DAMAGE TO LAND AS A DISASTER DEDUCTION / THE CALIFORNIA VINEYARD FIRES
by Robert L. Rojas, M.S. – Taxation, Rojas & Associates, CPAs, J. Michael Pusey, National Tax Director
Los Angeles, Woodland Hills, Sacramento, Orange County
Our focus will be disaster/casualty loss deductions for taxpayers in the vineyard/winery business in Northern California in the context of the devastating fires of October, 2017. ((Section 165.)) The principles we discuss may have much wider application than just vineyards; e.g., whether the casualty/disaster loss deductions have failed to consider land generally, whether it is under residential, commercial, or agricultural property, or raw land.
The two activities, growing grapes and producing wine, are often combined directly or through ownership of related entities.
The fires were declared a national disaster. ((“California fires coverage: Crews gain upper hand on deadliest blazes as search and recovery efforts continue,” Los Angeles Times, 10/16/17, http://www.latimes.com/local/california/la-northern-california-fires-live-pence-major-disaster-declaration-1507658219-htmlstory.html.))
Some 8,800 homes and commercial structures were “demolished.” (“Brown seeks $7.4 billion for fire relief,” Liam Dillon, Los Angeles Times, 11/4/17, p. B-1.))
The fires scorched an estimated 245,000 acres of land, including vineyards. ((“How to Help Napa Valley Recover from the California Wildfires,” Conde Nast Traveler, Katie Hammel, 10/24/17; https://www.cntraveler.com/story/how-to-help-napa-valley-recover-from-the-california-wildfires.))
Taxes and Damage to the Land
Casualty/disaster loss deductions for damaged buildings, cars, etc. are much the focus of the day, but we also ask:
- Could the fires have scorched the land in a manner that justifies an income tax deduction under the disaster/casualty loss rules?
- Could the land be less valuable for transfers subject to the gift, estate and generation-skipping tax?
- Could the land be less valuable under the property tax rules?
As to property taxes, which vary with local rules, a representative of the County of Napa wrote the authors an affirmative response under three scenarios. ((Thanks to John Tuteur, Assessor-Recorder-County Clerk for his emails of November 17 and 20, 2017.)
The communication discussed land under destroyed buildings as benefiting from a short, temporary “calamity adjustment” of 35% to “reflect that cost to cure and based on studies of the cost of debris removal…” It noted vineyards are not eligible for a “calamity adjustment” but: “If the property is under the Williamson Act, any reduction in productivity of the vines or the price received for the crop will be reflected over time in the income figures used to calculate the restricted value.” His communication noted the need for a study of sales of land in areas that were burned for the purpose of discerning “temporary impact on the market value of those lands….and the base year value restored once the `stigma’ associated with the fire calamity no longer impacts the market value of the properties.” ((Compare the following discussion by officials in Northern California which presumes damage to the structure but not the land. “Tax relief arrives for North Bay fire-damaged properties,” Gary Quackenbush, North Bay Business Journal, 10/18/17, http://www.northbaybusinessjournal.com/northbay/sonomacounty/7538447-181/sonoma-fire-property-tax-relief.))
We noted some other discussions of reductions in property tax valuations when groves are damaged. ((Property tax assessors may contemplate a grove decreasing in value as a result of storm or fire. The County of San Diego responded to “Do I qualify for property tax relief if a storm damaged my avocado or citrus grove?” The response was affirmative if the damage exceeds $10,000 but notes damage to the fruit doesn’t count because it is not taxed. See https://arcc.sdcounty.ca.gov/Pages/property-tax.asp. See also Sacramento County Assessor’s discussion, “Property Damaged or Destroyed by Calamity,” re R&T 170; http://www.assessor.saccounty.net/LowerMyTaxes/Calamities/Pages/PropertyDamagedOrDestroyedByCalamity.aspx#HowIs.))
There seems some recognition in the property tax rules of the concept that land can be less valuable after calamities but we generally find little or no discussion of the concept in the income tax rules and commentaries. Our main focus will be the income tax question we raise.
The authors are not scientists but we suggest that the issue of damage to the land is worthy of more research and discussion. ((See generally “Fire Effect on Soil, Fire Effects on Soil Nutrients,” http://www2.nau.edu/~gaud/bio300w/frsl.htm.; http://fire.forestencyclopedia.net/; http://fire.forestencyclopedia.net/p/p138, http://fire.forestencyclopedia.net/p/p622.))
