Casualty Losses And Involuntary Casualty Losses And Involuntary ConversionsConversions

Chapter 10Chapter 10

Casualty Losses And Involuntary Casualty Losses And Involuntary ConversionsConversions

• CasualtiesCasualties

• Non-casualty business lossesNon-casualty business losses

• TheftsThefts

• Involuntary conversionsInvoluntary conversions

• Reinvestment and tax deferralReinvestment and tax deferral

• The CourtsThe Courts

Casualty Losses And Involuntary Casualty Losses And Involuntary ConversionsConversions

• Generally, all losses -- including casualties -- Generally, all losses -- including casualties -- uncompensated by insurance or otherwise are uncompensated by insurance or otherwise are deductible in the year sustaineddeductible in the year sustained

• For individuals, general rule is limited to apply For individuals, general rule is limited to apply in 3 situations when the loss:in 3 situations when the loss:– Occurred in a businessOccurred in a business

– Occurred in an investmentOccurred in an investment

– While not connected with a business, or investment, While not connected with a business, or investment, is the result of a casualty or theft is the result of a casualty or theft

Loss DeductionsLoss DeductionsFor Corporate and Individual OwnersFor Corporate and Individual Owners

• Loss deductions are always limited to property’s Loss deductions are always limited to property’s “adjusted basis” -- IRC “adjusted basis” -- IRC §§165(b)165(b)

• Investors or businesses -- do not normally need to Investors or businesses -- do not normally need to qualify loss as a casualty qualify loss as a casualty

• DefinitionDefinition of casualty is nevertheless important to of casualty is nevertheless important to owners -- specific regulations provide method for owners -- specific regulations provide method for computing casualty lossescomputing casualty losses

• Owners claiming a loss as a casualty, avoid the Owners claiming a loss as a casualty, avoid the application of I.R.C. application of I.R.C. §§ 1231 which are netted 1231 which are netted

Definition Of CasualtyDefinition Of CasualtyA Casualty Loss Deduction:A Casualty Loss Deduction:

• Must be physical in nature, caused by natural Must be physical in nature, caused by natural factors acting in a sudden, and unexpected and factors acting in a sudden, and unexpected and unusual mannerunusual manner

• Evidenced by a closed and completed Evidenced by a closed and completed transactiontransaction

• Fixed by identifiable events, andFixed by identifiable events, and

• Must have been sustained during the tax yearMust have been sustained during the tax year

CasualtiesCasualtiesMeaning of IRC Meaning of IRC §§ 165 165

• Fires, storms and shipwrecks are within Code Fires, storms and shipwrecks are within Code meaning, but generally limited by Courts and meaning, but generally limited by Courts and IRS to these plus windstorm, sleet and hailIRS to these plus windstorm, sleet and hail

• Emphasis on “suddenness”, e.g., fire, tornadoEmphasis on “suddenness”, e.g., fire, tornado

• Natural mortality -- including over-topping Natural mortality -- including over-topping trees, normal levels of insects and disease, and trees, normal levels of insects and disease, and low rainfall -- is not a casualtylow rainfall -- is not a casualty

Non-casualty LossesNon-casualty Losses“Suddenness Not Necessary”“Suddenness Not Necessary”

• Destruction of timber held for profit as a business Destruction of timber held for profit as a business or investment may result in a non-casualty or investment may result in a non-casualty deductible loss, if unusual & unexpecteddeductible loss, if unusual & unexpected

• E.g., timber loss over 9 months due to unexpected E.g., timber loss over 9 months due to unexpected and unusual SPB insect attack gave rise to an and unusual SPB insect attack gave rise to an allowable business loss deduction under allowable business loss deduction under §§ 1231 -- 1231 -- RR 87-59, but see the Weyerhaeuser exceptionRR 87-59, but see the Weyerhaeuser exception

• Deductible loss also permitted due to unusual and Deductible loss also permitted due to unusual and unexpected drought losses – RR 90-61unexpected drought losses – RR 90-61

Reporting ProceduresReporting ProceduresInvoluntary ConversionsInvoluntary Conversions

• Losses are limited to adjusted basis, less insurance Losses are limited to adjusted basis, less insurance or other compensation, and plus associated costor other compensation, and plus associated cost

