STAND OF PINE TREES DESTROYED BY BEETLES GIVES RISE TO NONCASUALTY LOSS THAT MUST BE NETTED UNDER SECTION 1231.

Rev. Rul. 87-59

ISSUE

Is a loss deduction allowable with respect to the death of pine trees from attack by southern pine beetles and the subsequent destruction of timber in some of the trees by wood-destroying organisms?

FACTS

The corporate taxpayer grows, manages, and harvests pine timber for use in its wood products manufacturing facilities. A 40-acre stand of merchantable pine trees that the taxpayer had grown on its timberland was attacked by southern pine beetles (Dendroctonus frontalis). Although the beetle was indigenous to the area in normal populations, this extensive, widespread beetle attack was unexpected and unusual. The attack caused the death of 90 percent of the merchantable trees in the stand within 30 days.

The taxpayer immediately began to cut the dead trees and to process the timber cut from the trees. Operational problems of the loggers and adverse weather conditions, however, forced suspension of the logging operations. Because of the suspension, 15 percent of the units of timber contained in the beetle-killed trees were not cut and removed by the end of the year in which the beetle attack occurred. Nine months after the beetle attack, the uncut timber had deteriorated to the point of worthlessness as a result of the action of wood- destroying organisms (insects and fungi). This occurred before weather conditions improved and logging operations could be resumed.

The killing of the pine trees by the southern pine beetles had no immediate effect on the usefulness of the timber because the beetles do not appreciably damage wood. The death of the trees, however, rendered them vulnerable to wood-destroying organisms that gradually caused the deterioration of the wood in the uncut trees and eventually rendered the timber worthless.

None of the timber was insured. Logging debris and trees containing timber that was rendered worthless were bulldozed into piles and burned. Subsequently, the affected timberland was reforested by planting. The timber was "property used in the trade or business" as that term is defined in section 1231(b) of the Internal Revenue Code.

LAW AND ANALYSIS

Section 165(a) of the Code provides the general rule that there shall be allowed as a deduction any loss sustained during the tax year and not compensated for by insurance or otherwise.

Section 1.165-7(a)(1) of the Income Tax Regulations provides, in general, that any loss arising from fire, storm, shipwreck, or other casualty is allowable as a deduction under section 165(a) of the Code for the tax year in which the loss is sustained. "Other casualty" refers to an event that is (1) indentifiable, (2) damaging to property, and (3) sudden, unexpected, and unusual in nature. To be sudden, an event must be of a swift and precipitous nature and not gradual or progressive. Rev. Rul. 72-592, 1972-2 C.B. 101. Damage or loss resulting from progressive deterioration of property through a steadily operating cause would not be a casualty loss.

Section 1.165-1(b) of the regulations provides that an allowable loss must be evidenced by closed and completed transactions, fixed by identificable events, and, with an exception not relevant here, actually sustained during the tax year. The deduction is allowed by section 1.165-1(d)(1) in the tax year that the loss occurs as evidenced by such transactions and events.

Section 611(a) of the Code provides that there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion in the case of timber, under regulations prescribed by the Secretary.

Section 1.611-3(e) of the regulations describes circumstances under which the units of timber in a depletion account are to be adjusted without a corresponding basis adjustment. It provides that if, as the result of the growth of the timber, of changes in standards of utilization, of losses not otherwise accounted for, of abandonment of timber, or of operations or development work, it is ascertained that there remain on the ground available for utilization more or less units of timber at the appropriate time for measurement than remain in the timber account on the basis of the original estimate, then the original estimate (but not the basis for depletion) shall be revised.

Section 1231(a) of the Code provides that if recognized gains on sales or exchanges of "property used in the trade or business," as defined in section 1231(b), plus recognized gains from the involuntary conversion into other property or money of property used in the trade or business or of certain capital assets, exceed the recognized losses in the tax year from such sales, exchanges, or conversions, they are treated as long-term capital gains and losses. If such gains do not exceed such losses, they are not treated as resulting from the sale or exchange of capital assets. In the case of any involuntary conversion of such property arising from fire, storm, shipwreck, or other casualty, or from theft, section 1231(a) does not apply if the recognized losses exceed the recognized gains from such conversions. Losses upon the complete or partial destruction of property are treated as losses upon an involuntary conversion whether or not there is conversion of the property into other property or money according to section 1231(a)(4)(B) and section 1.1231(e)(1) of the regulations.

Rev. Rul. 57-599, 1957-2 C.B. 142, concerns a loss arising from the death of trees as a result of a disease or an attack by insects. The loss was not allowable as a casualty loss because the death of the trees resulted from progressive deterioration and, therefore, the clement of suddenness was lacking. Rev. Rul. 79-174, 1979-1 C.B. 99, modified Rev. Rul. 57-599 to remove the implication that fatal damage to ornamental trees as a result of insect infestation can never be sufficiently sudden to meet the requirement of a casualty loss. Rev. Rul. 79-174 holds that a casualty loss deduction is allowable to the taxpayer for the death of ornamental trees on residential property within 5 to 10 days of an unexpected, massive attack by southern pine beetles. The ornamental trees became worthless on their death.

