Wildfires across Washington, Oregon, Idaho, and California have been devastating this year. While there’s always an economic loss in these situations, it doesn’t have to result in a total loss. In fact, there may be tax savings.
There are two different tax provisions that may have a meaningful impact on your business in the event of damage:
- Casualty loss. Internal Revenue Code (IRC) Section 165 allows for a loss deduction measured in the reduction in the value of the property attributed to an event that’s sudden, unexpected, and unusual and isn’t compensated by insurance or other means of reimbursement.
- Involuntary conversion. IRC Section 1033 allows for gain deferral and can be applied when you’re forced or required to convert property into other property, in most cases money. This is typically due to destruction, theft, condemnation, or disposal under threat of condemnation.
These provisions are applied to losses related to ice storm damage, lightning, heavy wind damage, fires, insect infestations, and landslides, among others. Slow and progressive losses aren’t covered, such as deterioration of trees, decay, or a gradual insect infestation.
To determine your deductible tax loss, you compare the fair market value of the property immediately before the event to the fair market value immediately after the event. If there’s a decline in value, the amount of the decline may be the maximum amount of the loss that’s deductible. Your overall loss deduction is limited to your cost basis in the property; effectively, you deduct the smaller of the calculated loss in value or your cost basis.
The IRS doesn’t always agree on how the loss provisions may be applied.
An example: Mount St. Helens erupted in Washington state in 1980 and damaged 68,000 acres of timberland. Weyerhaeuser sought to identify the largest possible property, the southwest Washington region, for determination of the tax basis because its loss was going to be limited by the amount of tax basis in the property. The IRS believed the basis was tied to a smaller portion of the property (a portion of the Mount St. Helens Tree Farm). This resulted in legal action to determine what constituted the so-called single, identifiable property (SIP). While the SIP was smaller than Weyerhaeuser claimed, the court effectively sided with Weyerhaeuser and allowed a deduction for the full basis of the SIP, not a portion as contended by the IRS.
There are also questions in how you quantify the loss. In the case of fire, young trees don’t stand a chance—fires completely destroy them, making it easy to identify the ending fair market value. Putting a value on young trees immediately before the fire may be more challenging, especially if the property is managed as a mixed-aged class of timber. Fires will also kill large, mature trees, but the damage isn’t always so extensive that you aren’t able to salvage them. Even with a substantial burn, you may avoid 100 percent economic loss by harvesting burned timber that has commercial volume. This is where Section 1033 kicks in.
Section 1033: Gain Deferral
Imagine that your market value for the timber on your land is $1 million. There’s a fire, but you’re able to salvage $400,000. The gain recognized from salvage activities can be deferred if you make a reinvestment of the proceeds. The reinvestment needs to be made in property that’s similar or related in service or use to the converted property. For an involuntary conversion of timber, the replacement property may be items such as timber, timberland, logging road construction, or investments in reforestation. The best property reinvestments are those that have the longest time before they will be converted to cash or deducted for income tax purposes. For example, if you invest in land to be held “forever” after a fire, you’ll defer the gain ”forever,” which is ideal. However, if you purchase timber to be harvested next year as replacement property, your gain is deferred only for one year.
Another perspective: Your $1 million property now is valued at $400,000 after being ravaged by fire, representing a decline in fair market value of $600,000. The basis of the property is $300,000, resulting in a casualty loss deduction of $300,000 (the lesser of the basis in the property, which is $300,000, or the decline in fair market value at $600,000).
You can deduct $300,000 immediately as a loss on your return and have no basis left in the property. If you cut the trees and realize the $400,000 gain, the gain may be deferred into the basis of replacement property. In other words, if you spent $400,000 on trees as replacement property, the basis in new trees is $0 ($400,000 purchase price less $400,000 gain to be deferred). As illustrated, it’s possible to utilize both IRC sections. Given the advantages of tying the two sections together, the benefits provided to taxpayers can be subject to challenge by the IRS.
The IRS has concerns about how to value the loss for purposes of taking a tax deduction because the taxpayer is motivated to make that figure as big as possible. The IRS would agree the trees are dead in this hypothetical situation, but they may argue about the value of a tree that’s killed but not fully destroyed, retaining most or all of its commercial volume.
But what is the shelf life of a dead tree on the stump with merchantable volume? Depending on the species of tree, you may have only a very short period of utility on the stump to take action. Timing of the fire may also be important. If there’s a fire at the end of September, you may have little time to obtain the appropriate permits to harvest the trees down before weather inhibits your ability to construct roads and get access to the trees.
Other questions to consider when determining a loss may include:
- What is the value of immature trees?
- How is the basis of the SIP ascertained?
- What constitutes the SIP?
For involuntary conversions, the value subject to deferral may be impacted by a company with a 631(a) election in place. Does the valuation take into account the condition of the property on the first day of the year, when the property wasn’t burned, or the condition of the property when cut? What adjustments are taken into account for determining the value of burned timber? Has the client segregated the volume that needed to be harvested from adjacent volume being harvested that isn’t damaged by the fire? These questions and many more need to be taken into account.
These two tax provisions are often combined, but they can also be applied individually. The burden of proof is on taxpayers to prove, first, that there was a loss, and second, the value of what they receive on conversion of the damaged timber (whether to money or other property).
If a company owns trees and sells the stumpage, the amount received is easy to identify. If the company cuts the trees and sells logs, the amount received for the stumpage may be less clear. But if it cuts the trees and processes them in a sawmill, then the value of the stumpage becomes more difficult to ascertain because it’s selling lumber (unless it has a 631(a) election in place).
In order to prove loss, it’s important that companies pull together information to document it. There are many ways to do this, but a good rule of thumb is to be incredibly thorough and use as many methods as possible. Here are some examples:
- Written narrative related to events of fire
- Pictures of the damaged property with a date stamp
- Video of the damaged property, including identifiable landmarks to substantiate the location
- Dated newspapers or articles detailing the damage
- Discussions with officials or responders who are managing the fire, such as the US Forest Service
- Maps showing the affected and unaffected areas
If you intend to apply the involuntary conversion provisions, you have two years after the close of the first taxable year in which the gain is realized to acquire replacement property. There are limited circumstances where a taxpayer may approach the IRS for an extension, but the situation would have to be an exceptional circumstance.
We’re Here to Help
With the prevalence of fires this year, taxpayers may have additional work related to their tax filings. If you’d like to learn more about how these tax provisions might affect your business, contact your Moss Adams professional. We can help you navigate the rules and explore opportunities that might result in tax savings.