Treasury Decisions

October 24, 1984

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary income tax regulations relating to the limitations placed on the amount of cost recovery deductions and investment tax credit allowed for taxpayers who purchase passenger automobiles for use in a trade or business or for use in the production of income. These temporary income tax regulations also relate to the limitations placed on cost recovery deductions and the investment tax credit allowed for taxpayers who use certain types of property ("listed property") for other than "qualified business" purposes. A person who leases "listed property" is similarly affected by these temporary regulations. Additionally, this document contains temporary income tax regulations relating to substantiation requirements for "listed property". The applicable law was amended by the Tax Reform Act of 1984. These regulations affect all purchasers or lessees of "listed property" (including passenger automobiles).

DATE

The temporary regulations relating to the limitations on the investment tax credit and recovery deductions are effective in general for "listed property" placed in service or leased after June 18, 1984 (§§1.280F-IT-1.280F-6T). Those regulations do not apply, however, to certain property acquired or leased pursuant to a binding contract in effect on June 18, 1984. The temporary regulations relating to substantiation requirements for the use of "listed property", §1.274-5T, are effective for taxable years beginning after December 31, 1984.

FOR FURTHER INFORMATION CONTACT

George T. Magnatta (with respect to cost recovery deduction questions) (202-566- 6456), Michel A. Daze (with respect to investment tax credit or leasing questions) (202-566-3458), Cynthia E. Grigsby (with respect to definitional questions) (202- 566-3935), of the Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, D.C. 20224 (Attention: CC:LR:T).

SUPPLEMENTARY INFORMATION

Background

This document adds new temporary regulations to the Income Tax Regulations (26 CFR Part 1) under sections 274 and 280F of the Internal Revenue Code of 1954, relating, respectively, to substantiation requirements and to the limitations on cost recovery deductions and the investment tax credit for certain property. Section 179 of the Tax Reform Act of 1984 (Pub. L. 98-369, 98 Stat. 494) amended Code section 274 and added new Code section 280F. The temporary regulations provided by this document will remain in effect until superseded by later temporary or final regulations on the subject.

Explanation of Provisions

Generally, new section 280F limits the amount of cost recovery deductions under section 168 and the investment tax credit ("ITC") under section 46(a) that are allowable for a passenger automobile. With certain exceptions, the term "passenger automobile" includes generally any 4-wheeled vehicle for highway use with a gross weight of 6,000 pounds or less. Thus, a light-duty truck may be a "passenger automobile." Additionally, section 280F limits the method of cost recovery and the amount of the ITC allowable when "listed property" (including a passenger automobile) is used for other than certain qualified business purposes. Special Limitations for "Passenger Automobiles" Section 280F(a) provides that the amount of the cost recovery deduction under section 168 for the year a passenger automobile (as defined in section 280F(d)(5)) is placed in service may not exceed $4,000. Any cost recovery deduction claimed in a succeeding taxable year during the recovery period may not exceed $6,000. Furthermore, the amount of the ITC claimed for the automobile may not exceed $1,000 (2/3 of $1,000 in the case of an election to take a reduced ITC under section 48(q)(4)). For automobiles placed in service after 1984, the allowable cost recovery deductions and investment tax credit amounts will be adjusted to reflect the automobile price inflation adjustment (see section 280F(d)(7)). If, after the end of the recovery period, the taxpayer has any "unrecovered basis" (described below) in the passenger automobile, that amount is treated as an expense for the first taxable year and succeeding taxable years after the recovery period. However, the amount treated as an expense for any taxable year after the close of the recovery period shall not exceed $6,000. In no event may any amount be expensed unless a cost recovery deduction under section 168 would have been allowable for the taxable year. For example, a taxpayer may not deduct any amount in a year during which a passenger automobile is disposed of or used exclusively for personal purposes. The term "unrecovered basis" means the difference (if any) between the unadjusted basis (as defined in section 168(d) without any reduction for the amount (if any) the taxpayer elects to expense under section 179) of the passenger automobile and the amount of the cost recovery deductions (including any section 179 deduction) which would have been allowable for taxable years in the recovery period (determined after taking into account the limitations imposed on cost recovery deductions during the recovery period) if the passenger automobile was used exclusively in a trade or business or for use in the production of income. Under section 280F, any amount allowable as a deduction under section 179 (relating to the election to expense certain depreciable business assets) is treated as a deduction allowable under section 168. The limitation on the amount of cost recovery deductions allowable for a passenger automobile may adversely affect a taxpayer who makes a section 179 election. The Internal Revenue Service is considering under what circumstances a taxpayer should be granted permission to revoke a section 179 election to avoid any unforeseen consequences of the interaction between sections 179 and 280F. If the passenger automobile is also used for personal purposes, the limitations imposed on the cost recovery deductions and the ITC must be reduced in proportion to the personal use of the automobile. For example, if a passenger automobilie is placed in service on July 1, 1984, and is used 20 percent for personal purposes (determined on an annual basis) during that year, the cost recovery deduction for that year may not exceed $3,200 (i.e., 80 percent of $4,000) and the ITC may not exceed $800 (i.e., 80 percent of $1,000) or $533.33 (i.e., 80 percent of 2/3 of $1,000 if section 48(q)(4) is elected). The limitations imposed on the cost recovery deductions and the ITC are also reduced if the taxpayer has a short taxable year. The temporary regulations provide special rules for a passenger automobile that is acquired in a transaction to which section 1031 or section 1033 applies. The temporary regulations have reserved special rules for other nonrecognition transactions. These rules require taxpayers to take restrictions on potential recovery deductions with respect to an automobile into account when they acquire another automobile in a "like kind" exchange (including a "trade-in") or after an involuntary conversion. Additionally, these regulations provide special rules for an improvement made to a passenger automobile that qualifies as a capital expenditure under section 263. Limitations With Respect to "Listed Property" When "Qualified Business Use" Does Not Exceed 50 Percent Section 280F(b) provides limitations for "listed property" when the property is not "predominantly used in a qualified business use for any taxable year." The term "listed property" includes: (1) Any passenger automobile (2) any other property used as a means of transportation, (3) any property of a type generally used for purposes of entertainment, recreation, or amusement, and (4) any computer or peripheral equipment (unless the computer or equipment is used exclusively at a regular business establishment). The temporary regulations define "means of transportation" to include boats, airplanes, motorcycles, and any other vehicles for transporting persons or goods. The term does not include any vehicle or property that is of a type ordinarily not susceptible to personal use (e.g., cement mixers and forklifts). However, any vehicle used by an individual for commuting purposes does not meet that exception. The ITC and use of the accelerated percentages under section 168 are permitted for listed property only if the property is used predominantly (that is, more than 50 percent, determined on an annual basis) in a qualified business use. The use of listed property for the production of income is not "qualified business use" (as explained below). However, if the "predominant use" test is otherwise met, use in an activity for the production of income is taken into account in determining the amount of the ITC and the cost recovery deduction that may be claimed. For example, if the property is used 40 percent in a qualified business use and 20 percent for the production of income, no ITC may be claimed and the accelerated percentages under section 168 are unavailable. However, if the property is used 60 percent in a qualified business use and 20 percent for the production of income, an ITC may be claimed and the accelerated percentages under section 168 are available based on 80 percent business/investment use. "Qualified business use" means generally use in a trade or business, but section 280F(d)(6)(C) provides certain exceptions. For example, the use of property provided as compensation to 5-percent owners and related taxpayers is generally not treated as qualified business use. Additionally, the leasing of property to any 5- percent owner or related party is not treated as qualified business use to the extent that an individual who is a 5-percent owner or related party with respect to the owner or the lessee of the property uses the property. If listed property does not meet the "predominant use" test in the year it is placed in service, no ITC or section 179 deduction is available. Additionally, in these circumstances, the taxpayer must recover the cost of the property over its earnings and profits life (see section 312(k)(3)(A)) using the straight ilne method and the half-year convention for property other than 15-year or 18-year real property. For example, the cost of a passenger automobile that does not meet the "predominant use" test must be recovered over a 5-year recovery period using the straight line method. Once it is determined that the straight line method of cost recovery must be used, both the business and investment uses of the property are taken into account for purposes of computing the allowable cost recovery deduction. If, however, listed property does meet the "predominant use" test in the year it is placed in service but in a succeeding taxable year does not meet the test, the property ceases to be section 38 property in its entirety as of the beginning of that later year and the ITC may be recaptured. Additionally, this event will cause a recapture of any "excess depreciation." "Excess depreciation" is the difference (if any) between the cost recovery deductions allowable (including any section 179 deduction) during the preceding recovery years and the amount that would have been allowable had the taxpayer computed his cost recovery deductions over the property's earnings and profits life using the straight line method. Any excess is included in gross income and is added to the property's adjusted basis for the taxable year in which the property is used 50 percent or less in a trade or business. The cost recovery deduction for the year in which the business use is 50 percent or less and for subsequent taxable years must be computed using the straight line method over the property's earnings and profits life. Special Rules With Respect to Leased Property Section 280F(c) provides that section 280F does not apply to listed property leased or held for leasing by a person regularly engaged ni the business of leasing. The limitations on the investment tax credit for listed property will apply to a lessee who is treated by the lessor as having acquired the property under section 48(d). In addition, section 280F(c) requires the Secretary to impose limitations on lessees of luxury automobiles and other listed property which are "substantially equivalent" to the limitations imposed on similarly situated owners of such property. These temporary regulations require a lessee of a luxury automobile to include in gross income an amount based on the fair market value of the automobile (at the beginning of the lease term) and the lessee's business/investment use. The inclusion approximates the present value of the limitations imposed on a similarly situated owner. These temporary regulations require a lessee of listed property (including passenger automobiles) not used predominantly in a qualified business use to include in income in the first taxable year in which such listed property is not used predominantly in a qualified business use an amount based on the fair market value of the listed property (at the beginning of the lease term) and average business/investment use of such property. The amount which a lessee must include in income in such circumstances is generally limited to the deductible portion of the rent allocable to the taxable year and approximates the present value to a similarly situated owner of any recapture of investment tax credit and the denial of the use of the accelerated percentages under section 168. Miscellaneous Rules Two special rules under section 280F apply with respect to all listed property, whether the limitations described above affect the property or not. Under section 280F(d)(2), if there is any use of listed property for business/investment purposes during a taxable year, then for purposes of determining recovery deductions in later years the property is treated as having been used solely for business/investment purposes during that year. Thus, the amount that the taxpayer may recover through later recovery deductions is reduced to the same extent that that amount would have been reduced if the taxpayer had used the property solely for business/investment purposes. However, the basis of property for purposes of determining gain or loss on the sale or other disposition of the property is not affected by this rule. Section 280F(d)(3) limits the circumstances in which an employee may treat use of listed property in connection with employment as trade or business use for purposes of determining tax credits and recovery deductions. An employee who owns listed property and uses the property in connection with his employment may treat that use as business use only if the use of the property is required as a "condition of employment" and is for the "convenience of the employer." In addition, temporary §1.280F-6T(d)(3)(iv) provides that use of the taxpayer's automobile by another person may not be treated as use of the automobile in a trade or business unless one of three conditions is met. Finally, these temporary regulations contain a substantiation requirement for "listed property." For taxable years beginning after December 31, 1984, no deduction or credit is allowed with respect to the use of "listed property" unless the taxpayer substantiates such use by adequate contemporaneous records. This requirement is satisfied by keeping a log, journal, diary, or other similar record in the manner prescribed by these temporary regulations. Because the recapture of "excess depreciation" may be triggered by a decline in the qualified business use of the property at any time during the earnings and profits life of the property, the temporary regulations require taxpayers to maintain contemporaneous records of the use of the listed property throughout that period. Thus, a taxpayer who has fully recovered the cost of 3-year listed property over the first three years by use of the accelerated recovery percentages must continue to maintain records on the use of the property for an additional three years (the "5- year" earnings and profits life actually extends into the sixth year because of the half-year convention).

