Casualty Losses As a Result of Fire or Other Casualty Events1
Your timberland has just experienced damage from a wildfire. What must you do now,
to be able to claim a potential loss on your Federal and state tax returns?
What is a casualty loss? A casualty loss for individuals is defined in Section § 165(c) of the Internal Revenue Code (IRC) as follows: In the case of an individual, the deduction under subsection (a) shall be limited to (1) losses incurred in a trade or business; losses incurred in any transaction entered into for profit, though not connected with a trade or business; and . . . losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm . . . or from theft.
Limitations in the calculation of a casualty loss. For all casualty losses, the maximum amount of a casualty is the lesser of the adjusted basis or the change in fair market value “before” and “after” the casualty for the SIP (explained below).
What is basis and how is it calculated? Basis is the accounting/taxation term for what does an item cost when purchased or when received as a gift on inheritance. Basis is used in a number of sections of the IRS code and regulations. For individuals or entities growing and harvesting timber it is used to determine taxable income, capital gains and casualty losses among other purposes. Because tax treatment varies by asset type, total basis (costs) for timbered properties needs to be allocated to different subaccounts, e.g. land, timber, and improvements, such as roads, and structures. The timber subaccount can and generally should be further divided to account for the cost and quantity of the merchantable timber, premerchantable timber, and reproduction. It is always best to make the allocation to these accounts at the time of purchase if possible. Dr. Tamara Cushing has a YouTube discussing basis in greater detail at the following link https://www.youtube.com/watch?v=C7LsNR46Py8.
An allocation of value to the subaccounts should be reflective of the asset as a whole, e.g., land and timber rather than timber or some other asset alone. If the purchase price is not reflective of all of the value of all of the assets, it needs to be allocated on a proportional basis across all assets categories based on fair market value.
Note: Basis of various asset classes can be calculated after the fact through consultation with foresters who can analyze comparable land and timber sales, a current or relatively recent inventory, and growth and yield calculations to provide a retrospective allocation to the appropriate account.
What is adjusted basis and how is it determined? Adjusted basis is the term to reflect changes between the time of acquisition and the time when a taxable event occurs. Examples include a timber harvest or fire, sale of a portion of the property, additional improvements such as construction of a pond, or depreciation of assets such as roads, and buildings. For the timber account, reforestation costs including site preparation are additions to basis unless provision of IRC § 194 (expensing of reforestation costs) are utilized.
What is the Single Identifiable Property (SIP) for purposes of determining a casualty loss? The SIP is the accounting unit for purposes of a casualty loss. The accounting block is often many acres and large dollar amounts for large commercial timber firms. For smaller owners it is often a single tract of land.
What is your purpose of ownership? Tax treatment for casualty losses varies for property held for investment purposes, or a trade/business, or as personal property. Proper classification of ownership purpose is beyond the scope of this document. Generally, homesites within forested subdivisions settings, or smaller acreages, e.g. five (5) acres or less, where periodic timber harvest would be marginal for economic reasons, would be considered personal property.2 Note: as a result of the 2017 tax legislation, casualty losses for personal property will generally not be deductible for federal income tax purposes unless the loss is within an area declared as a Federally Declared Disaster area after 2017. California has not amended its statutes as of mid-August 2021.
Any potential loss based on either the adjusted basis or change in fair market value must be reduced by any reimbursement such as insurance payments, legal settlements or net income from salvage of timber.
For investment and business ownership purposes the adjustments for personal property discussed below are not required.
For casualty losses associated with personal property there are additional limitations.
i. First, the preliminary loss is further reduced by deduction of 10% of the taxpayer’s adjusted gross income. This may result in no deductible loss in the year of the casualty.
ii. Second, the amount of $100 must be deducted from a preliminary determination of a casualty loss.
A Simplified Decision Process Guide
Consideration of basis and other factors to calculate a potential casualty loss.
1. All types of property: What is the adjusted basis of the assets, (improvements, trees, etc.) lost? If the property was purchased a long time ago or acquired as a gift, the basis may be very low and that will limit any potential deduction. Land is generally not subject to a casualty loss resulting from a fire.
2. Deduct from a preliminary estimated casualty loss any proceeds from insurance, judgements and/or salvage logging.
3. For personal property, determine if the property is within a Presidentially Declared Federal Disaster Zone. Next, do a quick calculation of adjusted gross income (AGI) and calculate 10% of that amount. Unless the preliminary loss exceeds 10% of AGI plus $100, do not bother as you will not be able to claim a casualty loss for income tax purposes.
4. Estimate the effort and cost that will be incurred in determining basis if it was not done at the time of acquisition especially for timber where a timber inventory may be necessary.
5. Ascertain what type of documentation is available to demonstrate that the loss was sudden and unexpected, e.g., photos, management plans, harvest records. Do keep track of costs to repair or replace damaged or destroyed equipment or assets (culverts, gates, etc.) as they may be considered as the difference in the before and after value depending on the facts and circumstances.
6. Obtain an estimate of the cost of having an appraisal done to reflect the “before” and “after” value of the property. Note that acceptable appraisals will usually often require the services of a state licensed appraiser or forester with formal appraisal training. Cost may exceed the value of a potential casualty or the adjusted basis, see item No. 1 above.
