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Casualty Loss Deduction: Guinea Pigs Needed

Tree Farmer Magazine: September/October 1999 - Volume 18, No. 5

Several articles in this magazine and others have pointed out the financial hardship resulting from losses to timber. This results primarily from how the IRS applies the law to timber. Attempts to change the underlying statutory law have failed. In part this is because the law provides more sensible results for most other kinds of property, for example shade trees. It's proven tough to get Congress to change the underlying law just for timber. It is also not clear that completely rewriting the law for timber is practical. But there is another process already in place that could provide some of you with relief.

I need to first review the law and its application to timber. Then I'll discuss how you might be able to help change the law through the courts and the IRS's administrative procedures.

The language in the statutory law, the Internal Revenue Code, is very broad: "There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise." (IRC Sec. 165(a)) The Code includes several restrictions on losses of individual taxpayers and more specific rules for some types of property. It doesn't include any specific rules for timber. The rules we're concerned about are those of the IRS, specifically IRS regulations. Of course these regulations carry the full authority of the government and must be followed unless changed by the courts or the IRS. But, there is a great amount of possible flexibility within the law as passed by congress.

The IRS's rules for timber are that the deductible loss is the lesser of the basis of the "single identifiable unit of property" subject to loss, or the change in the fair market value of the unit of property. The change is the difference between the fair market value of "the property"" before and after the event. The event could be a casualty or a non-casualty business loss. We're most concerned about casualty losses. A casualty is a sudden, unexpected and unusual event, such as a hurricane, wild fire, or tornado resulting in the partial or complete destruction of property.

In the case of timber ( trees held for the production income as an investment or business) "the property" is defined under IRS regulations as the individual unit of timber subject to the casualty. Unit means board feet, cords, cunits, or whatever other unit is used in your depletion accounts. The loss then is the lessor of the basis of the individual unit of timber or the change in the fair market value of the unit of timber. The tax tragedy results from the fact that in most cases the basis is less than the reduction in fair market value. Thus, your deductible loss is the depletion allowance for the volume of timber destroyed. Your depletion allowance is your depletion unit multiplied by the number of units destroyed. If you don't have a basis in your timber you have no loss at all.

Change in Law Already Underway

Several large forest products companies have taken to court the issue of what the proper definition of the "single identifiable unit of property" is in the case of timber. A national court has upheld these corporations' definition as the entire "block" of timber subject to casualty. The term block has a specific meaning in the regulations, being basically any aggregation of individual stands, tracts, or other parcels of timberland that are treated as a single unit for management and accounting purposes. Thus, in some cases all the timberland owned by a corporation in a given state could constitute a block. One of the arguments used by the corporations is that if the IRS accepts the block as the logical unit for calculating the depletion allowance it would seem logical to also use it in determining the deductible loss.

If you compare the basis of an entire block of timber to the change in fair market value of a portion of the timber in a block there's a much greater chance that the change in fair market value will be less than the basis of all the timber in the block. In such a case the deductible loss would be the change in fair market value. That's the result we'd like to always have.

I need to point out that approach is useful only in some circumstances. A key factor is the proportion of the timber in a block that is destroyed. If all of it is destroyed the change in fair market value is less likely to be less than the basis, unless you have a basis that somehow exceeds the fair market value of the timber. Keep in mind that the change in fair market value must reflect any salvage value.

Despite the court cases the IRS continues to contest any company that uses the block as the single identifiable unit of property for casualty loss purposes.

Is There a Middle Ground?

The IRS continues to fight the block approach. The corporations willing to go to court over the issue are more or less guaranteed a win if they litigate in the right court. Congress could make the court's position the law, but based on its record over the last several decades this would be an unusual action. Sometimes the IRS is willing to compromise to avoid the hassle of constantly being in court over the same issue. A middle ground would be to define the "single identifiable unit of property" as something smaller than an entire block. An example would be a stand or other management unit meeting the needs of a given owner. The most logical definition is the one used for your depletion accounts, the definition the courts have agreed with. But, many Tree Farmers have their accounts set up by individual stands, all the properties in a given county, or some other way.

My purpose is to suggest to you that if you are subject to a casualty loss and some definition of the single identifiable unit of property other than MBF or cords, etc. would give you a larger loss deduction, please consider calculating your tax return using a more logical definition. We need a few "guinea pigs" with the factual circumstances, fortitude, and financial resources who are willing to test the waters on this. It seems to be an approach that offers a greater chance of success than waiting for Congress to find our predicament worth dealing with. I hope I'm wrong on this, but we''ve been waiting unsuccessfully for a long time.

The following article has been reproduced here from the "Tree Farmer" magazine with the permission of the American Forest Foundation, 1111 19th Street, N.W., Suite 780, Washington, D.C. 20036. (Telephone 202.463.2462)