Non-Applicability of Executive Order

12291 The Commissioner of Internal Revenue has determined that this temporary rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis is not required.

Regulatory Flexibility Act

A notice of proposed rulemaking is not required by 5 U.S.C. 553 for temporary regulations. Accordingly, the temporary regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. Chapter 6).

Paperwork Reduction Act

The collection of information requirements contained in these regulations have been submitted to the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB under control number 1545-0074.

Drafting Information

The principal authors of these temporary regulations are George T. Magnatta, Michel A. Daza and Donald W. Stevenson of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, on matters of both substance and style.

List of Subjects

in 26 CFR 1.61-1 through 1.281-4 Income taxes, Taxable income, Deductions, Exemptions.

Amendments to the Regulations

Accordingly, the Income Tax Regulations (26 CFR Part 1) are amended as follows:

PART 1-[AMENDED]

Paragraph 1. A new §1.274-5T is added immediately before §1.274-6. New §1.274-

§1.274-5T Substantiation with respect to listed property for taxable years

Par. 2. New §1.208F-1T is added in the appropriate place and reads as follows:

§1.280F-1T Limitations on investment tax credit and recovery deductions

Par. 3. New §1.280F-2T is added immediately after §1.280F-1T and reads as follows:

§1.280F-25 Limitations on recovery deductions and the investment tax

§1.46-3(c)(1), is $27,800. The maximum amount of E's investment tax credit is

Par. 4. New §1.280F-3T is added immediately after §1.280F-2T and reads as follows:

§1.280F-3T Limitations on recovery deductions and the investment tax

Par. 5. New §1.280F-4T is added immediately after §1.280F-3T and reads as follows:

§1.280F-4T Special rules for listed property (temporary).

§1.280F-3T, as applied to the item of listed property as a whole.

Par. 6. New §1.280F-5T is added immediately after §1.280F-4T and reads as follows:

§1.280F-5T Leased property (temporary).

§1.280F-6T(d)(3)(i)) for the particular taxable year. The inclusion amount-

Par. 7. New §1.280F-6T is added immediately after §1.280F-5T and reads as follows:

§1.280F-6T Special rules and definitions (temporary).

Commissioner of Internal Revenue.

Approved: October 15, 1984. 5T reads as follows: beginning after 1984. (Temporary) (a) In general. For taxable years beginning after December 31, 1984, no deduction or credit shall be allowed with respect to the use of any listed property (as defined in section 280F(d)(4) and §1.280F-6T(b)) unless the taxpayer substantiates such use by adequate contemporaneous records. Note that this section applies with respect to all property that is listed property (as so defined), regardless of the date on which the property was placed in service or leased by the taxpayer.

• (b) "Adequate contemporaneous record" requirement-(1) In general. The "adequate contemporaneous record" requirement shall be satisfied only by keeping a log, journal, diary, or other similar record in the manner prescribed in this paragraph.

(2) Content of log, etc.

-(i) Separate entry. Except as otherwise provided in paragraph (b)(2)(ii) of this section, the taxpayer shall make a separate entry in the log, diary, journal, or other similar record for each use of the listed property. Uses which may be considered part of a single use, for example, a round trip, may be accounted for by a single entry. Each entry shall specify-

• (A) The date of the use of the property,

• (B) The name of the user of the property,

• (C) The number of miles, in the case of a passenger automobile or in the case of any other means of transportation; or the amount of time that the property was used, in the case of any other listed property, and

• (D) The purpose of the use of the property (e.g., "to make a sales presentation to a customer", "to devise a personal budget plan").

• (ii) Entries with respect to non-business use not required in certain circumstances. The requirements of paragraph (b)(2)(i) of this section shall be satisfied by making an entry only with respect to a business or investment use of the property (and not with respect to other uses) if the overall use of the property for a taxable year can be definitely determined without entries for other uses. If the overall use of the property cannot be definitely determined without entries for each use, then the taxpayer must make an entry for each such use. For example, the overall use of a passenger automobile during a taxable year can be determined by comparing the odometer readings at the beginning and the end of the taxable year. Thus, the taxpayer is required to keep a log only with respect to business or investment uses of the automobile during the year.