The "suddenness" element of a casualty loss is discussed in Maher v. Commissioner, 76 T.C. 593 (1981), aff'd, 680 F.2d 91 (11th Cir. 1982), That case involves the death of ornamental palm trees following their infection by insects with lethal yellowing, a disease that kills palm trees in an average of 9 to 10 months. When the palm trees were infected and the disease became apparent, there was no treatment for, nor precautionary measures against, the disease. In denying a casualty loss deduction, the court reasoned that the suddenness of the loss itself, not the suddenness of its onset, determines whether the suddenness requirement is met. The lapse of time from infection to the death of the trees indicated not a sudden loss, but a loss resulting from gradual deterioration.

In the present case, the attack of the insects and the death of the trees rendered the wood in the trees vulnerable to the wood- destroying organisms that gradually caused the deterioration of the wood and destroyed the timber in the uncut trees. The entire process occurred over a 9-month period. Applying the reasoning in Maher to a situation involving trees grown for timber rather than ornamental use, the period of time from the precipitating event, the beetle attack, to the identifiable event that fixes the loss, the bulldozing and burning of worthless timber, determines the suddenness of the timber loss, and the period of 9 months over which the damage occurred is not sufficiently sudden to indicate a casualty loss. As in Maher, the fact that the damage was the result of the combined action of more than one organism does not effect this determination.

Section 1.611-3(e) of the regulations requires that a taxpayer adjust the quantity, but not the depletion basis, in a timber depletion account for losses not otherwise accounted for. Such an adjustment is the proper method of accounting for normal and expected physical losses that occur in growing timber. Thus, for example, a loss resulting from deterioration of timber in trees killed by southern pine beetles in normal populations would not be a deductible loss, but would be recovered through depletion of the remaining timber in the account.

In the present case, however, although the southern pine beetle was present in the affected area in normal populations, the loss of timber from the combined effects of the beetles and the wood- destroying organisms was unexpected and unusual. This distinguishes the taxpayer's timber loss from losses properly recoverable through depletion under section 1.611-3(e) of the regulations.

The taxpayer's unexpected and unusual loss of timber need not result from casualty in order to be deductible under section 165(a) of the Code, since the loss was incurred in a trade or business. The taxpayer must demonstrate, however, pursuant to section 1.165-1(b) of the regulations, that the loss is evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained. Subsequent to the extensive, widespread attack by the pine beetles, an attempt was made to cut and remove the timber in the killed trees. Trees containing timber eventually determined to have become worthless because of the action of wood-destroying organisms were bulldozed and burned. These facts are sufficient to evidence a closed and completed transaction, fixed by identifiable events. Under section 1.165(d)(1), the loss was sustained and is allowable in the tax year that the timber became worthless and was bulldozed and burned.

Under section 1231(a) of the Code, gains or losses from the sale, exchange, or conversion of qualifying property are netted together in a "hotchpot" computation. Any net gain is treated as long-term capital gain, and net loss gives rise to a deduction against ordinary income. However, if losses from casualty or theft exceed gains therefrom in a preliminary netting computation, they are not taken into account in the main hotchpot, and the net loss is deductible from ordinary income. In the present case, the timber was property used in the taxpayer's trade or business within the meaning of section 1231(b). The overall destruction of the timber in the killed trees not cut was an involuntary conversion pursuant to section 1.1231-1(e)(1) of the regulations. Because the loss did not result from casualty, it is taken into account in the main hotchpot computation under section 1231(a).

HOLDING

The taxpayer's unusual and unexpected loss of timber in trees killed in the extensive, widespread attack by southern pine beetles gives rise to an allowable business loss deduction under section 165(a) of the Code in the tax year that the timber became worthless and was bulldozed and burned. Because the loss did not result from a casualty, it must be netted with other noncasualty section 1231 gains and losses.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79-174 is distinguished because in that revenue ruling the trees became worthless as ornamentals on death, which occurred within a few days of the insect attack, whereas in the present case the loss of timber in the affected trees occurred gradually over a 9- month period, extending beyond the death of the trees.

Rev. Rul. 66-9, 1966-1 C.B. 39, concerns a casualty loss allowed on the destruction of a portion of the taxpayer's timber by a hurricane. That revenue ruling is distinguished because in it the hurricane immediately rendered the timber unfit for use. In the present case, by contrast, the killing of the trees by the southern beetles did not immediately make the timber in the trees unfit for use; instead, the timber was gradually rendered unfit by subsequent deterioration of the wood.