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Revenue Ruling 90-61, 1990-2 CB 39

Losses: Drought: Tree seedlings

[Code Sec. 165. Also, Code Secs. 48, 194, 611 and 1231 ]

Losses: Drought: Tree seedlings.--Greater than normally anticipated failure of planted tree seedlings because of an abnormal drought results in a deductible loss under Code Sec. 165. The deductible loss, allowable for the year in which the seedlings died, is in an amount equal to previously capitalized reforestation costs that had to be duplicated on replanting. The loss is treated as a loss from an involuntary conversion of property under Code Sec. 1231(a)(4)(B). Rev. Rul. 81-2 distinguished; Rev. Rul. 87-59 amplified.

ISSUE

If abnormal drought causes the death of tree seedlings planted for use in a taxpayer's business, is there a deductible loss under section 165 of the Internal Revenue Code? If so, what is the timing, amount, and character of the deductible loss?

FACTS

The taxpayer, which files its federal income tax returns on a calendar-year basis, owns forested lands in the southeastern United States and manages them to yield timber on a continuous basis for use in the business of manufacturing lumber.

During November 1985, having previously harvested the timber on 2O0 acres of its lands by clearcutting, the taxpayer reforested the cutover area by planting nursery-grown tree seedlings. Reforestation practices vary, depending, among other factors, on the particular site and on the species of tree being grown. For the site and species that was planted in this case, the taxpayer's method is to plant 600 well-spaced seedlings per acre. Because of the vulnerability of newly planted seedlings, the taxpayer's normal practice is to examine planted areas at the end of the second growing season to determine whether the number and spacing of the surviving seedlings are sufficient to produce a satisfactory stand of timber and thus use the productive capability of the land economically. As a rule, if fewer than 300 well-spaced seedlings per acre survive, the reforestation is unsatisfactory, and the taxpayer replants the understocked areas. In normal years, replanting is required on not more than 5 percent of the acreage inspected.

In this instance, however, during the spring and summer of 1986, the planted area was subject to a drought of unexpected and unusual severity. By the time drought conditions subsided in the fall of 1986, stocking was still adequate on the area of the reforested tract that was located near water. On the remaining 60 percent of the tract, however, only 50 or fewer seedlings per acre (less than 10 percent) had survived the drought. Because more than 90 percent of the seedlings on the understocked acreage had died in 1986, the planting on this acreage was worthless, and complete replanting of this understocked acreage was required. (The failure of 60 percent of the planting is greatly in excess of the normally anticipated failure of 5 percent or less.) During January 1987, the understocked acreage was replanted by machine with 600 well-spaced seedlings per acre.

The seedling deaths were attributable to the drought and were not sudden enough to qualify as a loss due to casualty under section 1231(a)(4)(C) of the Code. They were not covered by any type of insurance. The taxpayer continued to use the area for growing timber for eventual use in the taxpayer's lumber-manufacturing facilities.

The costs of the initial reforestation during November 1985 included site preparation expenditures (for example, costs of windrowing of logging slash and brush, preparing seedling beds with disc equipment, and depreciation on equipment) and planting expenditures (for example, seedling costs, labor expense, tool expense, and depreciation on equipment). For federal income tax purposes, the taxpayer capitalized both the site preparation and the planting expenditures into a plantation, or deferred reforestation, account representing the costs attributable to the seedlings (immature timber) on the 200-acre tract. This plantation account, along with other plantation accounts and a merchantable timber account, is part of a larger account that consists of the costs attributable to all the timber on 50,000 acres of the taxpayer's lands, including the 200-acre tract. When the planted trees reach merchantable size, the amounts in the plantation account are transferred to the merchantable timber account and eventually recovered through a depletion deduction as the timber is cut, processed, and sold as lumber.

Except for the extraordinary nature of the cause for the replanting, the facts in the present situation do not differ substantially from those in Rev. Rul. 81-2, 1981-1 C.B. 78.

LAW AND ANALYSIS

Section 165(a) of the Code 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.

Section 1.165-1(b) of the Income Tax Regulations provides that to be allowable as a deduction, a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and, except as otherwise provided (such as in section 165(i) of the Code), actually sustained during the tax year.

Section 165(b) of the Code provides that the basis for determining the amount of the deduction for any loss shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property. Section 1.165-1(c) of the regulations provides that the amount of loss allowable under section 165(a) shall not exceed the amount prescribed by section 1.1011-1 as the adjusted basis of the property involved.

Section 165(i) of the Code provides that any loss attributable to a disaster in an area determined by the President of the United States to warrant assistance under the Disaster Relief and Emergency Assistance Act (prior to November 23, 1988, the Disaster Relief Act of 1974) may be taken into account for the preceding tax year at the election of the taxpayer.