(3) Time for making entry.

Each entry in the log, journal, diary, or similar record shall be made at or near to the time the listed property is actually used. (Approved by the Office of Management and Budget under control number 1545-0074) under section 168 for passenger automobiles and certain other listed property; overview of regulations (temporary).

(a) In general.

Section 280F(a) limits the amount of investment tax credit determined under section 46(a) and recovery deductions under section 168 for passenger automobiles. Section 280F(b) denies the investment tax credit and requires use of the straight line method of recovery for listed property that is not predominantly used in a qualified business use. In certain circumstances, section 280F(b) requires the recapture of an amount of cost recovery deductions previously claimed by the taxpayer. Section 280F(c) provides that lessees are to be subject to restrictions substantially equivalent to those imposed on owners of such property under section 280F (a) and (b). § 280F(d) provides definitions and special rules; note that section 280F(d) (2) and (3) apply with respect to all listed property, even if the other provisions of section 280F do not affect the treatment of the property.

(b) Key to Code provisions.

The following table identifies the provisions of section 280F under which regulations are provided, and lists each provision below with its corresponding regulation section: Section Section Section Section Section 1.280F-6T 1.280F-2T 1.280F-3T 1.280F-4T 1.280F-5T(a) ............. (b) .......... (d)(2) ....... (c) ......... (d)(3) (d)(1) .......... (d)(1) ....... ------------- ------------ (d)(4) (d)(8) .......... ------------- ------------- ------------ (d)(5) (d)(10) ......... ------------- ------- ------ ------------ (d)(6) Sections 1.280F-2T(f) and 1.280F-4T(b) also provide special rules for improvements to passenger automobiles and other listed property that qualify as capital expenditures.

(c) Effective dates-(1) In general.

This section and §§1.280F-2T through 1.280F-6T apply to property placed in service or leased after June 18, 1984, in taxable years ending after that date.

(2) Exception.

This section and §§1.280F-2T through 1.280F-6T shall not apply to any property-

• (i) Acquired pursuant to a binding contract in effect on June 18, 1984, and at all times thereafter, or under construction by the taxpayer on that date, but only if the property is placed in service before January 1, 1985 (January 1, 1987, in the case of 15-year real property), or

• (ii) Leased pursuant to a binding contract in effect on June 18, 1984, and at all times thereafter, but only if the lessee first uses such property under the lease before January 1, 1985 (January 1, 1987, in the case of 15-year real property). credit for certain passenger automobiles (Temporary).

(a) Limitation on amount of investment tax credit-(1) General rule.

The amount of the investment tax credit determined under section 46(a) for any passenger automobile shall not exceed $1,000. For a passenger automobile placed in service after December 31, 1984, the $1,000 amount shall be increased by the automobile price inflation adjustment (as defined in section 280F(d)(7)) for the calendar year in which the automobile is placed in service.

(2) Election of reduced investment tax credit.

If the taxpayer elects under section 48(q)(4) to reduce the amount of the investment tax credit in lieu of adjusting the basis of the passenger automobile under section 48(q)(1), the amount of the investment tax credit for any passenger automobile shall not exceed two-thirds of the amount determined under paragraph (a)(1) of this section.

(b) Limitations on allowable recovery deductions-(1) Recovery deduction for year passenger automobile is placed in service.

For the taxable year that a taxpayer places a passenger automobile in service, the allowable recovery deduction under section 168(a) shall not exceed $4,000. See paragraph (b)(3) of this section for the adjustment to this limitation.

(2) Recovery deduction for remaining taxable years during the recovery period.

For any taxable year during the recovery period remaining after the year that the property is placed in service, the allowable recovery deduction under section 168(a) shall not exceed $6,000. See paragraph (b)(3) of this section for the adjustment to this limitation.

(3) Adjustment to limitation by reason of automobile price inflation adjustment.

The limitations on the allowable recovery deductions prescribed in paragraph (b) (1) and

(2) of this section are increased by the automobile price inflation adjustment (as defined in section 280F(d)(7)) for the calendar year in which the automobile is placed in service.

(4) Coordination with section 179.

For purposes of section 280F(a) and this section, any deduction allowable under section 179 (relating to the election to expense certain depreciable trade or business assets) is treated as if that deduction were a recovery deduction under section 168. Thus, the amount of the section 179 deduction is subject to the limitations described in paragraph (b) (1) and (2) of this section.

(c) Disallowed recovery deductions allowed for years subsequent to the recovery period-(1) In general.

(i) Except as otherwise provided in this paragraph (c), the "unrecovered basis" (as defined in paragraph (c)(1)(ii) of this section) of any passenger automobile is treated as a deductible expense in the first taxable year succeeding the end of the recovery period.

• (ii) The term "unrecovered basis" means the excess (if any) of-

  • (A) The unadjusted basis (as defined in section 168(d)(1)(A), except that there is no reduction by reason of an election to expense a portion of the basis under section 179) of the passenger automobile, over

  • (B) The amount of the recovery deductions (including any section 179 deduction elected by the taxpayer) which would have been allowable for taxable years in the recovery period (determined after the application of section 280F (a) and paragraph

• (b) of this section and as if all use during the recovery period were used described in section 168(c)(1)).

(2) Special rule when taxpayer elects to use the section 168(b)(3) optional recovery percentages.

If the taxpayer elects to use the optional recovery percentages under section 168(b)(3) or must use the straight line method over the earnings and profits life (as defined and described in §1.280F-3T(f)), the second succeeding taxable year after the end of the recovery period is treated as the first succeeding taxable year after the end of the recovery period for purposes of this paragraph (c) because of the half-year convention. For example, assume a calendar-year taxpayer places in service on July 1, 1984, a passenger automobile (i.e., 3-year recovery property) and elects under section 168(b)(3) to recover its cost over 5 years using the straight line optional percentages. Based on these facts, calendar year 1990 is treated as the first succeeding taxable year after the end of the recovery period.

(3) Deduction limited to $6,000 for any taxable year.

The amount that may be treated as a deductible expense under this paragraph (c) in the first taxable year succeeding the recovery period shall not exceed $6,000. Any excess shall be treated as an expense for the succeeding taxable years. However, in no event may any deduction in a succeeding taxable year exceed $6,000. The limitation on amounts deductible as an expense under this paragraph (c) with respect to any passenger automobile is increased by the automobile price inflation adjustment (as defined in section 280F(d)(7)) for the calendar year in which such automobile is placed in service.

(4) Deduction treated as a section 168 recovery deduction.

Any amount allowable as an expense in a taxable year after the recovery period by reason of this paragraph

• (c) shall be treated as a recovery deduction allowable under section 168. However, a deduction is allowable by reason of this paragraph (c) with respect to any passenger automobile for a taxable year only to the extent that a deduction under section 168 would be allowable with respect to the automobile for that year. For example, no recovery deduction is allowable for a year during which a passenger automobile is disposed of or is used exclusively for personal purposes.

(d) Additional reduction in limitations by reason of personal use of passenger automobile or by reason of a short taxable year.

See paragraph (i) of this section for rules regarding the additional reduction in the limitations prescribed by paragraphs

• (a) through (c) of this section by reason of the personal use of a passenger automobile or by reason of a short taxable year.

(e) Examples.

The provisions of paragraphs (a) through (c) of this section may be illustrated by the following examples. For purposes of these examples, assume that all taxpayers use the calendar year and that no short taxable years are involved. Example (1). (i) On July 1, 1984, B purchases for $45,000 and places in service a passenger automobile which is 3-year recovery property under section 168. In 1984, B does not elect under section 179 to expense a portion of the cost of the automobile. The automobile is used exclusively in B's business during taxable years 1984 through 1990.

