For example, consider when Mount St. Helens erupted in Washington in 1980, damaging 68,000 acres of timberland. The Weyerhaeuser company identified its largest possible property—the southwest Washington region—for determination of the tax basis because its loss was limited by the amount of tax basis in the property.
The IRS argued the basis was tied to a much smaller portion of the property, which 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 questions around how to quantify the casualty loss, such as:
- What is the value of immature trees?
- How is the basis of the SIP ascertained?
- What constitutes the SIP?
In the case of fire, young trees are typically completely destroyed, making it easy to identify the ending fair market value. Putting a value on young trees immediately before the fire can be more challenging, however, especially if the property is managed as a mixed-aged class of timber.
Fires can also kill large, mature trees, but the damage isn’t always so extensive that they aren’t salvageable. Companies may avoid 100% economic loss by harvesting burned timber that has commercial volume, which is where Section 1033 kicks in.
Qualify for Gain Deferral
Section 1033 aims to return a taxpayer to the condition they were in previous to the event that gave rise to an involuntary conversion. For these conversions, the value subject to deferral may be impacted by a company with a 631(a) election in place.
Some questions to consider include:
- 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?
- How is involuntarily converted volume determined?
- Does the calculation only involve the damaged trees?
- Does it include trees in proximity to the damaged trees?
- Does it include trees harvested to gain access to the fire-impacted area?
The market value for the timber on a company’s land before a fire is $1 million. The company intends to harvest this timber in three years in accordance with its sustainable yield plan. After the fire, the company is forced to salvage the damaged timber, earning $400,000 on the sale of logs. This $400,000 gain is only being realized today because of the fire.
The gain from salvage activities can be deferred—potentially indefinitely—if a company adheres to the reinvestment requirements under IRC 1033. This gain deferral also works if a company has a IRC Subsection 631(a), Timber Capital Gains, election in place.
Replacement Property Options
To qualify for the gain deferral, the proceeds from the salvage sale or IRC 631(a) fair market value must be reinvested into property that’s similar or related in service or use to the converted property. For an involuntary conversion of timber, the replacement property may include the following items:
- Logging road construction
- Reforestation investments
There’s a time limit associated with this reinvestment. Typically, a taxpayer has two years from the end of the tax year that resulted in the involuntary conversion. For example, if salvage sales occurred on September 21, 2020, the two-year time period would end on December 31, 2022.
Make the Most of a Reinvestment
The best property reinvestments are those that have the longest time before they’ll be converted to cash or deducted for income tax purposes.
For example, if a business invests in land that’s meant to be held forever after a fire, those gains will be indefinitely deferred. However, if a company purchases timber to be harvested next year as replacement property, the gain is deferred only for one year.
Federal Disaster Area
If a state has suffered severe fire damage, it’s possible the federal government will declare a federal disaster. If this occurs, the reinvestment requirements are broadened significantly. It’s important to understand the requirements so that good business decisions can be made.
Combine Tax Provisions
It’s also possible to combine the two tax provisions to further benefit a company impacted by wildfires.
For example, a $1 million property is valued at $400,000 after being ravaged by fire, representing a decline in fair market value of $600,000. The tax basis of the property is $300,000, resulting in a casualty loss deduction of $300,000. This is the lesser of the basis in the property, which is $300,000, and the decline in fair market value, which is $600,000.
The company can deduct $300,000 immediately as a loss on its return and have no basis left in the property. If it cuts the trees and realizes the $400,000 gain, the gain may be deferred into the basis of replacement property. If the company then spends $400,000 on trees as replacement property, the basis in new trees is $0, which is $400,000 purchase price less $400,000 gain to be deferred.
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 casualty loss for purposes of taking a tax deduction because a taxpayer is motivated to make that figure as big as possible. The IRS may 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.
This leaves the question of determining the shelf life of a dead tree on the stump with merchantable volume. Depending on the species of tree, there may only be a very short period of utility on the stump to take action.
The timing of the fire may also be important. If there’s a fire at the end of September, a company may have little time to obtain the appropriate permits to harvest the trees before weather inhibits its ability to construct roads and gain access to the trees.
While these two tax provisions are often combined, they can also be applied individually. The burden of proof is on taxpayers to prove the following:
- The property loss
- The value received converting 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 a company cuts the trees and sells logs, however, the amount received for the stumpage may be less clear.
If a company that doesn’t have a IRC 631(a) election in place harvests the trees and processes them in a sawmill, then the value of the stumpage becomes even more difficult to ascertain because the company is selling lumber.
To prove loss, it’s important to pull together the information that documents it. There are many ways to do this, but a good rule of thumb is to be incredibly thorough and to use as many methods as possible, such as:
- Written narrative related to events of the 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 the officials or responders managing the fire, such as the US Forest Service
- Maps showing the affected and unaffected areas
We’re Here to Help
For help effectively capturing the information needed to develop tax positions amid the continued prevalence of fires, contact your Moss Adams professional.