Rev. Rul. 73-408

Advice has been requested concerning the Federal income tax consequences of emergency loan cancellations under the circumstances described below.

As a result of a drought in a farming area in August 1972, the taxpayer, a farmer, suffered an uninsured crop loss in the amount of $8,000. At the time of the crop loss, the taxpayer had no adjusted basis in his growing crops. Shortly thereafter, he was granted an $8,000 emergency loan by the Farmers Home Administration pursuant to the provisions of the Consolidated Farmers Home Administration Act of 1961, as amended, 7 U.S.C. 1961-1967.

At the time the loan was granted, the Farmers Home Administration cancelled $5,000 of the principal of the loan. The loan cancellation was authorized by section 5 of Pub. L. 92-385, 86 Stat. 554, which amended the foregoing Act. Section 5 stated that the Secretary of Agriculture shall cancel up to $5,000 of the principal of a loan made in connection with a loss resulting from a major or natural disaster (including drought) which occurred after June 30, 1971, and before July 1, 1973, where the loss or damage is not compensated for by insurance or otherwise. (See Pub. L. 93-24, 87 Stat. 24, enacted April 20, 1973, which repealed the above loan cancellation provisions in section 5 of Pub. L. 92-385.)

Although Pub. L. 92-385 is cast in terms of the cancellation of the principal of a loan, the Senate Report accompanying Pub. L. 92-385 characterizes this type of loan and loan cancellation as a "grant" of up to $5,000 coupled with a bona fide loan for the balance of the uninsured loss. S. Rep. No. 92-1008, 92d Cong., 2d Sess. 2 (1972).

Where an emergency loan is made to a farmer because of an uncompensated production loss sustained as a result of destruction of or damage to his growing crops by a major or natural disaster, the method used by the Farmers Home Administration for computing his uncompensated production loss is to first determine the excess of his average crop production per acre for the two preceding years over his production per acre for the year of the disaster. This excess is then multiplied by the unit market price of the product for the year of the disaster, and the resulting figure is again multiplied by the acres of production for such year. The amount so obtained, after reduction by the proceeds of insurance on the crop and by any gain in other production areas, is the farmer's uncompensated production loss.

Section 61 of the Internal Revenue Code of 1954 and section 1.61-1 of the Income Tax Regulations provide that gross income includes all income from whatever source derived, unless excluded by law.

Section 165(a) of the Code allows a deduction for any loss sustained during the taxable year which is not compensated for by insurance or otherwise. In the case of individuals, section 165(c) limits deductions allowed under section 165(a) to (1) losses incurred in a trade or business, (2) losses incurred in a transaction entered into for profit, though not connected with a trade or business, and (3) casualty or theft losses not connected with a trade or business.

Generally, the amount of any section 165(a) loss deduction for property damaged or destroyed shall not exceed the taxpayer's adjusted basis as prescribed by section 1.1011-1 of the regulations. Section 1.165-1(c) of the regulations.

Rev. Rul. 73-51, 1973-1 C.B. 75, in holding that any loss resulting from damage to surviving merchantable trees caused by an ice storm would be in the nature of a contemplated loss of future profits or potential income, and thus not a deductible loss, states that section 165 of the Code contemplates only a loss of actual or measurable property, and this does not encompass a failure of profits or the loss of potential income.

The purpose of the loan "cancellation" provisions of Pub. L. 92-385 is to provide disaster victims, including farmers, with compensation for their otherwise uncompensated disaster losses. Such a loan "cancellation," when made in connection with the crop production loss suffered by the taxpayer in the instant case, has the substantive effect of providing him with compensation for his loss of future profits or potential income that would have been included in his gross income absent the disaster.

Accordingly, the $5,000 "cancelled" portion of the emergency loan (the "grant") in the instant case is includible in the taxpayer's gross income pursuant to the provisions of section 61(a) of the Code and the regulations thereunder.

Since the $8,000 crop loss sustained by the taxpayer was a loss of future profits or potential income (the taxpayer having no adjusted basis in his growing crops), no loss deduction is allowable under section 165 of the Code. See Rev. Rul. 73-51, and compare section 1.165-6(c) of the regulations. The amounts the taxpayer actually expended in growing such crops, however, may be deductible as business expenses in the year in which they are paid or incurred as provided under section 162 and section 1.162-12 of the regulations.

The disaster loan "cancellation" considered in Rev. Rul. 71-160, 1971-1 C.B. 75, is distinguishable from the loan "cancellation" in the instant case. That Revenue Ruling involves a loan "cancellation" made to a taxpayer, an individual, who incurred a property loss that was deductible under section 165 of the Code. The instant case, however, does not involve a loan "cancellation" made in connection with a property loss that is deductible under section 165.