• (ii) The maximum amount of B's investment tax credit is $1,000 (i.e., the lesser of $1,000 or .06×$45,000). B's unadjusted basis for purposes of section 168 is $44,500 (i.e., $45,000 reduced under section 48(q)(1) by $500). B selects the use of the accelerated recovery percentages under section 168(b)(1).

• (iii) The maximum amount of B's recovery deduction for 1984 is $4,000 (i.e, the lesser of $4,000 or .25×$44,500); for 1985, $6,000 (i.e., the lesser of $6,000 or .38×$44,500); and for 1986, $6,000 (i.e., the lesser of $6,000 or .37×$44,500).

• (iv) At the beginning of taxable year 1987, B's unrecovered basis in the automobile is $28,500 (i.e., $44,500-$16,000). Under paragraph (c) of this section, B may expense $6,000 of the unrecovered basis in the automobile in 1987. This expense is treated as a recovery deduction under section 168. For taxable years 1988 through 1990, B may deduct $6,000 of the unrecovered basis per year. At the beginning of 1991, B's unrecovered basis in the automobile is $4,500. During that year, B disposes of the automobile. B is not allowed a deduction for 1991 because no deduction would be allowable under section 168 based on these facts. Example (2). (i) On July 1, 1984, C purchases for $50,000 and places in service a passenger automobile which is 3-year recovery property under section 168. The automobile is used exclusively in C's business during taxable years 1984 through 1992. In 1984, C does not elect under section 179 to expense a portion of the automobile's cost. C elects under section 48(q)(4) to take a reduced investment tax credit in lieu of the section 48(q)(1) basis adjustment.

• (ii) The maximum amount of C's investment tax credit is $666.67 (i.e., the lesser of 2/3 of $1,000 or .04×$50,000). C's unadjusted basis for purposes of section 168 is $50,000. C elects to use the optional recovery percentages under section 168(b)(3) based on a 5-year recovery period.

• (iii) The maximum amount of C's recovery deduction for 1984 is $4,000 (i.e., the lesser of $4,000 or .10×$50,000); for taxable years 1985 through 1988, $6,000 per year (i.e., the lesser of $6,000 or .20 of $50,000). C's recovery deduction for 1989 is $5,000 (i.e., the lesser of .10×$50,000 or $6,000).

• (iv) At the beginning of taxable year 1990, C's unrecovered basis in the automobile is $17,000. Under paragraph (c) of this section, C may expense $6,000 of the unrecovered basis in the automobile in 1990. this expense is treated as a recovery deduction under section 168. For taxable years 1991 and 1992, C may deduct $6,000, and $5,000, respectively of the unrecovered basis per year. Example (3). Assume the same facts as in example (2), except that C disposes of the passenger automobile on July 1, 1990. Under paragraph (c) of this section, C is not allowed a deduction for 1990 or for any succeeding taxable year because no deduction would be allowable under section 168 based on these facts. Example (4). (i) On July 1, 1984, G purchases for $15,000 and places in service a passenger automobile which is 3-year recovery property under section 168. The automobile is used exclusively in G's business during taxable years 1984 through 1987. In 1984, G elects under section 179 to expense $5,000 of the cost of the property.

• (ii) The maximum amount of G's investment tax credit is $600 (i.e., the lesser of .06×$10,000 or $1,000).

• (iii) G's unadjusted basis for purposes of section 168 is $9,700 (i.e., $15,000 minus the sum of $5,000 (the amount of the expense elected under section 179) and $300 (one-half of the investment tax credit under section 48(q)(1))). Under paragraph (b)(4) of this section, the allowable deduction under section 179 is treated as a recovery deduction under section 168 for purposes of this section. Thus, the maximum amount of G's section 179 deduction is $4,000 (i.e., the lesser of $4,000 or $5,000+.25×$9,700). G is entitled to no further recovery deduction under section 168 for 1984. The amount of G's 1985 and 1986 recovery deductions are $3,686 (i.e., the lesser of .38×$9,700 or $6,000) and $3,589 (i.e., the lesser of .37×$9,700 or $6,000), respectively. At the beginning of 1987, G's unrecovered basis in the automobile is $3,425 (i.e., $14,700-$11,275). Under paragraph (c) of this section, G may expense the remaining $3,425 in 1987. Example (5). (i) On July 1, 1984, D purchases for $55,000 and places in service a passenger automobile which is 3-year recovery property under section 168. The automobile is used exclusvely in D's business during taxable years 1984 through 1993. In 1984, D elects under section 179 to expense $5,000 of the cost of the property.

• (ii) The maximum amount of D's investment tax credit is $1,000 (i.e., the lesser of $1,000 or .06×$50,000).

• (iii) D's unadjusted basis for purposes of section 168 is $49,500 (i.e., $55,000 minus the sum of $5,000 (the amount of the expense elected under section 179) and $500 (one-half of the investment tax credit under section 48 (q)(1))). Under paragraph (b)(4) of this section, the allowable deduction under section 179 is treated as a recovery deduction under section 168 for purposes of this section. Thus, the maximum amount of D's section 179 deduction is $4,000 (i.e., the lesser of $4,000 or $5,000+.25×$49,500). D is entitled to no further recovery deduction under section 168 for 1984. The maximum amount of D's 1985 recovery deduction is $6,000 (i.e., the lesser of $6,000 or .38×$49,500); and for 1986, $6,000 (i.e., the lesser of $6,000 or .37 of $49,500).

• (iv) At the beginning of 1987, D's unrecovered basis is $38,500. D may expense the remaining unrecovered basis at the rate of $6,000 per year through 1992 and $2,500 in 1993. Example (6). Assume the same facts as in example (5), except that in 1993, D uses the automobile only 60 percent in his business. Under paragraph (c)(4) of this section for 1993, D may expense $1,500 (i.e., .60×$2,500). D is entitled to no further deductions with respect to the automobile in any later year. Example (7). (i) On July 1, 1984, F purchases for $44,500 and places in service a passenger automobile which is 3-year recovery property under section 168. The automobile is used exclusively in F's business during taxable years 1984 through 1992. In 1984, F elects under section 179 to expense $5,000 of the cost of the property.

• (ii) F elects under section 48(q)(4) to take a reduced investment tax credit in lieu of the section 48(q)(1) basis adjustment. The maximum amount of F's investment tax credit is $666.67 (i.e., the lesser of 2/3 of $1,000 or .04×$39,500).

• (iii) F's unadjusted basis for purposes of section 168 is $39,500 (i.e., $44,500- $5,000 (the amount of the expense elected under section 179)). F elects to use the optional recovery percentage under section 168(b)(3) based on a 5-year recovery period. Under paragraph (b)(4) of this section, the allowable section 179 deduction is treated as a recovery deduction under section 168 for purposes of this section. Thus, the maximum amount of F's section 179 deduction is $4,000 (i.e., the lesser of $4,000 or $5,000+.10×$39,500). F is entitled to no further recovery deduction under section 168 for 1984. The maximum amounts of F's recovery deductions for 1985 through 1988 are $6,000 per year (i.e., the lesser of $6,000 or .20×$39,500). F's recovery deduction for 1989 (the first taxable year after the 5-year recovery period but the sixth recovery year for purposes of section 168) is $3,950 (i.e., the lesser of .10×$39,500 or $6,000).

• (iv) Under paragraph (c), taxable year 1990 is considered to be the first taxable year succeeding the end of the recovery period. At the beginning of taxable year 1990, F's unrecovered basis in the automobile is $12,550 (i.e., $44,500-$31,950). Under paragraph (c), F may expense $6,000 of his unrecovered basis in the automobile in 1990 and in 1991. This expense is treated as a recovery deduction under section 168. For taxable year 1992, F may expense the remaining $550 of his unrecovered basis in the automobile.

(f) Treatment of improvements that qualify as capital expenditures.

