Issue: What are the legal requirements for valuing timber property that is damaged or destroyed by casualty, for purposes of claiming a § 165(a) casualty loss? Background: Under §165(a) a deduction is allowed for any loss sustained during the taxable year. Business casualty losses are determined by reference to the single, identifiable property damaged or destroyed. Treas. Reg. § 1.165-7(b) (2). For timber property the SIP is generally the depletion block. Revenue Ruling 99-56, 1999-51 IRB 676. Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value of the SIP or its adjusted basis. Treas. Reg. § 1.165-7(b) (2). This generally requires that the fair market value of the SIP (block) be ascertained by competent appraisal, immediately before and after the casualty. Treas. Reg. § 1.165-7(a) (2), The major problem in this area arises when taxpayers, contrary to the regulations, do not perform an appraisal of the SIP (i.e., depletion block) before and after the casualty. Instead, these taxpayers seek to extrapolate the loss in value from per-unit FMVs, multiplying that figure by the number of units lost or damaged. In essence, this method consists of determining the volume of lost timber and multiplying that volume by the market price per applicable unit (cord, thousand board feet ("MBF"), etc.). This fragmented, additive approach is sometimes called the gross timber value and does not reflect the reduction in value of the SIP as a unitary whole. In other words, it does not follow that the loss of a specific volume of merchantable timber, whose value is often readily known, necessarily reduces the value of the larger block by the same amount. In some situations, where the loss area is relatively small and the block size is very large, the loss may not reduce the value of the depletion block at all. This additive approach does not work because larger timber properties often sell at a substantial discount, (reflecting a wholesale price,) compared to their gross retail timber value. Hancock Timber Resource Group 1999. "Analysis of Timberland Transactions Reveals Size Discount." In 1-6 Hancock Timberland Investor. Third Quarter; Hancock Timber Resource Group 2000. "Taking Advantage of the Wholesale Discount for Large Timberland Transactions." February 2000, R-00-1. These studies associate larger discounts with properties that have larger volumes and acreages. For example, a Western sale of 250,000 MBF on 25,000 acres yielded an average discount of 35%, while a sale of 2,000,000 MBF on 200,000 acres yielded an average discount of 48%. The literature suggests several reasons for the relationship between property size and discounts. The wholesale value typically reflects a price discount, which recognizes that merchantable volume may be too large to cut and market in the immediate future. Even if it were physically and legally possible to harvest all the timber immediately, however, complete liquidation might depress local prices by producing a market glut. Moreover, some of the merchantable timber may be in stands that currently contain too little volume to be economically operable, is too expensive to access, or is in inaccessible riparian zones or buffer areas. The timber harvest must be deferred until later, in some cases indefinitely, so the time value of money is relevant. As the time to harvest increases, risk also increases, because of the volatility in timber prices and future market conditions. Additionally, larger properties attract longer-term investors, who desire sustained yield, not short-term liquidation. Another factor that tends to diminish liquidity of larger tracts is that the pool of potential buyers declines as the property size increases. Very large timber properties require buyers to have access to large amounts of capital. The lack of potential buyers tends to put downward pressure on the prices for these parcels. Law and Argument: Treas. Reg. 1.165-1(C) provides that the amount of loss allowable as a deduction under Section 165(a) shall not exceed the amount prescribed by Treas. Reg. 1.1011-1 as the adjusted basis for determining the loss from the sale or other disposition of the property involved. When timber property is damaged or destroyed by a casualty event, the first step in determining the amount of the casualty loss is the identification of the single identifiable property (SIP).1 In the case of timber casualty losses, the Court of Appeals for the Federal Circuit has declared that, as a matter of law, the SIP is the timber depletion block "when that property serves for commercial, forest management, and depletion purposes". 2 Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value (of the SIP) or the adjusted basis (of the SIP). Treas. Reg. 1.165-7(b)(2). Under Treasury Reg. 1.165-7(a)(2), this generally requires that the fair market value of the SIP (block) be ascertained by competent appraisal, immediately before and immediately after the casualty, to determine the amount of the loss deductible. This formula, including the requirement that the reduction in fair market value be determined with reference to the SIP, has been acknowledged by every Court that concluded that the SIP is the depletion block. As noted above, to determine the allowable loss, a court must take the difference between the fair market value of the SIP before and after the casualty. "No one denies that the 'single identifiable property damaged or destroyed' must be ascertained in order to delineate the casualty loss, the fair market values, the adjusted basis, and, ultimately, to determine the allowable deduction, if any." Westvaco Corp. v. United States, 639 F.2d 700, 708 (Ct.Cl. 1980) (citations omitted). See, Weyerhaeuser Co. v. United States, 39 Fed. Cl. 410, 411 (1997) ("[T]he court must determine plaintiff's allowable casualty loss deduction by reference to each of the depletion blocks affected… For each depletion block so affected, plaintiff's casualty loss deduction is limited to the lesser of (I) the diminution in the fair market value of the depletion block as a result of the casualty event, or (ii) the amount of the adjusted basis of the depletion block.") Using the additive approach does not necessarily accurately reflect this difference. "[A]n aggregation of the value of destroyed units of merchantable timber, together with the value of the partial losses resulting from nonfatal injuries to merchantable trees, does not necessarily measure the reduction in fair market value of the property." Westvaco, 639 F.2d at 707. In a similar case, the court of federal