• To claim a loss, the timber destroyed, the SIP, To claim a loss, the timber destroyed, the SIP, must be identified and expressed in same terms as must be identified and expressed in same terms as taxpayer’s accounts -- e.g., cords, MBF, tonstaxpayer’s accounts -- e.g., cords, MBF, tons

• Report casualties and thefts on Form 4684, Section Report casualties and thefts on Form 4684, Section B. Aggregate gains or losses are transferred to B. Aggregate gains or losses are transferred to Form 4797 or Schedule AForm 4797 or Schedule A

SIPSIPSingle Identifiable PropertySingle Identifiable Property

• IRS position has been to narrowly define SIP IRS position has been to narrowly define SIP in terms of unit volume replacementin terms of unit volume replacement

• Three Courts held otherwise – In Westvaco, Three Courts held otherwise – In Westvaco, Court of Claims held that depletion block was Court of Claims held that depletion block was the most reasonable unit of propertythe most reasonable unit of property

• In Weyerhaeuser, Court agreed that the stand In Weyerhaeuser, Court agreed that the stand was SIP, but was reversed in Appeals Courtwas SIP, but was reversed in Appeals Court

SIPSIPResolved By CourtsResolved By Courts

• In IPCO case, Court upheld use of depletion In IPCO case, Court upheld use of depletion blockblock

• SIP is depletion block when it serves taxpayer SIP is depletion block when it serves taxpayer for commercial, management and depletionfor commercial, management and depletion

• Court held that facts established that IPCO’s Court held that facts established that IPCO’s depletion blocks served all three purposesdepletion blocks served all three purposes

IRS PositionIRS Position

• IRS has refused to officially change positionIRS has refused to officially change position

• Casualty is volume destroyed x depletion unitCasualty is volume destroyed x depletion unit

• Nevertheless, IRS revoked RR 66-9 and 73-51Nevertheless, IRS revoked RR 66-9 and 73-51

• IRS fell short of adopting wider SIP definitionIRS fell short of adopting wider SIP definition

• Although IRS action is not acquiescence it Although IRS action is not acquiescence it seems clear that they will not oppose taxpayers seems clear that they will not oppose taxpayers who rely on 3 Court decisionswho rely on 3 Court decisions

IRS Modified ApproachIRS Modified Approach

• IRS concerned over valuation issues and has IRS concerned over valuation issues and has issued timber casualty loss audit guideissued timber casualty loss audit guide

• Partial interest appraisals require skillPartial interest appraisals require skill

• Form T should be used in filing loss claims Form T should be used in filing loss claims with emphasis on line 14 of part IIwith emphasis on line 14 of part II

• IRS examiner should request forester’s IRS examiner should request forester’s assistance on auditsassistance on audits

IRS AuditsIRS Audits

• Taxpayers must keep a depletion account in Taxpayers must keep a depletion account in the same units as the SIP and must not switch the same units as the SIP and must not switch accounting methods for casualty loss purposesaccounting methods for casualty loss purposes

• IRS is concerned about short-cut methods that IRS is concerned about short-cut methods that foster errors in valuationfoster errors in valuation

• Retroactive determination of basis is possbile Retroactive determination of basis is possbile as discussed aboveas discussed above

Involuntary Conversion ExampleInvoluntary Conversion Example

• 100 acres purchased in 1992 for $90,000100 acres purchased in 1992 for $90,000• Basis in land -- $30,000; Timber -- $60,000 Basis in land -- $30,000; Timber -- $60,000

(400MBF x $150/MBF)(400MBF x $150/MBF)• In 2002 storm destroyed 100MBF and In 2002 storm destroyed 100MBF and

damaged 50MBF; Salvaged for $10,000damaged 50MBF; Salvaged for $10,000• Between ’92 and ’02 volume doubled to 800 Between ’92 and ’02 volume doubled to 800

MBF: market value doubled to $300/MBFMBF: market value doubled to $300/MBF• Appraisal difference before to after $35,000Appraisal difference before to after $35,000

Tax Recovery Under Old RulesTax Recovery Under Old Rules

• Depletion unit=$75/MBF($60,000/800MBF)Depletion unit=$75/MBF($60,000/800MBF)

