Friday, July 7, 2017
Wednesday’s post was the first of a two-part series on timber tax issues. In that post, I took a look at the tax issues facing timber farmers and investors. In Part Two today, I examine timber casualty loss issues and timber like-kind exchanges.
Defined. A deductible casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Thus, losses due to hurricanes, tornadoes, wild fires and similar natural disasters are deductible. However, timber losses due to disease or insect damage are generally not deductible because they are progressive in nature.
Calculating the loss. For deductible casualty losses (which are deducted from ordinary income), the loss is the lesser of the decrease in the fair market value of a “single identifiable property” (SIP) or the adjusted basis of the SIP, less any insurance proceeds, salvage value or other compensation received. In effect, the measure of the loss is the economic loss suffered limited by the basis.
For casualty loss deduction purposes, the SIP is any unit of property having an identifiable adjusted basis that can be identified in relation to the area impacted by the casualty. Thus, the allowable loss isn’t limited to merchantable units of timber totally destroyed. Instead, it is also allowed for trees that were damaged but not made worthless. Rev. Rul. 99-56, 1999-2 CB 676. The deductible loss is equal to the difference in fair market value of the SIP immediately before and after the casualty, limited by basis. Thus, in an IRS Field Service Advice from 2002, it was not correct for a taxpayer to deduct as a casualty loss the difference between the fair market value for the volume of timber from each type of affected tree before an ice storm and the reduced fair market value for the volume of timber remaining after a storm. F.S.A. 200229007 (Apr. 5, 2002).
Claiming the loss. A casualty loss is claimed in the year that the loss takes place. Also, deductible are costs incurred to substantiate the loss (such as appraisal or timber cruise). The loss is reported on Form 4684, Section B where it is then carried to Form 4797, Part II (an ordinary loss, which avoids the netting against §I.R.C. 1231 gains). For a casualty loss to timber held as an investment, the loss is reported on Form 1040, Schedule A. There is an exception for casualty losses that occur in Presidentially declared disaster areas. Those losses can be deducted on an original or amended return for the year immediately before the year the disaster took place.
Postponing the loss. If a gain results from a casualty loss due to proceeds from a salvage sale or other form of reimbursement that exceed the taxpayer’s adjusted income tax basis in the timber, the gain can be postponed if the taxpayer acquires replacement property within two years after the end of the first tax year in which the taxpayer realizes any portion of the gain. I.R.C. §1033.
Example: Boris owns 80 acres of timber with 1280 cords of pulpwood-sized timber. Boris’s basis in the timber is $10,000. A tornado damaged trees containing 300 cords of wood such that they will have to be removed. The tornado damage reduced the fair market value of the timber by $2,000. Boris found a buyer willing to pay $4,000 for the damaged timber. Boris calculates his casualty loss deduction as follows:
Step 1: Adjusted basis in the tract: $10,000
Step 2: Difference in fair market value before and after the casualty: $10,000 - $8,000 = $2,000
Step 3: Smaller of Steps 1 and 2: $2,000
Adjusted basis in timber after the casualty: $10,000 - $2,000 = $8,000 ($6.25/cord)
Boris has gain on sale of the damaged timber of $2,125: ($4,000 – ($6.25 x 300)). The $2,125 gain recognition can be postponed if Boris purchases qualified replacement property within two years.
Losses for investors. The above discussion on losses was restricted to timber farmers. For investors, the loss is a non-business casualty loss. For property held for nonbusiness use, the first $100 of casualty or theft loss attributable to each item is not deductible. The deduction is also limited to the excess of aggregate losses over 10 percent of AGI, except for victims of certain hurricanes. Nonbusiness losses are deductible only to the extent total nonbusiness casualty losses exceed 10 percent of the taxpayer’s AGI. However, each casualty loss of nonbusiness property is deductible only to the extent the loss exceeds $100.
Personal casualty gains and losses (from nonbusiness property) are netted against each other. If the losses exceed the gains, all gains and losses are ordinary. Losses to the extent of gains are allowed in full. Losses in excess of gains are subject to the 10 percent AGI floor. All personal casualty losses are subject to the $100 floor before netting. If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses.