One scientist wrote the authors: “(A)fter looking at some of the damaged areas in person and reading what you have written, I have decided the situation is much more complicated than it first appears and I do not have enough information or data to make any statements about the extent or longevity of the damage to the soils and vineyards that burned.” ((Email by Dr. Paul Skinner of 11/13/17, http://www.terraspase.com/.))
Another scientist thought soil erosion might be more of a factor after the fires but that much depends on future storms. He thought generally that landslides could be more of a problem. While few vineyards were burned directly there may be more issues with surrounding areas. He would be surprised if there was significant immediate damage to much of soil but soil tests could be performed. He also mentioned that “sense of place” is important to the industry – the land’s beauty, etc. He wrote: “Clearly a complex and unresolved issue.” ((Dr. David Howell, November, 2017. Thanks to Ms. Patsy McCaughy, Communications Director, Napa Valley Vintners, napavintners.com, for the referrals to these two scientists who were gracious enough to communicate with the authors.))
If the discussions of the scientists and appraisers conclude that some land was damaged and less valuable because of the fires, there could be tax savings that in turn affect the level of recovery to this important industry.
The Basic Rules Governing Disaster Loss Deductions
For a more comprehensive review, we suggest generally the authors’ discussion in “Catastrophic Disasters – The CPA’s Expertise Can Help with Recovery and Planning;” see rojascpa.com, “Articles.”
Personal casualty/disaster loss deductions under the income tax rules may be at risk of repeal or diminution after 2017 if there is new tax legislation. Writing in November, 2017, the Senate version of proposed tax law changes would preserve personal casualty loss deductions if related to a disaster (rather than a mere “casualty,”) whereas the House version of changes would eliminate all such deductions.
A disaster or casualty that damages personal-use property is nevertheless deductible in 2017, albeit subject to special rules. The general rule is the itemized deduction must be reduced by $100, and the result must exceed 10% of adjusted gross income. Even if the casualty relates to a boat used for pleasure, the personal casualty loss can give rise to an itemized deduction. The Disaster Tax Relief and Airport and Airway Extension Act of 2017 ( H.R. 3823) provides an exception to benefit non-itemizers and waives the 10% of adjusted gross income rule for uncompensated disaster losses arising after certain dates related to Hurricanes Harvey, Irma and Maria. Those special relief provisions don’t reach the Northern California fires that occurred shortly after these 2017 hurricanes.
Our focus in this particular discussion is the wine industry rather than personal disaster or casualty losses. Business disaster or casualty losses are not subject to the $100 reduction rule or the 10% of adjusted gross income rule; i.e., they are fully deductible as business expenses.
The general measure of a disaster loss is the lesser of adjusted basis prior to the disaster or the decrease in the property’s fair market value as a result of the disaster; such amount is then reduced by any insurance proceeds. The concept of decline in value doesn’t apply when the property is wholly destroyed, which could apply to vines or grapes but seemingly not land.
One of the issues relating to the basis in land is whether the purchase included an intangible “AVA” – the American Viticultural Area designation that says the land is particularly desirable and known for wines. This value has been distinguished from land costs and held to be an intangible asset amortizable under Section 197. ((General Counsel Memorandum 201040004, 6/24/10; file:///C:/Users/JM/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.IE5/2LWYGD03/1040004.pdf.)) It is understood this asset is often buried in land costs but it is also possible that one would find this separate asset arising upon acquisition of a vineyard. The disaster loss issues up for review because of the fires could also focus on “AVA” as a distinct asset.
In measuring the disaster/casualty loss for a personal residence, trees and landscaping and the personal residence are treated as one asset. ((See “FAQ for Disaster Victims, Casualty Loss and Section 165,” https://www.irs.gov/businesses/small-businesses-self-employed/faqs-for-disaster-victims-casualty-loss-valuations-and-sections-165-i.))
But in our business context, there is a focus on each asset; i.e., “the single, identifiable property damaged or destroyed.” ((Regs. 1.165-7(b)(2).))
One would seemingly need to distinguish, for example, damage to the land, vines, and grapes.
There may at times be issues of whether a particular cost was capitalized as land or vine. In general, it would be easier to show a casualty loss for a vine because physical damage could be demonstrated more easily.
The IRS Audit Manual on our topic generally equates the vineyard part of operations as farming, and the winery aspect as manufacturing. ((See generally “The Wine Industry Audit Technique Guide,” March 2011, https://www.irs.gov/pub/irs-utl/wine_industry_atg.pdf.))