7. Consider the potential costs and time of a claim. These include:
a. Accountant’s or Enrolled Agent’s charges.
b. Charges by other experts such as foresters and others.
c. Potential uncertainty associated with an audit, perhaps as long as three (3) years after the return is filed. If the case is referred to IRS Appeals a decision may take 6-12 additional months. Finally if a case is litigated, it may be a year or more from the time of trial before a judgment is rendered. Interest will accrue if the disputed amount is not paid.
8. Consider amending your previous year’s tax return if the loss occurred in a Federally Declared Disaster Zone. This may not be worth the time and trouble, but discuss the issue with your tax advisor.
10. Consider the use of IRC § 1033 (Involuntary Conversion) if salvage logging will result in net income exceeding the adjusted basis of the timber account.
11. Consider the impact of IRC § 126 (State and Federal Cost share programs such as CFIP
and EQIP), IRC § 194 (deduction for future reforestation costs), IRC § 469 (Passive Loss Rules) if these code sections apply to your situation.
- www.irs.gov – use to search for forms, publications and other documents. Use publ for publications. I recommend IRS Publication 547 titled Casualties, Disasters, & Thefts and Form 4684 (Casualties & Thefts) and the instructions for this form.
- www.timbertax.org – a good non-government site sponsored by USFS, University of Georgia, and the American Tree Farm System. Note that not all case law, Revenue Rulings and other IRS materials are listed in the professional research tab, but this site is better than most others as a point of departure.
- Agricultural Handbook 731 Forest Landowners’ Guide to the Federal Income Tax (February 2013). Although outdated, this has good information regarding casualty losses and provides a point of beginning. An electronic version is available at www.timbertax.org. The section on casualty losses is outdated with respect to personal and investment property because of the changes in the 2017 tax bill. However, it still provides a primer on haw to calculate a casualty loss.
- www.fs.fed.us/spf/coop – USDA Forest Service tax publications
- Cooperative Extension Services
Recommendations If a Casualty Loss Is Claimed and the Return Is Examined
1. When corresponding with the IRS, keep copies of all documentation including emails. Summarize all telephone conversations in a short contemporaneous memo to a file including date and time. Request a name, badge ID number, and telephone number of the person you spoke with. Consider emailing the agent a copy of any memos prepared as a result of telephone conversations and ask for concurrence as to the contents to prevent future misunderstandings.
2. If asked for documents, request that the IRS agent send you the document request in an IDR (Information Document Request) format.
3. Provide as much information as possible to support your position. Incomplete answers will often lead to more questions and potential delays as your case is not the only one being examined by a revenue agent.
4. Meet mutually agreed upon deadlines and contact the agent early if complications arise and establish a revised date.
5. Provide a release to permit the agent to talk with your experts, other than your CPA, enrolled agent, or attorney, if necessary as this may speed up resolution of the examination.
6. If conflicts arise, consider requesting a conference with agent’s manager. Any meeting should be about the issues and procedures not personalities. Keep the meeting professional.
7. Consider requesting involvement of an IRS forester (generically referred to as an Engineer from the Large Business and International (LB&I) division of the IRS. This request can be done on a consultation basis between the forester and revenue agent.
8. Request a copy of the agent’s report and appraisal and other documentation, if appropriate, if the claim is proposed for partial or complete disallowance. The report should identify the issue, the facts, the applicable statutes, regulations, rulings and court cases applicable to your tax return. Identify the time frame to prepare a rebuttal if there are substantial errors in the agent’s report.
9. Consider contacting the Taxpayer Advocate’s office if other efforts at resolution are unsuccessful.
10. Consider requesting forwarding of your case to the Appeals office of the IRS if resolution cannot be achieved at the audit level. At this point, you may want to review your position and facts to reassess your probability of success.
Personal observation: Much of the audit portion of the IRS is understaffed and overloaded with work, and lack the knowledge to deal with forest fire casualty losses; however, most employees want to do the right thing. As a result, remember that a “Please” and “Thank-you” will probably buy more cooperation and faster resolution of the issue than bluster and bombast.
Caveat: While the statements and examples cited in the publications/links above are considered to be correct based on regulations and court cases, the IRS is not bound by the analysis, conclusions or recommendations from the last four sources during an audit. Its authority stems from the applicable statutes and regulations. Proceed with caution if you take an aggressive position relative to the interpretation of the regulations and statutes.
Note: On August 23, the Governor asked the President to declare the California major fire damaged areas as federal disaster areas. We will update members by email and post on the website.
Disclaimer: The purpose of this document is educational and is general in nature. It is NOT intended to provide legal or accounting advice, since the facts and circumstances of each taxpayer’s individual situation need to be taken into consideration for an appropriate application of the tax law and associated regulations related to the preparation or filing of a completed tax return. Questions should be discussed with your accounting, legal and other appropriate professional advisors.
1 Larry Camp, forestland owner, California Registered Professional Forester, and retired IRS forester.
2 A coalition of forestry-favorable NGOs has introduced legislation in 2021 to change the provisions for casualty losses to recognize the long-term nature of forest growth.
There are no upcoming events.