As I write this post, wildfires are raging along the West Coast, hurricanes have battered the Southeast, and heavy rains have brought flooding to many parts of the country. Even North Carolina, where I call home, had a minor earthquake earlier this year.
Even if a natural disaster hasn’t affected you or your timberland this year, the likelihood is that a natural disaster will befall you at some point in the future.
In the midst of a natural disaster, taxes will likely be the last thing on your mind. However, the deductibility of losses due to natural disasters, also known as “casualty losses,” have special rules and limitations in the tax code. Proper deduction of timber casualty losses is important because they can provide significant tax savings to offset any property damage or destruction.
What is a Casualty Loss?
According to the IRS, a casualty is “the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.”
Some examples of casualties are fires, floods, earthquakes, hurricanes, and vandalism. All of these examples are sudden events that can damage timber. However, tree damage due to insect infestations, drought, or disease are generally not considered casualties because they tend to result in gradual damage over time.
The deductibility of a timber casualty loss is based on the whether the timber destroyed is held as business/investment property, or whether it is personal property. Therefore, correct classification of a timber activity is extremely important!
Business or Investment Property Casualty Losses
Most timber owners operate their timberland as a business or investment, rather than a hobby, so this section will apply to most timber owners.
All timber losses due to a casualty are fully deductible on a timber owner’s tax return if the trees are totally destroyed or unable to be saved.
If the trees cannot be saved, the deductible “loss” is the adjusted basis of the timber, not its market value.
The adjusted basis of timber is typically the allocated purchase price of the timber plus any capitalized expenses. If you planted the destroyed trees, the adjusted basis is typically the cost of the seedlings plus any capitalized planting expenses. An accurate timber basis is extremely important because it will maximize your deduction!
If a timber owner can salvage the destroyed trees in any way, such as cutting and selling the timber at a reduced price, he may still deduct the adjusted basis of the timber, but must also report any sales proceeds as taxable income.
The deduction for the destroyed timber should also be reduced by any actual or expected insurance proceeds. If the insurance proceeds exceed the adjusted basis of the trees destroyed, a taxable gain may result.
A timber owner should make a separate casualty loss calculation for each Single Identifiable Property (SIP) that is damaged or destroyed. An SIP is generally a portion of timberland for which a separate adjusted basis calculation is kept. For example, a timber owner might keep track of timber basis by tract or block. If a timber owner has multiple SIPs, a casualty loss calculation can only be made for the SIPs that were damaged by a casualty.
Personal Property Casualty Losses
In addition to affecting timberland, a natural disaster may also damage or destroy personal-use property, such as a home or personal vehicle located on the timberland.
Generally, personal losses are not tax-deductible. However, personal casualty losses are an exception to this general rule and are deductible on a timber owner’s individual tax return, subject to significant limitations.
The main limitation on deductible personal casualty losses is that they must result from a federally or presidentially declared disaster. For example, President Trump declared the California wildfires a major disaster under the Stafford Act on August 22, 2020. Any personal property destroyed by the wildfires in qualifying parts of California is eligible for a casualty-loss deduction.
However, a tree falling and destroying a personal vehicle due to a thunderstorm is not a deductible casualty loss because the thunderstorm was not a federally or presidentially declared disaster.
Another major limitation on deducting personal casualty losses is that the total casualty loss must be reduced by 10% of a timber owner’s Adjusted Gross Income (AGI). This rule often results in no deductible casualty loss for small losses. For example, a timber owner with an AGI of $100,000 would only be able to deduct personal casualty losses exceeding $10,000.
There are a few more limitations and rules applicable to personal casualty losses that are outside the scope of this article. If you have a personal casualty loss in the future, make sure to consult with a knowledgeable CPA for the correct treatment.
Conclusion
After a natural disaster strikes your timberland, a casualty loss deduction can provide helpful tax savings. There are many nuances and limitations to deducting casualty losses, especially personal casualty losses. Therefore, a timber owner with a casualty loss should consult with a knowledgeable CPA to calculate the proper deduction.