An improvement to a passenger automobile that qualifies as a capital expenditure under section 263 is treated as a new item of recovery property placed in service in the year the improvement is made. However, the limitations in paragraph (b) of this section on the amount of recovery deductions allowable are determined by taking into account as a whole both the improvement and the property of which the improvement is a part. If that improvement also qualifies as an investment in new section 38 property under section 48(b) and §1.48-2(b)(2), the limitation in paragraph (a)(1) of this section on the amount of the investment tax credit for that improvement is determined by taking into account any investment tax credit previously allowed for the passenger automobile (including any prior improvement considered part of the passenger automobile). Thus, the maximum credit allowable for the automobile (including the improvement) will be $1,000 (or 2/3 of $1,000, in the case of an election to take a reduced credit under section 48(q)(4)) (adjusted under section 280F(d)(7) to reflect the automobile price inflation adjustment for the year the property of which the improvement is a part is placed in service).

(g) Treatment of section 1031 or section 1033 transactions-(1) Treatment of exchanged passenger automobile.

For a taxable year in which a transaction described in section 1031 or section 1033 occurs, the unadjusted basis of an exchanged or converted passenger automobile shall cease to be taken into account in determining any recovery deductions allowable under section 168 as of the beginning of the taxable year in which the exchange or conversion occurs. Thus, no recovery deduction is allowable for the exchanged or converted automobile in the year of the exchange or conversion.

(2) Treatment of acquired passenger automobile-(i) In general.

The acquired automobile is treated as new property placed in service in the year of the exchange (or in the replacement year) and that year is its first recovery year.

• (ii) Limitations on recovery deductions. If the exchanged (or converted) automobile was acquired after the effective date of section 280F (as set out in §1.280F-1(c)), the basis of that automobile as determined under section 1031(d) or section 1033(b) (whichever is applicable) must be reduced for purposes of computing recovery deductions with respect to the acquired automobile (but not for purposes of determining the amount of the investment tax credit and gain or loss on the sale or other disposition of the property) by the excess (if any) of-

  • (A) The sum of the amounts that would have been allowable as recovery deductions with respect to the exchanged (or converted) automobile during taxable years preceding the year of the exchange (or conversion) if all of the use of the automobile during those years was use described in section 168(c), over

  • (B) The sum of the amounts allowable as recovery deductions during those years.

(3) Examples.

The provisions of this paragraph (g) may be illustrated by the following examples: Example (1). (i) In 1982, F purchases and places in service a passenger automobile which is 3-year recovery property under section 168. The automobile is used exclusively in F's business.

• (ii) On July 1, 1984, F exchanges the passenger automobile and $1,000 cash for a new passenger automobile ("like kind" property). Under paragraph (g)(1) of this section, no recovery deduction is allowed in 1984 for the exchanged automobile. Any investment tax credit claimed with respect to that automobile is subject to recapture under section 47.

• (iii) F's basis in the acquired property (as determined under section 1031(d) and F's qualified investment are $20,000. Under the provisions of paragraph (g)(2)(i) of this section, the acquired property is treated as new recovery property placed in service in 1984 to the extent of the full $20,000 of basis. The maximum amount of F's investment tax credit is limited to $1,000 (i.e., the lesser of $1,000 or .06×$20,000). Cost recovery deductions are computed pursuant to paragraph (b) of this section. Example (2). (i) On July 1, 1984, E purchases for $30,000 and places in service a passenger automobile which is 3-year recovery property under section 168. In 1984, E's business use percentage is 80 percent and such use constitutes his total business/investment use.

• (ii) E elects under section 48(q)(4) to take a reduced investment tax credit in lieu of the section 48 (q)(1) basis adjustment. The maximum amount of E's investment tax credit is $533.33 (i.e., the lesser of 2/3 of $1,000×.80 or .80 ×.04×$30,000).

• (iii) E's unadjusted basis for purposes of section 168 is $30,000. E selects the use of the accelerated recovery percentages under section 168(b)(1). The maximum amount of E's recovery deduction for 1984 is $3,200 (i.e., the lesser of .80×$4,000 or .80×.25×$30,000).

• (iv) On June 10, 1985, E exchanges the passenger automobile and $1,000 cash for a new passenger automobile ("like kind" property). Under paragraph (g)(1) of this section, no recovery deduction is allowable in 1985 for the exchanged automobile. The investment tax credit claimed is subject to recapture under section 47. Under paragraph (g)(2)(ii) of this section, E's basis in the acquired property for purposes of computing recovery deductions under section 280F is $27,000 (i.e., $27,800 (section 1031(d) basis)-$800). The acquired automobile is used exclusively in F's business during taxable years 1985 through 1988. Under paragraph (g)(2) of this section, the acquired property is treated as new recovery property placed in service in 1985. Assume that the automobile price inflation adjustment (as described under section 280F(d)(7)) is zero. E's qualified investment in the property, as determined under $1,000 (i.e., the lesser of $1,000 or .06×$27,800). E's unadjusted basis for purposes of section 168 is $26,500 (i.e., $27,000 reduced under section 48(q)(1) by $500). Cost recovery deductions are computed pursuant to paragraph (b) of this section.

• (h) Other nonrecognition transactions. [Reserved]

• (i) Limitation under this section applies before other limitations-(1) Personal use. The limitations imposed upon the maximum amount of the allowable investment tax credit and the allowable recovery deductions (as described in paragraphs (a) through

• (c) of this section) must be adjusted during any taxable year in which a taxpayer makes any use of a passenger automobile other than for business/investment use (as defined in §1.280F-6T(d)(3)). The limitations on the amount of the allowable investment tax credit (as described in paragraph (a) of this section) and the allowable cost recovery deductions (as described in paragraphs (b) and (c) of this section) are redetermined by multiplying the limitations by the percentage of business/investment use (determined on an annual basis) during the taxable year.

(2) Short taxable year.

The limitations imposed upon the maximum amount of the allowable recovery deductions (as described in paragraphs (a) through (c) of this section) must be adjusted during any taxable year in which a taxpayer has a short taxable year. In this case, the limitation is adjusted by multiplying the limitation that would have been applied if the taxable year were not a short taxable year by a fraction, the numerator of which is the number of months and part-months in the short taxable year and the denominator of which is 12.

(3) Examples.

The provisions of this paragraph (i) may be illustrated by the following examples: Example (1). On July 1, 1984, A purchases and places in service a passenger automobile and uses it 80 percent for business/investment use during 1984. Under paragraph (i)(1) of this section, the maximum amount of the investment tax credit that A may claim for the automobile is $800 (i.e., .80×$1,000). Example (2). Assume the same facts as in example (1), except that A elects under section 48(q)(4) to take a reduced investment tax credit in lieu of the section 48(q)(1) basis adjustment. Under paragraph (i)(1) of this section, the maximum amount of the investment tax credit that A may claim for the automobile is $533.33 (i.e., .80×2/3 ×$1,000). Example (3). On July 1, 1984, B purchases and places in service a passenger automobile and uses it 60 percent for business/investment use during 1984. Under paragraph (i)(1) of this section, the maximum amount of the investment tax credit that B may claim for the automobile is $600 (i.e., .60×$1,000). B uses the car 70 percent for business/investment use during 1985 and 80 percent during 1986. Under paragraph (i)(1) of this section, the maximum amount of recovery deductions that B may claim for 1984, 1985, and 1986 are $2,400 (i.e., .60×$4,000), $4,200 (i.e., .70×$6,000), and $4,800 (i.e., .80×$6,000), respectively. Example (4). Assume the same facts as in example (3) with the added facts that B's unrecovered basis at the beginning of 1987 is $6,000 and that B uses the automobile 85 percent for business/investment use during 1987. Under paragraph (i)(1) of this section, the maximum amount that B may claim as an expense for 1987 is $5,000 (i.e., .85×$6,000). Example (5). On August 1, 1984, C purchases and places in service a passenger automobile and uses it exclusively for business. Taxable year 1984 for C is a short taxable year which consists of 6 months. Under paragraph (i)(2) of this section, the maximum amount that C may claim as a recovery deduction for 1984 is $2,000 (i.e., 6/12 ×$4,000). Example (6). Assume the same facts as in example (5), except that C uses the passenger automobile 70 percent for business/investment use during 1984. Under paragraph (i) (1) and (2) of this section, the maximum amount that C may claim as a recovery deduction for 1984 is $1,400 (i.e., .70×6/12 ×$4,000). credit when the business use percentage of listed property is not greater than 50 percent. (Temporary).

