber — Part II
For most Large and Midsize taxpayers the generally accepted method for maintaining
timber accounting records is via Part II of Form T. This schedule tracks the
adjusted volumes of timber in a specified "block" (the SIP) along
with the adjusted allocated basis associated with the timber in each separate
block. Part II identifies all additions and deletions to a timber depletion
block. The individual depletion block identifies the property unit that will
be the SIP for all casualty computations. Part II defines the limits of the
remaining basis in the SIP.
If no Form T is filed then look to the taxpayer's other accounting records.
Not all taxpayers will provide a Form T as part of their tax return. For those taxpayers other records will indicate what constitutes the SIP for casualty loss purposes. Generally, these records will be various ledger/sub-ledger accounts derived from purchase contracts. These ledger/sub-ledger accounts reflect an allocation of purchase price among the various acquired assets of land, timber, and other improvements. These accounts may consist of separate stands, separate tracts, small blocks, or some combination. The SIP is generally decided by the taxpayer based on the method and/or date for acquiring the property.
C. Geographic Relationship Requirement
The appropriate SIP is any unit of property that has an identifiable adjusted basis and that is reasonable and logical and identifiable in relation to the area affected by the casualty. The timber basis in the taxpayer's block must correspond to the SIP as defined by the taxpayer. No shifting to encompass additional timber is allowable when computing casualty claims. The basis in a selected SIP is an historical balance reflected in timber accounts corresponding to specific property boundaries within a geographical location. The basis in the SIP is that basis associated with timber only and does not include any basis associated with land, roads, or other timberland assets.
D. Determine the SIP used to compute casualty losses
As verification for analyzing a taxpayer's SIP valuation, it is suggested that an IDR (Information Document Request) be issued requesting specific data. The taxpayer should be asked to provide the depletion schedule and/or the account data for the SIP used in determining the basis limitation for the claimed loss. Additionally, he should be asked to provide information documenting the property included in the SIP for purposes of determining the diminution in value of the SIP before and after the allowable casualty event. This documentation may include total acres in the block, maps, legal descriptions or a combination of these or other geographical data that delineates the SIP on the ground. The SIP and corresponding account information should be verified as an historical carry forward account and not a newly devised "block" for purposes of a casualty claim. Once a taxpayer has selected the property unit (SIP) for tax accounting purposes he cannot switch to another method or change the block boundaries without the director's permission.
Another IDR should be issued requesting that the taxpayer provide detailed calculations showing how the casualty loss was computed. This IDR should indicate that all data and/or assumptions, projections, limiting conditions, etc. used in the computation must be provided in order to substantiate the loss.
An IDR should be issued requesting a valuation appraisal of the selected SIP immediately before the casualty and a valuation appraisal of the selected SIP immediately after the casualty as defined in Section 1.165-7(b)(1).
E. Consequences associated with the SIP
There are several consequences of using the depletion block as the SIP for
a casualty loss. First, it permits the borrowing of basis from non-damaged
units within the block, but at a price. The price is the "consistency"
requirement imbedded in the regulation that requires both the basis limit
and the loss in value to be determined with reference to the same property
unit. Thus, the selection of the depletion block as the SIP means that the
valuation requirement changes from a valuation of damaged timber units (cords,
board feet), which is fairly easy to determine, to a valuation of the entire
depletion block, which could potentially include hundreds of thousands of
acres.
Second, there is a significant cost associated with the valuation of an entire
depletion block. For many taxpayers, this cost is prohibitively expensive,
and therefore, taxpayers do not typically perform valuations of the entire
SIP, but instead utilize a variety of short-cut techniques which are often
flawed.
Third, the larger the depletion block (SIP), the more the taxpayer is able
to borrow basis, but the less the damaged volume contributes to the value
of the property unit as a whole. Thus, small volume losses, as part of a large
SIP, may reflect little or no loss in overall value when the required "before
and after" valuation is properly performed.
Fourth, the block size, for purposes of determining the discount allowed in the Field Directive on Timber Casualty Losses, is the number of acres represented by the timber depletion account that the taxpayer uses to compute a depletion deduction for its tax return. The blocks used must be based upon the taxpayer's historical timber accounts delineated by geographical or political management boundaries or upon logical management areas. If the taxpayer has "reengineered" their depletion block size to take advantage of the lower discounts required under the director's field directive, the examiner may disregard the taxpayer's blocks. If the examiner determines that the taxpayer's blocks should be disregarded, the examiner should determine the taxpayer's correct blocks with respect to the most appropriate divisions. This determination should take into account the historical timber accounting records as well as the geographic and political boundaries and any blocks that the taxpayer has customarily used for management purposes.
Lastly, declining timber markets, such as those experienced in the Forest Products industry since 2000, may adversely impact a taxpayer's ability to recover basis and put pressure on improper (excessive) valuations. For example, if a timber property were acquired in 1999 (at peak prices) and experienced a casualty event in 2002, when timber values were at depressed levels, the aggregate basis of the property may be significantly higher than its value, particularly if the property were valued as a unitary whole (in a depressed market). Thus, there is more tax incentive to inflate values to recover more of the basis.
As can be seen, the use of the depletion block as the SIP can greatly complicate the valuation of a casualty loss. Examiners should explain to the taxpayer the purpose of the Field Directive on Casualty Losses in simplifying the examination process.