Section 611(a) of the Code provides that in the case of timber there shall be allowed as a deduction a reasonable allowance for depletion under regulations prescribed by the Secretary.

Section 1.611-3(c) of the regulations requires every taxpayer claiming or expecting to claim a deduction for depletion of timber property to establish accounts in which to record the basis of the timber, including allowable capital additions.

Section 1.611-3(a) of the regulations provides that amounts paid or incurred in connection with the planting of timber shall be capitalized and shall be recoverable through depletion allowances.

Section 1.611-3(b) of the regulations, in general, provides that the allowable depletion for a year is determined by dividing the adjusted basis in an account by the total number of units of merchantable timber in the account, and multiplying the resulting "depletion unit" by the number of units cut.

With respect to merchantable timber, section 1.611-3(e) of the regulations describes circumstances in which the units of timber in a depletion account are to be adjusted without a corresponding basis adjustment. It provides that if, as the result of the growth of timber, of changes in standards of utilization, of losses not otherwise accounted for, of abandonment of timber, or of operations or development work, it is ascertained that there remain available for utilization more or fewer units of timber than remain in the timber account on the basis of the original estimate, then the original estimate (but not the basis for depletion) shall be revised.

Section 165(f) of the Code provides that losses from the sale or exchange of a capital asset shall be allowed only to the extent allowed in sections 1211 and 1212. Under section 1231, the character of gains and losses from sales, exchanges, and conversions of specified types of assets depends on the outcome of computations netting such gains and losses for the tax year. In these computations, losses on the destruction of qualifying assets are regarded as losses from an involuntary conversion. The precise treatment of these losses depends on whether they arise from casualty. See section 1231(a)(4)(B) and (C).

In Rev. Rul. 81-2, the taxpayer grew timber for business use. As did the taxpayer in the present case, the taxpayer in Rev. Rul. 81-2 planted a cutover tract with 600 seedlings per acre. Following its normal practice, the taxpayer examined the planted area at the end of the second growing season to determine whether stocking was satisfactory or whether some replanting would be necessary. The examination showed that some of the tract was not satisfactorily reforested, and the taxpayer therefore replanted the understocked portions. The seedling deaths were not due to casualty. Rev. Rul. 81-2 holds that the taxpayer did not sustain any deductible loss attributable to the seedlings that died, even though portions of the tract had to be replanted. That ruling also holds that the replanting costs, as well as the original planting costs, must be capitalized in accordance with section 1.611-3(a) of the regulations.

In Rev. Rul. 87-59, 1987-2 C.B. 59, the taxpayer lost timber used in the taxpayer's trade or business. An unexpected and unusual insect attack on a stand of merchantable pine trees caused the death of the trees but did not appreciably damage the wood. The death of the trees rendered them vulnerable to wood-destroying organisms that gradually caused the deterioration and worthlessness of the uncut timber. That revenue ruling holds that the loss was not sudden enough to constitute a casualty loss. However, the loss of the timber from the combined effects of the tree-killing insects and the wood-destroying organisms was unexpected and unusual. The ruling holds that this distinguishes the loss from normal and expected physical losses that occur in growing timber and that properly are recoverable through depletion under section 1.611-3(e) of the regulations. The taxpayer's loss of timber from an unexpected and unusual cause gives rise to an allowable business loss deduction under section 165(a) of the Code in the tax year when the loss of the timber in the trees was realized, which in that ruling was when the timber became worthless and was bulldozed and burned. Because the loss did not arise from a casualty, it was required to be netted with other noncasualty section 1231 gains and losses.

The regulations under section 611 of the Code generally require that the costs of acquiring or establishing a stand of timber be capitalized and recovered through a deduction for depletion as the timber is cut and the products produced are sold. To achieve this purpose, both merchantable and immature timber, as well as the related costs, are aggregated in accounts that reflect the taxpayer's basis in the timber.

With respect to merchantable timber, section 1.611-3(e) of the regulations requires that a taxpayer adjust the quantity, but not the basis, of timber in a depletion account for such factors as growth of timber, abandonment of timber, and losses not otherwise accounted for. This regulation contemplates two distinct ways to account for losses involving timber. First, some capitalized costs that could be associated with lost timber remain in the account and are recovered by the standard depletion mechanism, even though the quantity of timber in the account available for depletion is adjusted. Second, as is indicated by the reference to losses "not otherwise accounted for," some capitalized costs are recoverable as a current loss, with a corresponding adjustment to basis as well as quantity, prior to the time that the cost would have been otherwise recovered through depletion.