(a) In general.

Section 280F(b), generally, imposes limitations with respect to the amount allowable as an investment tax credit under section 46(a) and the amount allowable as a recovery deduction under section 168 in the case of listed property (as defined in §1.280F-6T(b)) if certain business use of the property (referred to as "qualified business use") does not exceed 50 percent during a taxable year. "Qualified business use" generally means use in a trade or business, rather than use in an investment or other activity conducted for the production of income within the meaning of section 212. See §1.280F-6T(d) for the distinction between "business/ investment use" and "qualified business use."

(b) Limitation on the amount of investment tax credit-(1) Denial of investment tax credit when business use percentage not greater than 50 percent.

Listed property is not treated as section 38 property to any extent unless the business use percentage (as defined in section 280F(d)(6) and §1.280F-6T(d)(1)) is greater than 50 percent. For example, if a taxpayer uses listed property in a trade or business in the taxable year in which it is placed in service, but the business use percentage is not greater than 50 percent, no investment tax credit is allowed for that listed property. If, in the taxable year in which listed property is placed in service, the only business/investment use (as defined in §1.280F-6T(d)(3)) of that property is qualified business use (as defined in §1.280F-6T(d)(2)(i)), and the business use percentage is 55 percent, the investment tax credit is allowed for the 55 percent of the listed property that is treated as section 38 property. The credit allowed is unaffected by any increase in the business use percentage in a subsequent taxable year.

(2) Recapture of investment tax credit.

Listed property ceases to be section 38 property to the extent that the business/investment use (as defined in §1.280F- 6T(d)(3)) for any taxable year is less than the business/investment use for the taxable year in which the property is placed in service. See §1.47-2(c). If the business use percentage (as defined in §1.280F-6T(d)(1)) of listed property is greater than 50 percent for the taxable year in which the property is placed in service, and less than or equal to 50 percent for any subsequent taxable year, that property ceases to be section 38 property in its entirety in that subsequent taxable year. Under §1.47-1(c)(1)(ii)(b), the property (or a portion thereof) is treated as ceasing to be section 38 property on the first day of the taxable year in which the cessation occurs.

(c) Limitation on the method of cost recovery under section 168 when business use of property not greater than 50 percent-(1) Year of acquisition.

If any listed property (as defined in §1.280F-6T(b)) is not predominantly used in a qualified business use (as defined in §1.280F-6T(d)(4)) in the year it is acquired, the recovery deductions allowed under section 168 for the property for that taxable year and for succeeding taxable years are to be determined using the straight line method over its earnings and profits life (as defined in paragraph (f) of this section). Additionally, the taxpayer is not entitled to make any election under section 179 with respect to the property for that year.

(2) Subsequent years.

If any listed property is not subject to paragraph (c)(1) of this section because such property is predominantly used in a qualified business use (as defined in §1.280F-6T(d)(4)) during the year it is acquired but is not predominantly used in a qualified business use during a subsequent taxable year, the rules of this paragraph (c)(2) apply. In such a case, the taxpayer must determine the recovery deductions allowed under section 168 for the taxable year that the listed property is not predominantly used in a qualified business use and for any subsequent taxable year as if such property was not predominantly used in a qualified business use in the year in which it was acquired and there had been no section 179 election with respect to the property. Thus, the recovery deductions allowable under section 168 for the remaining taxable years are computed by determining the applicable recovery percentage that would apply if the taxpayer had used the straight line method over the property's earnings and profits life beginning with the year the property was placed in service.

(3) Effect of rule on recovery property that is not listed property.

The mandatory use of the straight line method over the property's earnings and profits life under paragraphs (d) (1) and (2) of this section does not have any effect on the proper method of cost recovery for other recovery property of that same class placed in service in the same taxable year by the taxpayer and does not constitute an election to use an optional recovery period under section 168(b)(3).

(d) Recapture of excess recovery deductions claimed-(1) In general.

If paragraph (c)(2) of this section is applicable, any excess depreciation (as defined in paragraph (d)(2) of this section) must be included in the taxpayer's gross income and added to the property's adjusted basis for the first taxable year in which the property is not predominantly used in a qualified business use (as defined in §1.280F-6T(d)(4)).

(2) Definition of "excess depreciation".

For purposes of this section, the term "excess depreciation" means the excess (if any) of-

• (i) The amount of the recovery deductions allowable with respect to the property for taxable years before the first taxable year in which the property was not predominantly used in a qualified business use, over

• (ii) The amount of the recovery deductions which would have been allowable for those years if the property had not been predominantly used in a qualified business use for the year it was acquired and there had been no section 179 election with respect to the property. For purposes of paragraph (d)(2)(i), any deduction allowable under section 179 (relating to the election to expense certain depreciable trade or business assets) is treated as if that deduction was a recovery deduction under section 168.

(3) Recordkeeping requirement.

The taxpayer shall maintain adequate contemporaneous records (within the meaning of §1.274-5T) of the use of any listed property for any taxable year for which recapture under section 280F(b)(3) and paragraphs (d) (1) and (2) of this section may occur even if the taxpayer has fully depreciated (or expensed) the listed property in a prior year. For example, in the case of 3-year recovery property, the taxpayer shall maintain a log, journal, etc. for six years even though the taxpayer fully depreciated the property in the first three years.

(e) Earnings and profits life-(1) Definition.

The earnings and profits life with respect to any listed property is generally the following: In the case of-- The applicable recovery period is-- 3-year property ............................. 5 years. 5-year property ............................. 12 years. 10-year property ............................ 25 years. 18-year real property and low-income housing 40 years. 15-year public utility property ............. 35 years. However, if the recovery period applicable to any recovery property under section 168 is longer than the above assigned recovery period, such longer recovery period shall be used. For example, generally, the recovery period for recovery property used predominantly outside the United States is the property's present class life (as defined in section 168(g)(2)). In many cases, a property's present class life is longer than the recovery period assigned to the property under the above table. Pursuant to this paragraph (e)(1), the property's recovery period is its present class life.

(2) Applicable recovery percentages.

If the applicable recovery period is determined pursuant to the table prescribed in paragraph (e)(1) of this section, the applicable recovery percentage is:

• (i) For property other than 18-year real property or low-income housing: If the recovery year is-- And the recovery period is-- ----------------------------------- ---------------------------------- 5 12 25 35 ----------------------------------------------- ---------------------- 1 .................................. 10 4 2 1 2 .................................. 20 9 4 3 3 .................................. 20 9 4 3 4 .................................. 20 9 4 3 5 .................................. 10 8 4 3 7 ........................... --------- 8 4 3 8 ........................... --------- 8 4 3 9 ........................... --------- 8 4 3 10 .......................... --------- 8 4 3 11 .......................... --------- 8 4 3 12 .......................... --------- 8 4 3 13 .......................... --------- 4 4 3 14 .......................... --------- -------- 4 3 15 .......................... --------- -------- 4 3 16 .......................... --------- -------- 4 3 17 .......................... --------- -------- 4 3 18 .......................... --------- -------- 4 3 19 .......................... --------- -------- 4 3 20 .......................... --------- -------- 4 3 21 .......................... --------- ------- - 4 3 22 .......................... --------- -------- 4 3 23 .......................... --------- ----- --- 4 3 24 .......................... --------- -------- 4 3 25 .......................... --------- --- ----- 4 3 26 .......................... --------- -------- 2 3 27 .......................... --------- - ------- -------- 3 28 .......................... --------- -------- -------- 3 29 .......................... --------- -------- -------- 3 30 .......................... --------- -------- -------- 3 31 .......................... --------- -------- -------- 3 32 .......................... ---- ----- -------- -------- 2 33 .......................... --------- -------- -------- 2 34 .......................... --------- -------- -------- 2 35 .......................... --------- -------- -------- 2 36 .......................... --------- -------- -------- 1 ----------------------------- ----------------------------------------

• (ii) For 18-year real property: [Reserved]

• (iii) For low-income housing: [Reserved]

(f) Examples.

