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Plantation Loss Due to Severe Drought

Note: This ISP Paper was Decoordinated on March 3, 1992

ISSUE

(1) Does the unexpected and unusual seedling mortality (which required the taxpayer to replant) caused by a severe and prolonged drought give rise to a casualty loss deductible under Section 165(a) of the Internal Revenue Code? The seedlings were not insured.

(2) If not, is a deduction allowable under Section 165(a) as a noncasualty loss?

(3) If a deduction is allowable, how should it be computed and treated?

BACKGROUND, LAW, AND ANALYSIS

Rev. Rul. 72-592, 1972 C.B. 101, specifies the following rules in determining whether a loss is a casualty loss.

The loss must result from some event that is (1) identifiable, (2) damaging to property, and (3) sudden, unexpected, and unusual in nature.

To be "sudden" the event must be one that is swift and precipitous and not gradual or progressive.

To be "unexpected" the event must be one that is ordinarily unanticipated that occurs without the intent of the one who suffers the loss.

To be "unusual" the event must be one that is extraordinary and nonrecurring, one that does not commonly occur during the activity in which the taxpayer was engaged when the destruction or damage occurred, and one that does not commonly occur in the ordinary course of day-to-day living of the taxpayer.

Rev. Rul. 66-303, 1966-2 C.B. 55, states that where a prolonged drought causes damage or loss from progressive deterioration, as in the case of ornamental trees or shrubs progressively affected and ultimately killed from lack of water, the loss is not deductible as a casualty loss.

Rev. Rul. 77-490, 1977-2 C.B. 44, states that drought losses ordinarily will not meet the requirements of casualty losses.

Accordingly, in most cases, drought-related losses must be incurred in a trade or business or in a transaction entered into for profit to be deductible.

Rev. Rul. 81-2, 1981-1 C.B. 78, concerns whether the death, not due to casualty, of tree seedlings the corporate taxpayer planted in its initial reforestation effort on a tract gives rise to a deductible loss. It was the taxpayer's practice to examine planted tracts at the end of the second growing season (the first 2 years after planting were critical to survival of the seedlings) to determine whether enough seedlings had survived to satisfactorily stock the tract. Examination of the reforested tract as scheduled at the end of the second growing season showed that many seedlings had died and that portions of the planted areas were understocked. The taxpayer replanted the understocked portions. That revenue ruling holds that the taxpayer did not sustain any deductible loss attributable to the tree seedlings that died even though portions of the tract had to be replanted.

Whether the taxpayer is successful in its initial reforestation effort or whether it must replant in order to achieve satisfactory stocking, all amounts paid or incurred are capital costs incurred in the planting of timber and must be capitalized under Section 1.611-3(e) of the Income Tax Regulations. These amounts are recoverable when the timber is cut and depletion takes place or the tract is abandoned for the purpose of growing timber.

Subsequent to publishing Rev. Rul. 81-2, the Internal Revenue Service considered whether a corporate taxpayer's loss of timber in trees killed as a result of an epidemic attack of southern pine beetles was deductible under Section 165(a) of the Code. Section 165(a) provides the general rule that there shall be allowed as a deduction any loss sustained during the tax year and not compensated for by insurance or otherwise. In the GCM in which this situation was considered, GCM 39427, it was noted that normal and expected physical losses, as well as growth, that occur in growing timber, are accounted for in the depletion regulations. Section 1.611-3(e) of the regulations requires that the taxpayer adjust the quantity, but not the depletion basis, in a timber depletion account for losses not otherwise accounted for. The Service concluded that the losses of timber from the combined effect of the beetles and wood-destroying organisms was unexpected and unusual, but not sudden. Since the loss was not sudden, it could not be a casualty loss because, based on reasoning in Maher v. Commissioner, 76 T.C. 59 [593] (1981) [CCH Dec. 37,816], aff'd 680 F.2d 91 (11th Cir. 1982) [82-2 USTC ¶9460] (a case concerning the death of ornamental palm trees following their infection by insects with a fatal disease), the suddenness of the loss, rather than its onset, determines whether the suddenness requirement of a casualty loss is met. A noncasualty loss deduction under Section 165(a) was allowable though because the unexpectedness and unusualness of the loss distinguished it from those losses properly recoverable through the depletion regulations.

Whether the loss of seedlings results from a sudden, unexpected, and unusual event is a factual matter that must be determined in light of all the facts and circumstances. The sever drought that occurred in the Southeast in 1986 is not the kind of event normally encountered in the day-to-day activities of growing timber. Seedling mortality due to such an event very likely would be characterized as unexpected and unusual, but not sudden. The loss of property due to drought generally is a gradual or progressive loss.

The adjusted basis of property limits the amount deductible on the loss of that property. With respect to establishment of a stand of timber, capitalizable costs include those incurred in acquiring seedlings, for labor and tools used in planting, and for site preparation. It is such costs that are available for deduction in case of loss.

Section 1231(a) of the Code provides that if recognized gains on sales or exchanges of "property used in the trade or business," as defined in Section 1231(b), plus recognized gains from the involuntary conversion into other property or money of property used in the trade or business of any capital asset which is held for more than 6 months and is held in connection with a trade or business or a transaction entered into for profit, exceed the recognized loss in the tax year from such sales, exchanges, or conversions, they are treated as long-term capital gains and losses. If such gains do not exceed such losses, they are not treated as resulting from the sale or exchange of capital assets. "Property used in the trade or business" includes real property used in the trade or business, held for more than 6 months, which is not property of a kind which would properly be includable in the inventory of the taxpayer if on hand at the close of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business. In the case of any involuntary conversion of such property arising from fire, storm, shipwreck, or other casualty, or from theft, section 1231(a) does not apply if the recognized losses exceed the recognized gains from such conversions. Losses upon the complete or partial destruction of property are treated as losses upon an involuntary conversion whether or not there is conversion of the property into other property or money according to section 1231(a)(4)(B) and Section 1.1231-1(e)(1) of the regulations.

SERVICE POSITION

(1) Whether the unexpected and unusual loss of the seedlings was sudden and constitutes a casualty loss is a factual matter that must be determined in light of all the facts and circumstances. In general, however, the loss of property due to drought is a gradual or progressive loss and it does not qualify as a casualty loss. Thus, a casualty loss deduction would not be allowed on the unexpected and unusual loss of the seedlings as a result of the drought unless the taxpayer can clearly show that the loss was sudden rather than gradual or progressive.

(2) The unexpected and unusual loss of the seedlings distinguishes it from those losses properly recoverable through depletion Section 611 of the Code. Thus, the loss would be a deductible noncasualty Section 165(a) loss if the loss were incurred in connection with a trade or business or a transaction entered into for profit.

(3) In the case of an allowable noncasualty loss deduction, the amount of the deduction includes:

a. The portion of the costs of seedlings, and for labor and tools used in the initial planting, plus . . .

b. The portion, if any, of the costs of site preparation incurred in the initial planting effort that was lost (for example, those costs of initial site preparation work that had to be duplicated on replanting) allocable to the dead seedlings or acres on the portion of the tract that was understocked and had to be replanted.

If the noncasualty loss resulting from the involuntary conversion is in connection with "property used in the trade or business" or any capital asset which is held for more than 6 months and is held in connection with a trade or business or a transaction entered into for profit, the loss must be netted with any other noncasualty gains and losses of the taxpayer under Section 1231(a) of the Code.