With the recent storms that have moved through Missouri, many landowners have been asking how to report the casualty loss of timber on their federal income tax returns. Unfortunately for many timberland owners, the federal tax rules that deal with casualty loss are often difficult to understand and may seem to penalize landowners who have suffered losses from damaged or destroyed timber. Many tax professionals have written publications regarding casualty loss for timber, but to truly understand the implications of the rules it is necessary to work through the process step-by-step.

The first step in the casualty loss process is identifying whether or not you have suffered a casualty. A casualty is defined as the damage, destruction or loss of a property resulting from an identifiable event that is sudden, unexpected or unusual. From a timber investment standpoint, the most common causes of casualty losses are fires, wind storms, vandalism, floods and earthquakes. It is important to understand that losses in timber due to progressive deterioration, such as fungus, diseases, insects, worms or similar pests are typically not considered casualty losses, because they are not sudden, unexpected or unusual.

The next step is to determine the maximum amount of deduction (this is not necessarily the actual amount of deduction). The maximum amount of deduction is the adjusted basis in the single identified property (SIP). The Internal Revenue Code states that the casualty loss deduction is the smaller of the adjusted basis of timber and the difference of the fair market value (FMV) immediately before and after the casualty. Therefore, the deduction is capped by the amount of adjusted basis in the SIP. A single identified property can be the entire timber stand, individual units of timber, or even distinguishable tracts of timber within the timber stand. More importantly, if there is no basis in the timber, there is no deduction. The deduction is further reduced by any insurance payments or revenue generated through a salvage sale.

For example, Landowner Ruff owns 25 acres of investment timber with an adjusted basis of $25,000 in the 25-acre SIP. A wind storm damages 15 acres of the timber. Landowner Ruff hires a professional forester to estimate the FMV before and after the casualty.

  • Scenario 1: The professional forester estimates that the decrease in FMV is $30,000. The maximum deduction would be the adjusted basis of $25,000 minus the revenue generated from a salvage sale.
  • Scenario 2: The professional forester estimates that the decrease in FMV is $15,000. The maximum deduction would be $15,000 minus the revenue generated from a salvage sale.
  • Scenario 3: The professional forester estimates that the decrease in FMV is $15,000. Landowner Ruff has a salvage sale and sells the damaged timber for $20,000. In this case, there is no deduction. Landowner Ruff has an involuntary conversion. Ruff may use the proceeds from the salvage sale to reestablish the timber that was removed or purchase a similar timber property to defer paying tax on the salvage sale proceeds. This situation is treated as a like-kind exchange and the adjusted basis in the newly acquired timber property would be equal to the basis in the original property plus any additional money paid to reforest or purchase the new property.

As illustrated by the three simple scenarios, casualty loss can become very complicated. It is important to realize that damaged or destroyed trees may be a great loss of personal time, sweat equity and emotional investment; the IRS is only concerned about the ability of the landowner to recover the adjusted basis (financial investment) in those trees.

For more on this topic, see the MU Center for Agroforestry’s Agroforestry in Action guide Understanding Casualty Loss in Timber (PDF). It uses a real world example and takes a step-by-step look at the rules that apply to casualty loss and the forms that are used to report casualty loss.