claims followed Westvaco. International Paper Co. v. United States, 39 Fed. Cl. 313 (1996). There, the Service requested detailed information concerning timber damaged by a hurricane. Claiming that the parties that already agreed to the volumes and types of timber damaged, International Paper refused to provide the requested information. Holding that the Service was entitled to the requested data, the court noted that, in order to value the loss, "[a]pparently, plaintiff seeks to extrapolate from per-unit FMVs, multiplying that figure by the number of units determined to be lost in each SIP." Id. at 319. This attempt to establish the amount of the loss prior to ascertaining the SIP was "somewhat backwards." Id. In the one case that did accept the use of the additive method, the Court of Federal Claims noted the method's shortcomings. Weyerhaeuser. There, rather than valuing the entire SIP, Weyerhaeuser valued the tree stands the damaged timber was in. The Court of Federal Claims evaluated the evidence and found that the taxpayer's appraisal yielded a result that was substantially the same as if they had appraised the entire depletion block. But the court cautioned that, absent evidence that the additive approach was equivalent to the decrease in FMV of the SIP, this valuation method was not the best method. "To the contrary, prudence counsels a similarly-situated taxpayer to eschew the fragmented, additive approach and establish its prima facie case by proving the diminution in the fair market value of the SIP, i.e., the timber depletion block viewed as a unitary property." Weyerhaeuser, 39 Fed. Cl. at 412, n. 5 (citations omitted). Once the SIP has been identified, it must be valued. Even after the unitary method has been selected, it's still necessary to determine the fair market value using appropriate valuation methodologies. Fair market value is traditionally defined as the price at which property would have changed hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. United States v. Cartwright, 411 U.S. 546, 551 (1973), see Treas. Reg. § 1.611-1(d) (2). Valuation is based upon the market the property would be sold for in the ordinary course of business. Anselmo v. Commissioner, 757 F.2d 1208 (11th Cir. 1985) (valuing unmounted gems using a wholesale price, rather than the retail price when mounted); Arbini v. Commissioner, T.C. Memo. 2001- 141 (holding that the value of donated newspapers should be determined at the wholesale not retail level). The fair market value of real property is determined with reference to the property as a whole, not by reference to artificially created subdivisions. Akers v. Commissioner, 799 F.2d 243 (6th Cir. 1986); Pope & Talbot v. Commissioner, T.C. Memo. 1997-116, 73 T.C.M. (CCH) 2229. This principle is best illustrated by Akers. In Akers, the Sixth Circuit addressed the valuation of a conservation easement. The Akers contributed an easement on several properties they owned, including a 1,261 acre tract known as the Treanor Tract. The property next to the Treanor Tract had been subdivided into lots of a few acres. In their valuation, the Akers assumed that the Treanor Tract would be subdivided into twenty-four lots of approximately fifty acres. They then valued the various tracts using sales of comparable lots. The Service valued the Treanor Tract as a whole, focusing on comparable sales of tracts over 1,000 acres. To determine which method was appropriate the court looked at applicable definition of fair market value under § 170(c), which looked at "the price at which the property would change hands between a willing buyer and a willing seller." Id. at 245 (emphasis in original). This language "suggest[s] that the appropriate question is what a hypothetical Malcolm Forbes would have paid for [the Treanor Tract] as one tract, rather than what two dozen hypothetical yuppies would have paid for it as 24 [smaller tracts]." Id. The Tax Court has applied the same principle to timber properties. In Pope & Talbot v. Commissioner, the court considered the valuation of 79,000 acres of timberland. Pope & Talbot valued the land as a block, while the Service proposed subdividing the land into six smaller parcels. Rejecting the Service's valuation, the court held that subdivision was not appropriate because the market was depressed; Pope & Talbot would incur additional costs if the land was subdivided and the available evidence indicated that the most likely buyer was a large, industrial buyer that would purchase the entire tract. As a result, the court valued the property at a 39 percent discount to its gross timber value. Thus, when valuing timber using a hypothetical sale, it's important to focus on a realistic transaction. If the property or block being valued includes several distinct tracts that are noncontiguous and contain different types of timber, subdivision may be appropriate. See Schapiro v. Commissioner, T.C. Memo. 1991-128 (accepting valuation based on subdivision in a case where an easement was granted specifically to preclude subdivision of the property); Symington v. Commissioner, 87 T.C. 892, 898 (valuing property based on subdivision where there was a strong demand for small lots in the area). If a party suggests subdivision, however, "the taxpayer must establish that there existed a reasonable probability that the land would be so used in the reasonably near future." Stanley Works v. Commissioner, 87 T.C. 389, 401 (1986). Absent evidence that subdivision would be expected or reasonable the property should be valued as a whole. Akers, 799 F.2d at 245; Pope & Talbot, 73 T.C.M. at 2236. And if a property is valued based on subdividing it, an allowance must be made for the cost of subdivision including marketing costs and liquidation time. Akers, 799 F.2d at 246; Symington, 87 T.C. at 899. Conclusion: Though there are no hard and fast rules for valuing timber casualty losses, some general guidance can be given. The appropriate SIP for a timber casualty is generally the depletion block. The loss is the difference between the FMV of the SIP before and after the casualty and generally cannot be based upon the retail value of the damaged timber. Moreover, the SIP must be valued as a single property or by using reasonable subdivisions. 1 International Paper Co. v. United States, 36 Fed. Cl. 313, (1996); Weyerhaeuser Co. v. United States, 32 Fed. Cl. at 109 2 Weyerhaeuser Co. v. United States , 92 F.3d 1148, 1151 (Fed. Cir. 1996); cert. denied, 117S. Ct. 776 (1997), aff’g in part and rev’g in part, 32 Fed. Cl. 80 (1994).