Chapter 4 - Timber Casualty Loss Audit Techniques Guide
Publication Date: April 2011
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.
4. Basis Verification: Basis of Timber in the SIP
A. Audit of Form "T"
The current Form T (Rev. 12-2005) consists of a group of detailed Parts and supporting taxpayer documentation. These Parts are as follows: Acquisitions (Part I); Timber Depletion ( Part II); Profit or Loss from Land and Timber Sales (Part III); Reforestation and Timber Stand Activities (Part IV); Land Ownership (Part V).
I. Verify that the ending balances from the prior year and the starting balances for the next year are the same on Part II, timber depletion.
II. Verify that all schedules are Tax vs. book.
The following lines on Part II should be analyzed.
A. Line 3 provides for corrections and details of any corrections should be examined to insure that they were properly determined.
B. Annual growth increment of the timber is recorded on line 4a. A reasonable growth factor should be used. If a growth factor is omitted, the taxpayer will be over claiming depletion.
C. The volumes and values on Line 5 should match the acquisitions as recorded on line 9 of Part I. The value of recently acquired timber should be checked for proper allocation. (i.e., only the prorated timber share of the FMV of the acquired property should be included on line5).
D. Any expenditure incurred during the year for silvicultural treatments that are capital in nature should be added to the appropriate timber account with an entry on line 6
E. The unit rate of depletion for merchantable timber is a simple calculation and is recorded on line 8. Be sure to check the division as this entry can sometimes be listed incorrectly
F. Line 9 shows the volume of timber harvested during the year and should be verified from taxpayer records.
G. The depletion sustained on the harvested timber is a simple multiplication of the unit rate on line 8 times the volume harvested on line 9. Verify the correctness of this entry on line10.
H. It will be necessary to verify the characterization of the disposition of timber as recorded on line 11. Occasionally non-recognition items such as like kind exchanges and involuntary conversion items are disguised as sales.
I. Verify the computation of allowable basis recovery for timber sales on line12.
J. Line 13 records the “Quantity of standing timber lost by fire or other causes during the year”. It will be necessary to verify the volumes claimed on this line with taxpayer field data. Any timber that was salvaged as the result of a casualty event should not be reported on this line as “lost” volume. Salvaged timber should not be double deducted, as the salvaged volumes should appear on Line 9.
K. The allowable basis of loss reported on line 14 records the unit basis of the “lost” timber and the remaining deductible loss provided by case law and Rev. Rul. 99-56. The correction for the additional basis recovery is made on line 14 of Part II to compute the carry forward basis for the next year.
B. Accounting Records
The financial accounting records may or may not mirror the tax accounting records. Since the tax basis and tax volumes are the only relevant facts, very little time should be spent reviewing the financial records. If the book and tax records mirror one another, then the audit steps as outlined above for Form T should be performed. If the book and tax basis are not the same, the auditor should determine that the proper schedule M-1/M-3 adjustment has been made for the book and tax difference. There should be an M-1/M-3 for the difference between the tax depletion as computed on Form T and the book depletion provided for in the financial records.
C. Retroactive Basis Determinations
Often medium and small taxpayers (SB/SE; Small Business/Self Employed) have not maintained records to verify their basis in the timber destroyed by casualty. Clearly, the taxpayer is entitled to a loss if the basis can be established or reconstructed. Retroactive basis determinations involve “ungrowing” the timber that is on the property at the time of the casualty to determine the approximate volume and value of the timber at the time of acquisition. A reconstruction of adjusted basis must consider all of the assets acquired. In addition, the property may have had very little timber or only young growth when acquired, so very little basis may be allocable to the timber affected.
The following steps may be used for reconstructing basis. It is suggested that a qualified forester be consulted to assist in some of these determinations.Step 1: When and how was the property acquired?
- Acquisition by Inheritance or Purchase
- Involves a determination of the Fair Market Value (FMV) at the date of acquisition.
- Acquisition by Gift or Exchange
- involves a determination of the carryover or substituted basis at the date of gift or exchange. Ideally, there will be records showing donor’s basis (in the case of gift property) or transferred property basis (in the case of exchanges). If such records do not exist, it still may be possible to reconstruct basis, if the original acquisition date (of donor or exchange property) can be determined. If so, the procedures for reconstructing basis will then be similar to those described for acquisitions by inheritance or purchase, which involve a determination of the FMV of the property at the date of original acquisition.