The provisions of this section may be illustrated by the following examples. For purposes of these examples, assume that all taxpayers use the calendar year and that no short taxable years are involved. Example (1). On July 1, 1984, B purchases for $50,000 and places in service an item of listed property (other than a passenger automobile) which is 3-year recovery property under section 168. For the first taxable year that the property is in service, B used the property 40 percent in a trade or business, 40 percent for the production of income, and 20 percent for personal purposes. Although B's total business/investment use is greater than 50 percent, the business use percentage for that taxable year is only 40 percent. Under paragraph (b)(1) of this section, no investment tax credit is allowed for the property. Example (2). (i) On January 1, 1985, C purchases for $40,000 and places in service an item of listed property (other than a passenger automobile) that is 3-year recovery property under section 168. Seventy percent of the use of the property is in C's trade or business and 30 percent of the use is for personal purposes. C does not elect a reduced investment tax credit under section 48(q)(4). The amount of C's investment tax credit is $1,680 (i.e., $40,000 × .60 × .10 × .70).

• (ii) In addition, in 1986, only 55 percent of the use of the property is in C's trade or business and 45 percent of the use is for personal purposes. Under paragraph (b)(2) of this section, the property ceases to be section 38 property to the extent that the use in a trade or business decreased below 70 percent. As a result, a portion of the investment tax credit must be recaptured as an increase in tax liability for 1986 under the rules of section 47 (relating to the recapture of investment tax credit). See section 47(a)(5) and §1.47-2(e) for rules relating to the computation of the recapture amount. Example (3). On July 1, 1984, B purchases and places in service an item of listed property (other than a passenger automobile) that is 3-year recovery property. B elects to take a reduced investment tax credit under section 48(q)(4). In 1984, B uses the property exclusively in his business. Assume that B's 1984 allowable recovery deduction is $12,500. In 1985 and 1986, the property is not predominantly used in a qualified business use. The investment tax credit claimed is subject to recapture in full under section 47 in 1985 since the property ceases to be section 38 property in its entirety on January 1, 1985. Under paragraph (c)(2) of this section, B must treat the property for 1985 and subsequent taxable years as if he recovered its cost over a 5-year recovery period (i.e., its earnings and profits life) using the straight line method (with the half-year convention) from the time it was placed in service. Therefore, taxable year 1985 is treated as the property's second recovery year (of its 5-year recovery period) and the applicable recovery deduction using the straight line method must be used to determine the recovery deduction. Under paragraph (d) of this section, B must recapture any excess depreciation claimed for taxable year 1984. If B had used the straight line method over a 5-year recovery period his recovery deduction for 1984 would have been $5,000. Under paragraph (d)(2) of this section, B's excess depreciation is $7,500 (i.e., $12,500 - $5,000) and that amount must be included in B's 1985 gross income and added to the property's basis. The taxable years 1986 through 1989 are the property's second through sixth recovery years, respectively, of such property's 5-year recovery period. Example (4). Assume the same facts as in example (3), except that in 1986 B used the property exclusively in his business. B is entitled to no investment tax credit with respect to the property in 1986 and must continue to recover the property's cost over a 5-year recovery period using the straight line method. Example (5). On July 1, 1984, H purchases and places in service listed property (other than a passenger automobile) which is 3-year recovery property under section 168. H selects the use of the accelerated recovery percentages under section 168. In 1984 through 1986, H uses the property exclusively for business. In 1987, the property is not predominantly used in a qualified business use. Under paragraph (c)(2) of this section, H must compute his 1987 and subsequent taxable year's recovery deductions using the straight line method over a 5-year recovery period with 1987 treated as the fourth recovery year. Under paragraph (d) of this section, H must recapture any excess depreciation claimed for taxable years 1984 through 1986 even though by 1987 the full cost of the property had already been recovered. Example (6). Assume the same facts as in example (5), except that H uses the property exclusively for personal purposes in 1987. Under paragraph (d) of this section, H must recapture any excess depreciation claimed for taxable years 1984 through 1986. H is entitled to no cost recovery deduction under the 5-year straight line method for 1987. Assume further that in 1988 H uses the property 70 percent in his business. Thus, H's business use percentage for that year is 70 percent. Under paragraph (c)(2) of this section, H must compute his 1988 cost recovery deduction using the straight line method over a 5-year recovery period with 1988 treated as the fifth recovery year. Example (7). (i) On July 1, 1984, F purchases for $70,000 and places in service listed property (other than a passenger automobile) which is 3-year recovery property under section 168. F's business use percentage for 1984 through 1986 is 60 percent. F elects under section 179 to expense $5,000 of the cost of the property.

• (ii) F elects a reduced investment tax credit under section 48(q)(4). The maximum amount of F's investment tax credit is $1,560 (i.e., $65,000×.04×.60).

• (iii) F's unadjusted basis for purposes of section 168 is $65,000 (i.e., $70,000 reduced by the $5,000 section 179 expense). F selects the use of the accelerated recovery percentages under section 168(b)(1). F's recovery deduction for 1984 is $9,750 (i.e., $65,000×.25×.60).

• (iv) In 1985, the property is not predominantly used in a qualified business use. The investment tax credit claimed is subject to recapture in full under section 47 in 1985 since the property ceases to be section 38 property in its entirety on January 1, 1985. Under paragraph (c)(2) of this section, F must treat the property for 1985 and subsequent taxable years as if he recovered its cost over a 5-year recovery period (i.e., its earnings and profits life) using the straight line method (with the half year convention) from the time it was placed in service. Under paragraph (d) of this section, F must recapture any excess depreciation claimed for taxable year 1984. F's excess depreciation is $10,550 [i.e., ($65,000×.25×.60+$5,000)- ($70,000×.10×.60)]. This amount must be included in F's 1985 gross income and added to the property's adjusted basis. Example (8). (i) On July 1, 1984, G purchases for $60,000 and places in service a passenger automobile which is 3-year recovery property under section 168.

• (ii) In 1984, G's business use percentage is 80 percent and such use constitutes his total business/investment use. G elects under section 48(q)(4) to take a reduced investment tax credit in lieu of the basis adjustment under section 48(q)(1). The maximum amount of G's investment tax credit is $533.33 (i.e., the lesser of .80×2/3 ×$1,000 or $60,000×.80×.04).

• (iii) In 1984, G does not elect under section 179 to expense a portion of the automobile's cost. G selects the use of the accelerated recovery percentages under section 168. G's unadjusted basis for purposes of section 168 is $60,000. The maximum amount of G's 1984 recovery deduction is $3,200 (i.e., the lesser of .80×$4,000 or .80×.25×$60,000).

• (iv) In 1985, G's business use percentage is 80 percent and such use constitutes his total business/investment use. The maximum amount of G's 1985 recovery deduction is $4,800 (i.e., the lesser of .80×$6,000 or .80×.38×$60,000).

• (v) In 1986, G's business use percentage is 45 percent and such use constitutes his total business/investment use. Under paragraph (b)(2) of this section, as a result of the decline in the business use percentage to 50 percent or less, the automobile ceases to be section 38 property in its entirety and G must recapture (pursuant to §§1.47-1(c) and 1.47-2(e)) the investment tax credit previously claimed. Since G's business use percentage in 1986 is not greater than 50 percent, under the provisions of paragraph (d) of this section, G must recompute (for recapture purposes) his recovery deductions for 1984 and 1985 using the straight line method over a 5-year recovery period (i.e., earnings and profits life for 3-year recovery property using the half-year convention) to determine if any excess depreciation must be included in his 1986 taxable income. G's recomputed recovery deductions for 1984 and 1985 are $3,200 (i.e., the lesser of .80×$4,000 or .80×.10×$60,000), and $4,800 (i.e., the lesser of .80×$6,000 or .80×.20×$60,000), respectively. G does not have to recapture any excess depreciation since his recovery deductions for 1984 and 1985 computed using the straight line method over a 5-year recovery period are the same as the amounts actually claimed during those years.