Like-Kind Exchange of Timber and Timberland
Under the like-kind exchange rules of IRC §1031, a broad definition of “like-kind” for purposes of real estate exchanges is utilized. For instance, undeveloped real estate can be exchange for developed real estate. The “class” and “type” requirements that apply to tangible personal property do not apply with respect to real estate exchanges. However, the real estate needs to be held for investment or used in the taxpayer’s trade or business, and not held for sale. Thus, real estate can be exchanged for real estate as long as the traded properties are held for either a business or investment purpose.
Whether land has timber on it or not is immaterial for purposes of a like-kind exchange with other real estate. See Rev. Rul. 72-515, 1972-2 C.B. 466; Rev. Rul. 76-253, 1976-2 C.B. 51 and Rev. Rul. 78-163, 1978-1 C.B. 257. Thus, an exchange of real estate for standing timber or right to cut standing timber can qualify as a like-kind exchange. To qualify, an interest in standing timber must be treated as real property under state law. In many states, growing timber is considered part of the land. See, e.g., Hutchins v. King, 68 U.S. 53 (1863); Laird v. United States, 115 F. Supp. 931 (W.D. Wis. 1953).
The quantity, quality, age and/or species of timber may relate to grade or quality of timberland, but has no impact on whether timberland is like-kind to other real estate, whether or not the replacement land is timberland. See Priv. Ltr. Rul. 200541037; Ltr. Rul. 8621012.
For like-kind exchanges involving timberland, a key case is Oregon Lumber Co. v. Comr., 20 T.C. 192 (1953). Under the facts of the case, a timber harvesting company exchanged timberland with the U.S. government for the right to cut certain timber marked for cutting on other timberland owned by the U.S. The exchange agreement contained a provision obligating the exchanger to cut certain timber marked for cutting within a certain time period. The Tax Court held that the conveyance was not like-kind because Oregon law treated the right to cut timber as a right to acquire goods only (personal property), and under the exchange agreement, the exchanger acquired the right and obligation to cut timber marked for cutting that was limited in duration.
So, state law may dictate that a right to cut timber on someone else’s land is not like-kind to timberland. Relatedly, the IRS has considered whether an exchange of standing timber and cut timber located on 60 acres owned by the exchanger for a fee interest in three parcels of timberland qualified as like-kind exchange. The IRS determined that it did not. Tech. Adv. Memo. 9525002 (Feb. 23, 1995). The relinquished property was conveyed by a “timber deed” of all standing and cut timber located on 60 acres that would be removed within a specified period with any remaining timber reverted to the exchanger and constituted personal property. The two-year contract period amounted to a de facto restriction on the number of trees that could be removed. Thus, the duration of interests was dissimilar.
The key points on exchanges can be summarized as follows:
- Know state law;
- Based on state law, is the timber right being conveyed limited in duration or is it perpetual (e.g., fee simple)?
- Under state law, are rights to cut timber in the nature of a service contract as opposed to a property right?
- Are the rights to harvest timber conveyed by deed? Are they conveyed by bill of sale? Are they conveyed by a license?
- Does the conveyance instrument contain any obligation to cut and remove timber?
For rights to harvest timber conveyed by license, the Tax Court issued a key decision in 1994. In Smalley, the issue was whether the taxpayer had constructive receipt of a payment for purposes of the installment sale rules. The taxpayer sold “the exclusive license and right to cut all merchantable pine and hardwood timber suitable for poles, saw timber, or pulpwood” on 95 acres of land. Under the contract terms, the buyer paid the purchase price to an escrow agent so that the taxpayer could complete a deferred exchange. The court held that if the taxpayer had a bona fide right to complete a like-kind exchange, then the taxpayer did not have constructive receipt of the payment to an escrow agent even if he did not acquire like-kind property within the replacement period. The court did not provide any analysis of whether like-kind property was involved, but did state that it was reasonable for taxpayer to believe that proposed transaction would qualify as a like-kind exchange. State law (GA) specified that standing timber that the buyer severs constitutes a transfer of real property.
Timber casualty loss and like-kind exchange tax issues are important to timber producers and investors. This post and the previous one provide an overview of the basic issues.