Step 2: What are the Characteristics of the Property?
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• Determine the original Purchase Price or Value for entire property
- Stand-by-stand listing of species, volume (MBF, cords), age, size, log grade.
- Improvements conducted by owner - reforestation, fertilization, thinning
- Prior timber losses, cutting or sales (volumes)
- Timber or land acquired since original purchase •Type of ownership (family partnership, other agreements)
• Catalog all property rights, known zoning or environmental restrictions.
• List all property improvements at the time of acquisition (buildings, roads, fences, etc.)
• Develop an acreage summary by land class. (forest, pasture, stream, wetland, home site, landscaping, etc.)
• Obtain property tax records, maps, aerial photos of property at time of acquisition or now.
• Current Timber information:
Step 3: Determine Timber Growth Rate - by acre or other unit
- Resources: Consulting foresters, local forestry schools or coops, local forest service offices, etc.
Step 4: Calculate Original Values, by property type
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• Volume:
- Ungrown current volumes, by species, to date of original acquisition.
- Make other volume adjustments for purchases, reforestation, losses, sales, or cuttings.
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• Value:
- Timber Value - stumpage prices from that time period, using “then” volume, size class, etc.
- Land Value - Property tax and real estate records from “then”.
- Building & Other Improvements Value - Property tax and real estate records from “then”, reconstruction of cost.
- Any other restrictions affecting value?
Step 5: Allocate Original Basis
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• List all assets, “then” FMV, and percentage of total FMV
• Multiply by Original Purchase Price
• Result is Cost Basis, allocated to various assets
Step 6: Make subsequent basis adjustments to Timber Account
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• Calculate depletion (basis recovery) rate by dividing original volume by cost basis.
• Reduce original basis for volumes removed
• Increase original basis for cost of improvements made
• Result is Adjusted Basis at time of Casualty
D. Examination Issues
The examination and verification of the tax basis as related to casualty losses is an essential audit step. The issues range from failure to support the tax basis to improper valuations. The following is a brief description of some issues related to the tax basis of timber and timberlands. This is not an all-inclusive list of the issues that may be detected during the verification of the tax basis.
A. IRC Section 165 requires a determination of the FMV of the entire SIP before and after the casualty. Often taxpayers will fail to obtain a proper valuation of the FMV of the entire SIP immediately before and after the casualty loss. This issue will be present for SB/SE, W&I, and LB&I taxpayers. The issue may be more prevalent in larger taxpayers, which have large timber blocks.
B. Failure to properly support the tax basis is one of the most common issues. This is more prevalent with small SB/SE and W&I taxpayers; however, it could be present in LB&I cases. The examiner should request the supporting documentation for the tax basis to become reasonably comfortable that the basis of the loss is properly supported.
C. Overvaluation of the timber loss based on inflated values of the timber is another common issue related to tax basis. In order to claim a substantial portion of the tax basis, taxpayers often inflate the diminution in the FMV of the timber loss.
D. The taxpayer may claim the entire cost basis of the timber and the cost of the underlying land as his basis limitation. The basis in the land is not an allowable deduction for a timber loss. An examination of the initial allocation of the cost basis between the land, land improvements and timber will reveal issues in this area. If the initial tax basis was not allocated among the various assets, the casualty loss may be overstated. Even if the original tax basis was allocated among the various assets the proper amount of basis may not have been allocated to the land and land improvements. Consequently, the casualty may be overstated as a result of the understated tax basis of the land and land improvements.
E. The tax basis may be improperly computed in cases where the taxpayer acquired the property by inheritance or as a gift. For example, when a taxpayer inherits property their tax basis is generally equal to the FMV on the date of death. In small estates, the heirs may have failed to obtain a valuation of the property on the date of death. Later, when a casualty occurs, the taxpayer obtains a current FMV determination and then claims the current FMV as the measure of the casualty loss. Scrutiny of the supporting documentation of the loss will reveal the use of the current FMV instead of the FMV at the date of death.
A similar situation occurs with property acquired by gift. The tax basis of property acquired by gift will be the donor’s basis plus the gift tax paid on the date of the gift. Some taxpayers may obtain a current FMV determination and then claim the current FMV as the measure of the casualty loss. In each of the above scenarios the difference between the current FMV and the correct tax basis could be substantial.