Which method is appropriate to account for timber losses depends on the facts of the case considered in the light of the role of capitalization, which is to match expenses with associated income. The first method is applicable with respect to normal, expected physical changes in the quantity of timber that occur in growing timber for the production of income on harvest. These changes, including losses of timber resulting from mortality of trees from normal expected causes, are accounted for by an adjustment in the quantity of timber in the depletion account without a corresponding adjustment in basis. Such an adjustment reflects the fact that no gain or loss is currently recognized for changes in the quantity of timber that reflect growth and yield expectations in the income-producing operation. In contrast, if identifiable timber losses are due to casualty or, although not sudden in nature, are from unexpected and unusual causes, then the timber losses give rise to a current loss deduction, with a corresponding downward adjustment to the basis as well as to the quantity in the depletion account. See Rev. Rul. 87-59.

With respect to immature timber, a similar analysis applies. When a cutover tract is planted, seedling mortality within a certain range, possibly requiring some replanting, is considered normal. The timber grower takes such mortality into account at the outset by planting more than enough seedlings to stock the area satisfactorily and by planning to inspect the area and replant where necessary. The benefit of these activities survives the foreseeable death of some of the seedlings. Accordingly, such anticipated seedling deaths, including deaths attributable to normal cyclical drought conditions, do not give rise to losses deductible under section 165 of the Code. See Rev. Rul. 81-2.

In the present case, the seedling deaths due to the abnormal drought were unexpected, unusual, and identifiable. The seedling deaths here are thus distinguishable from those that occurred in Rev. Rul. 81-2, and a loss deduction is allowable under section 165 of the Code if the requirements of that provision are otherwise met. Because the loss was incurred in a trade or business, it need not result from casualty to be deductible under section 165. See Rev. Ruls. 77-490, 1977-2 C.B. 64, and 87-59.

With respect to the timing of the deduction, the seedlings died, thereby becoming worthless, during 1986. There is no reasonable prospect of reimbursement for the loss through insurance or otherwise. Because the tract is not within a declared drought-related disaster area for 1986 (see Rev. Rul. 86-151, 1986-2 C.B. 29, for a listing of declared disaster areas), the taxpayer cannot elect under section 165(i) of the Code to deduct the loss in the preceding year. The taxpayer's loss is therefore deductible in 1986.

The amount of the deduction for the taxpayer's loss is limited to the adjusted basis in the lost property for determining gain or loss from its sale or other disposition. Section 165(b) of the Code and section 1.165-1(c)(1) of the regulations. In the present case, the adjusted basis of the lost property, and thus the deductible amount, consists of that portion of the initial planting and site preparation expenditures in the plantation account allocable to the acreage that had to be replanted, excluding any costs incurred in the initial planting effort that did not have to be duplicated on replanting, such as the cost of windrowing of logging slash and brush. See section 1.612-1(a) (providing for allocation of basis if part of a timber property is sold).

The taxpayer's basis in the plantation account must be reduced by the amount of the loss deduction, to prevent the equivalent of a double deduction. See sections 1.612-1(a) and 1.1016-6(a) of the regulations.

The loss of the tree seedlings in the present situation qualifies as an "involuntary conversion" of property resulting from "destruction" within the meaning of section 1231(a)(4)(B) of the Code but does not arise from "other casualty" under section 1231(a)(4)(C). If the tree seedlings qualify as assets described in section 1231, the netting computations required by section 1231 will determine whether the loss will be an ordinary loss or a capital loss. If it is a capital loss, it will be subject to the limitations described in sections 165(f) and 1211.

The costs of replanting must be capitalized. They may be subject to amortization under section 194 of the Code and to investment credit under sections 48(a)(1)(F) and 49(b)(3). See Rev. Rul. 81-2. For the types of costs subject to capitalization, see Rev. Rul. 75-467, 1975-2 C.B. 93.

HOLDING

The taxpayer sustained a loss deductible for 1986 under section 165 of the Code, in an amount equal to the portion of the basis in the taxpayer's plantation account properly attributable to the seedlings on the area that had to be replanted as a result of the abnormal drought. The deductible amount includes only those previously capitalized reforestation costs that had to be duplicated on replanting.

The deduction is subject to the limitations in sections 165(f) and 1211 of the Code if the loss is deemed to be a capital loss as a result of the computations required by section 1231.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 81-2 is distinguished, and, to the extent it implies that a deduction is never allowable for a loss of seedlings unless the loss is due to casualty, it is modified. The holdings in Rev. Rul. 81-2 with respect to capitalization of replanting costs, amortization, and investment credit remain valid.

Rev. Rul. 87-59 is amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mr. Harold Burghart of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Burghart on (202) 566-3292 (not a toll-free call).