The manual consists of some thirty-five pages of often complex and very detailed commentary. For example, among the nuances within this industry, the manual suggests that vine costs may not be depreciable until there is the first commercial crop. ((ibid, p. 20 of 35, citing TAM 199946003 for the definition of a “marketable crop.”))
The tax rules for vineyards can vary significantly depending on the size of the vineyard. ((ibid, p. 16 discussing Section 447.))
A disaster/casualty loss with respect to property such as vines generally means the property can no longer be depreciated under the percentage tables. ((See IRS Pub. 946 (2016), “How to Depreciate Property,” file:///C:/Users/JM/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.IE5/NYHPA0II/p946.pdf.))
The Damage Requirement
In general, “any loss arising from fire, storm, shipwreck, or other casualty is allowable as a deduction under section 165(a)….” ((Regs. 1.165-7(a)(1). There is a reference to farm losses under Regs. 1.165-6. See generally IRS Pub. 547 (2016), “Casualties, Disasters and Thefts, https://www.irs.gov/pub/irs-pdf/p547.pdf; “FAQs for Disaster Victims – Casualty Loss (Valuations and Section 165(i).))
There is generally a separate rule of measuring loss related to inventory. ((Regs. 1.165-7(a)(4).))
In general, the rules governing disaster/casualty losses related to vines would turn on the casualty loss rules governing depreciable property. As a practical matter, one of the key issues here would be resolving whether the vines are no longer useful. It is also possible one could wrestle with the issue of a decline in the fair market value of the vines due to damage from the fires.
The measure of the loss is affected by the decline in fair market value, and here the test is fair market value “immediately” before and after the casualty. ((Regs. 1.165-7(a)(2).)) As to our issue of whether land can suffer a disaster loss, this language would seem to moot the question of land recovering. For example, if a scientist could ascertain actual immediate damage, any eventual recovery of the land would seem not relevant according to this language of this regulation that focuses on values immediately before and after the casualty. A possible contrary argument, which would seem a weak one, is that the circumstances surrounding the question of damage to land are so unusual that one would need to make an exception to this language in the income tax regulations.
Among the more complex tax issues here is that while the land may be devoted to one purpose, it might also be devoted to different purposes, including different kinds of crops. There may be a question of whether a decline in market value might focus on a purpose other than the current use of the land; e.g., such questions as highest and best use.
For purposes of this initial discussion, the authors will focus on land devoted to raising grapes and ask whether the land’s value for that particular purpose may have declined.
In general, our presumption is land is devoted to raising high value grapes on their way to becoming high value wine, and highest and best use of the land is not in question.
The cost of land on the books may represent land devoted to different purposes, including residential use. There is also the issue of differing degrees of harm to different areas of the land.
The issues we raise for sustaining a disaster/casualty loss with respect to vineyards are admittedly difficult.
From our initial brief inquiries with the two scientists, the issues may also be complex from a scientific standpoint.
Another complexity is the practical problem of establishing, at the end of our process, that there was a decline in fair market value of the particular asset.
The general rule is that an appraisal is required to substantiate a decline in fair market value, and in this context the regulations go on to state: “The appraisal must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to the property.” ((Regs. 1.165-7(a)(2)(i) last sentence.))
In effect, the appraiser is charged with ascertaining the decline in fair market value arising only because of the physical damage. ((See generally Estate of Rinaldi, 38 Fed. Cl. 341, 353 (1997) aff’d without opinion, 178 F.3d 1308 (Fed. Cir. 1998) (casualty loss can only represent the change in fair market value attributable to actual damage or destruction), cited in What’s News in Tax, “Hurricanes Harvey and Irma, Casualty Loss Deductions,” James Atkinson, KPMG, 9/18/17, p. 4.))
Given that the tax regulations look to the decline in value immediately before and after the disaster, it would seem that practically, the appraisals measuring fire/smoke damage would be focused on approximately the same date anyway, or a narrow range of dates from just before the fire and at the end of the fire.
A key to our inquiry about land is that regulations refer to “damage.” ((See generally “Federal Income Tax: The Dilemma of the Casualty Loss Deduction,” 1961 Duke Law Journal, p. 440-451, http://scholarship.law.duke.edu/dlj/vol10/iss3/4/. As noted, when there is damage but not destruction, “the measure of the deduction is the change in fair market value resulting directly from the physical damage, capped by the property’s adjusted basis at the time of the casualty.” What’s News in Tax, “Hurricanes Harvey and Irma, Casualty Loss Deductions,” James Atkinson, KPMG, 9/18/17, p. 3.))