• Allowable tax loss: basis of SIP [timber Allowable tax loss: basis of SIP [timber destroyed = $11,250 ($75MBF x 150MBF)]destroyed = $11,250 ($75MBF x 150MBF)]

• Economic loss, which is non-deductible, is Economic loss, which is non-deductible, is $35,000 [($300 per MBF x 150MBF) - $35,000 [($300 per MBF x 150MBF) - $10,000 salvage]$10,000 salvage]

Tax Recovery with New RulesTax Recovery with New Rules

• First, loss is the lesser of adjusted basis of First, loss is the lesser of adjusted basis of property, or FMV before and after the stormproperty, or FMV before and after the storm

• Thus, $35,000 is the loss (which is less than Thus, $35,000 is the loss (which is less than $60,000)$60,000)

• Sale proceeds of $10,000 are a separate event Sale proceeds of $10,000 are a separate event for which net gain is $8,214 ($10,000 - $1,786) for which net gain is $8,214 ($10,000 - $1,786) adjusted basis [50MBF x $35.71[$60,000 - adjusted basis [50MBF x $35.71[$60,000 - $35,000) ÷ (800 – 100MBF)]$35,000) ÷ (800 – 100MBF)]

Reinvestment, Tax DeferralReinvestment, Tax Deferral Income From Involuntary ConversionIncome From Involuntary Conversion

• Gains from involuntary conversions may be Gains from involuntary conversions may be deferred by buying qualified replacementsdeferred by buying qualified replacements

• Replacement property must be purchased Replacement property must be purchased within 3 years following year of disposition, if within 3 years following year of disposition, if real property, in case of condemnation real property, in case of condemnation

• Replacement property must be purchased Replacement property must be purchased within 2 years following year of disposition in within 2 years following year of disposition in other involuntary conversion situations other involuntary conversion situations

Reinvestment, Tax DeferralReinvestment, Tax Deferral(Continued I)(Continued I)

• No requirement that entire amount of proceeds No requirement that entire amount of proceeds received be reinvested, or that it be done at received be reinvested, or that it be done at once. If all is not reinvested, difference must once. If all is not reinvested, difference must be reported as income.be reported as income.

• For involuntary conversions occurring after For involuntary conversions occurring after June 8, 1997, taxpayers generally cannot defer June 8, 1997, taxpayers generally cannot defer gain if replacement property is purchased from gain if replacement property is purchased from a related persona related person

Reinvestment, Tax DeferralReinvestment, Tax Deferral(Continued II)(Continued II)

• Qualifying replacement property -- timber; Qualifying replacement property -- timber; timberland; cost of reforestation; cost of timberland; cost of reforestation; cost of repairing and replacing roads, gates, culverts repairing and replacing roads, gates, culverts and fences; and cost of buying controlling and fences; and cost of buying controlling stock in a timber corporation.stock in a timber corporation.

• Written election must be made -- attach Written election must be made -- attach statement to tax return for year of gain with statement to tax return for year of gain with pertinent information concerning conversion pertinent information concerning conversion and replacement. and replacement.

Notes Notes Involuntary ConversionsInvoluntary Conversions

• Theft and casualty losses are not subject to Theft and casualty losses are not subject to passive loss rules for passive taxpayerspassive loss rules for passive taxpayers

• Specific procedures -- determine depletion unit Specific procedures -- determine depletion unit and multiply times the units destroyedand multiply times the units destroyed

• Appraisals and other costs of determining Appraisals and other costs of determining involuntary losses are also deductibleinvoluntary losses are also deductible

• No deduction allowed if damage does not No deduction allowed if damage does not render trees unfit for userender trees unfit for use

The Courts and IRS PositionThe Courts and IRS Position

• In Westvaco case (Court of Claims), loss due In Westvaco case (Court of Claims), loss due to reduced value of entire depletion blockto reduced value of entire depletion block

• Weyerhaeuser – Court of Claims agreed with Weyerhaeuser – Court of Claims agreed with IRS that depletion unit was affected property; IRS that depletion unit was affected property; was reversed by Appeals Courtwas reversed by Appeals Court

• IPCO – Court upheld depletion blockIPCO – Court upheld depletion block• IRS – has finally changed its position IRS – has finally changed its position