How would one assess whether the land, sometimes described as “scorched,” is damaged for income tax purposes?
One approach might be to assess whether the land is less productive in terms of speed and/or quality. ((We note one discussion of measuring fire damage to citrus trees where the methodology is basically one of extra costs but also the trees’ production pre-fire versus their production after the fire. See “Calculate Cost of Fire Damage to Citrus & Avocado Trees,” Division of Agriculture and Natural Resources, University of California, http://ceventura.ucanr.edu/Com_Ag/Subtropical/Avocado_Handbook/Economics/Calculate_Cost_of_Fire_Damage_to_Citrus_-_Avocado_Trees/; see also https://coststudies.ucdavis.edu/en/.))
Did the fire introduce any permanent changes or negative changes that take some time to reverse? ((As we indicated, the tax rules look to the change in value immediately following the disaster.))
Following a major fire, is there going to be a delay before the land will be productive or as productive? One issue here would be drawing the line between harm to the vines versus harm to the land. The latter would be harder to prove.
One might also argue that “damage” should consider the types of costs capitalized into land and whether those costs still contribute in the same manner as prior to the fire. For example, the IRS literature notes that typically included in land costs in this industry are: land clearing costs, as well as soil and water conservation costs to the extent not deducted under Section 175. ((See “The Wine Industry Audit Technique Guide,” March 2011, p. 17; also p. 3, 20, and Exhibit I-1; https://www.irs.gov/pub/irs-utl/wine_industry_atg.pdf.))
If costs were capitalized as land or vine costs and the effectiveness of those costs was compromised by the fires, it would seem a fair question whether the fires damaged the land or vines in the sense contemplated by the tax regulations.
The regulations specifically discuss “fruit trees” as an asset to be distinguished from building costs when a casualty relates to a business. ((Regs. 1.165-7(b)(2), (b)(3) Examples 2 and 3.))
Is the land’s productivity impeded at all by the fires? Even if the land just needs time to recover to its pre-fire state, isn’t that an indication of “damage” for purposes of the tax rules governing a disaster loss?
With the exception of the property taxes, we find little discussion in the tax literature of the concept of “damage” to the land.
The damage would seemingly be more easily determined for vines and grapes in the sense these are surfaced, visible assets, one rather known for its toughness (vines) and the other for its delicacy. With vines and grapes, the harm may be visible and conspicuous even to the untrained eye, although the professional’s perspective may well be needed.
One can also envision complexities here. For example, the IRS tells agents that “preproductive costs incurred during the preproductive period of vines must be capitalized into the cost of the vines.” ((The Wine Industry Audit Technique Guide,” March 2011, p. 17; https://www.irs.gov/pub/irs-utl/wine_industry_atg.pdf.) Are there particular types of costs capitalized as vines and if the effectiveness of particular costs is impaired, then were the vines “damaged” for purposes of the disaster loss rules?
One of the arguments for having “damage” would be new costs are necessary. The IRS regulations have their rules for measuring damage but they acknowledge repair costs as an indication of a casualty or disaster. ((See “Casualties, Disasters, and Thefts,” IRS Pub. 547 (2016), p. 5, “Figuring Decrease in FMV – Items to Consider.”))
In the literature immediately following the Northern California fires, there is much discussion of whether smoke may have damaged some grapes. The issue of the decline in value for grapes may be mooted by the absence of basis; i.e., the general rule is decline in fair market value but limited to basis and grown grapes may have no basis.
The general media discussion is more about the berries than the vineyards themselves. ((See, e.g., “California’s wildfires could make 2017 a very unusual wine vintage,” Claire Maldarelli, Popular Science, 10/18/17; https://www.popsci.com/california-wildfires-smoke-wine.))
But there are discussions of both vines and grapes: “It may take until spring to know how many vines were damaged from heat. Those that have to be replaced won’t be involved in wine-making for five years or more, according to growers.” ((How will the California fires impact wine?,” Geoffrey Mohan, Los Angeles Times, 10/14/17; http://www.latimes.com/business/la-fi-wine-damage-20171014-htmlstory.htm. See also “After the Fires, What Will Become of California’s Wine Crop, The vines that do survive may be tainted. We simply do not know enough yet.” Constance Casey, Slate, 10/18/17, http://www.slate.com/articles/health_and_science/science/2017/10/how_the_fires_might_affect_california_wine.html.))
We find discussions of damage to the vines and grapes but little discussion of damage to the land.
Can Land Be Damaged?
While there may be issues of measuring damage to vines or grapes, the most difficult question would seem to be whether the land itself can suffer a deductible disaster loss measured by the immediate decline in value (or basis if less).
Our perspective here might be by analogy to a fine machine that produces highly complex, delicate components, and it was rendered no longer capable of doing quite the old quality of work due to a casualty or disaster. Would this not qualify as a casualty or disaster loss under the tax rules? And could one not make an argument the same would be true if fire-ravaged land is not quite up to its old standards, at least for some time?
Applying the “damage” concept to the land itself may be problematic but worth investigating for the industry and individual vineyard owners.
The nature of the industry generally suggests that there could be very significant tax dollars at issue in the points we raise.
CAN YOU R&D LAND?
We brought up the possible importance of science to our tax question and make brief mention of yet another tax issue, a tax credit. The R&D credit is a special tax benefit aimed at encouraging research and development.
Our tax question of damage to the land has a scientific aspect. Could some of the scientific work be structured in a manner to qualify for the R&D credit? ((See, e.g., Sec. 174, Regs. 1.174-2, and “Achieving Tax Savings for Research and Development, A Compliance Guide,” Robert L. Rojas, Tax Management Memorandum, Vol. 58, 19, p. 393, 9/18/17; https://mail.google.com/mail/u/0/#search/bna/15e9cfe7b88b84d6?projector=1.))
The research and development regulations refer at times to scientific work relevant to improving the “product.” ((See Regs. 1.174-2(a)(3) defining “product” for this purpose.) The regulations refer to “product” as what might be held for sale or used in the business. With vineyards, the vine itself is often viewed as a depreciable asset, and the term “inventory” comes up rather often in IRS audit manual discussions of this industry. See generally “The Wine Industry Audit Technique Guide,” March 2011. https://www.irs.gov/pub/irs-utl/wine_industry_atg.pdf.)) One would argue that land meets the definition of a “product” for this purpose because it is used in the business, can be harmed, improved upon,“worked on.”
There is considerable discussion of R&D in this industry. ((See “How wineries often miss out on the R&D credit tax credit,” Travis Riley, North Bay Business Journal, 1/11/17, http://www.northbaybusinessjournal.com/home/6502290-181/winery-research-development-tax-credit?artslide=0., and “The R&D Tax Credit Aspects of Modern Wine Production,” Charles R. Goulding, Michael Wilshere, and Andrea Albanese, R&D Tax Savers, http://www.rdtaxsavers.com/articles/Wine-Production.))
The tax benefits accorded R&D are likely to survive if not be enhanced judging from the late 2017 Republican tax legislative proposals in the House and Senate.
We just introduce this topic but would contemplate that some of the science here may not be the type contemplated by the tax rules while other scientific work could be structured to qualify.
We believe R&D may not get the attention it deserves within the broader real estate community. ((For example, the following topics or endeavors might have particular work that could qualify even in a realty context: software, architectural and construction related research, tools enhancement, medical and health issues, mold, safety related research, earthquake safety, fire-related research, etc. See also “R&D in Commercial Real Estate – Does It Exist?,” Realcomm.com Staff Writer, 12/15/04; “How the Real Estate Industry Can Use the R&D Credit,” Cohen & Co., 2/20/15.))
We made a brief inquiry with the IRS National Office, asking whether fires may support a disaster loss income tax deduction for land under Section 165. One heavily experienced IRS professional thought the issue was interesting and multi-faceted but, without researching the issue, she also thought it may be lacking in precedent and guidance. The nature of the issue is difficult from a factual perspective which can only focus on the value of particular land, but we would suggest the nature of the issue is also conceptual and interpretative in nature, which could justify the IRS ruling on the issue.
The recent fires in Northern California raise complex tax questions that deserve significant industry focus and discussion bringing together such diverse skill sets and perspectives as the winemaker, the wine taster, the scientist, the appraiser, and the tax adviser, not to mention, the tax collector.
Our issue with its focus on damage to land can involve different industries, as well as investment or residential land, and different types of taxes – the income tax, transfer taxes, and property taxes.
The concept that land may suffer a disaster loss seems appropriately stressed in the wine industry where the particularities of the land, perhaps even its history, are reputed to have so much to do with the value of the end product.