• (vi) Under paragraph (c)(2) of this section, for 1986 and succeeding taxable years G must compute his remaining recovery deductions using the straight line method over a 5-year recovery period beginning with the third recovery year. The maximum amount of G's 1986 recovery deduction is $2,700 (i.e., the lesser of .45×$6,000 or .45×.20×$60,000). For taxable years 1987 through 1993, G's business use percentage is 55 percent and such use constitutes his total business/investment use. G's 1987 and 1988 recovery deductions are $3,300 per year (i.e., the lesser of .55×$6,000 or .55×.20×$60,000). For taxable year 1989 (the last recovery year), G's recovery deduction is $3,300 (i.e., .55×.10×$60,000 or .55×$6,000).

• (vii) As of the beginning of 1990, G will have claimed a total of $20,600 of recovery deductions. Under §1.280F-2T(c), G may expense his remaining unrecovered basis (up to a certain amount per year) in the first succeeding taxable year after the end of the recovery period and in taxable years thereafter. If G had used his automobile for 100 percent business use in taxable years 1984 through 1989, G could have claimed a recovery deduction of $4,000 in 1984 and a recovery deduction of $6,000 in each of those remaining years. At the beginning of 1990, therefore, G's unrecovered basis (as defined in section 280F(d)(8)) is $26,000 (i.e., $60,000- $34,000). The maximum amount of G's 1990 recovery deduction is $3,300 (i.e., .55×$6,000). At the beginning of 1991, G's unrecovered basis is $20,000 (i.e., $26,000 adjusted under section 280F(d)(2) and §1.280F-4T(a) to account for the amount that would have been claimed in 1990 for 100 percent business/investment use during that year). The maximum amount of G's 1991 recovery deduction is $3,300 (i.e., .55×$6,000) and his unrecovered basis as of the beginning of 1992 is $14,000 (i.e., $20,000-$6,000). In 1992, G disposes of the automobile. G is not allowed a recovery deduction for 1992.

(a) Limitations on allowable recovery deductions in subsequent taxable years-(1) Subsequent taxable years affected by reason of personal use in prior years.

For purposes of computing the amount of the recovery deduction for "listed property" for a subsequent taxable year, the amount that would have been allowable as a recovery deduction during an earlier taxable year if all of the use of the property was use described in section 168(c) is treated as the amount of the recovery deduction allowable during that earlier taxable year. The preceding sentence applies with respect to all earlier taxable years, beginning with the first taxable year in which some or all use of the "listed property" is use described in section 168(c). For example, on July 1, 1984, B purchases and places in service listed property (other than a passenger automobile) which is 5-year recovery property under section 168. B selects the use of the accelerated percentages under section 168. B's business/investment use of the property (all of which is qualified business use as defined in section 280F(d)(6)(B) and §1.280F-6T(d)(2)) in 1984 through 1988 is 80 percent, 70 percent, 60 percent, and 55 percent, respectively, and B claims recovery deductions for those years based on those percentages. B's qualified business use for the property for 1989 and taxable years thereafter increases to 100 percent. Pursuant to this rule, B may not claim a recovery deduction in 1989 (or for any subsequent taxable year) for the increase in business use because there is no adjusted basis remaining to be recovered for cost recovery purposes after 1988.

(2) Special rule for passenger automobiles.

In the case of a passenger automobile that is subject to the limitations of §1.280F-2T, the amount treated as the amount that would have been allowable as a recovery deduction if all of the use of the automobile was use described in section 168(c) shall not exceed $4,000 for the year the passenger automobile is placed in service and $6,000 for each succeeding taxable year (adjusted to account for the automobile price inflation adjustment, if any, under section 280F(d)(7) and for short taxable year under §1.280F-2T(i)(2)). See. §1.280F-3T(g). Example (8).

(b) Treatment of improvements that qualify as capital expenditures-(1) In general.

In the case of any improvement that qualifies as a capital expenditure under section 263 made to any listed property other than a passenger automobile, the rules of this paragraph (b) apply. See §1.280F-2T(f) for the treatment of an improvement made to a passenger automobile.

(2) Investment tax credit allowed for the improvement.

If the improvement qualifies as an investment in new section 38 property under section 48(b) and §1.48-2(b), the investment tax credit for that improvement is limited by paragraph (b)(1) of

(3) Cost recovery of the improvement.

The improvement is treated as a new item of recovery property. The method of cost recovery with respect to that improvement is limited by §1.280F-3T(c), as applied to the item of listed property as a whole.

(a) In general.

Except as otherwise provided in this section, the limitation on cost recovery deductions and the investment tax credit provided in section 280F (a) and

(b) and §§1.

280F-2T and 1.280F-3T do not apply to any listed property leased or held for leasing by any person regularly engaged in the business of leasing listed property. If a person is not regularly engaged in the business of leasing listed property, the limitations on cost recovery deductions and the investment tax credit provided in section 280F and §§1.280F-2T and 1.280F-3T apply to such property leased or held for leasing by such person. The special rules for lessees set out in this section apply with respect to all lessees of listed property, even those whose lessors are not regularly engaged in the business of leasing listed property.

• (b) Section 48(d) election. If a lessor elects under section 48(d) with respect to any listed property to treat the lessee as having acquired such property, the amount of the investment tax credit allowed to the lessee is subject to the limitation prescribed in §1.280F-3T(b) (1) and (2). If a lessor elects under section 48(d) with respect to any passenger automobile to treat the lessee as having acquired such automobile, the amount of the investment tax credit allowed to the lessee is also subject to the limitations prescribed in §1.280F-2T (a) and (i).

(c) Regularly engaged in the business of leasing.

For purposes of paragraph (a) of this section, a person shall be considered regularly engaged in the business of leasing listed property only if contracts to lease such property are entered into with some frequency over a continuous period of time. The determination shall be made on the basis of the facts and circumstances in each case, taking into account the nature of the person's business in its entirety. Occasional or incidental leasing activity is insufficient. For example, a person leasing only one passenger automobile during a taxable year is not regularly engaged in the business of leasing automobiles. In addition, an employer that allows an employee to use the employer's property for personal purposes and charges such employee for the use of the property is not regularly engaged in the business of leasing with respect to the property used by the employee.

(d) Inclusions in income of lessees of passenger automobiles-(1) In general.

For each taxable year during which a taxpayer leases a passenger automobile, the taxpayer must include in gross income an inclusion amount (prorated for the number of days of the lease term included in that taxable year) which is determined under this paragraph (d)(1) and multiplied by the business/investment use (as defined in

• (i) Is 7.5 percent of the excess (if any) of the automobile's fair market value over $16,500 for each of the first three taxable years during which a passenger automobile is leased.

• (ii) Is 6 percent of the excess (if any) of the automobile's fair market value over $22,500 for the fourth taxable year during which a passenger automobile is leased.

• (iii) Is 6 percent of the excess (if any) of the automobile's fair market value over $28,500 for the fifth taxable year during which a passenger automobile is leased.

• (iv) Is 6 percent of the excess (if any) of the automobile's fair market value over $34,500 for the sixth taxable year during which a passenger automobile is leased. For the seventh and subsequent taxable years during which a passenger automobile is leased, the inclusion amount is 6 percent of the excess (if any) of the automobile's fair market value over the sum of (A) $16,500 and

  • (B) $6,000 multiplied by the number of such taxable years in excess of three years. See paragraph (g)(2) of this section for the definition of fair market value.

(2) Additional inclusion amount when less than predominant use in a qualified business use.

(i) If a passenger automobile is not used predominantly in a qualified business use during a taxable year, the lessee must add to gross income in the first taxable year that the automobile is not so used (and only in that year) an inclusion amount determined under this paragraph (d)(2). This inclusion amount is in addition to the amount required to be included in gross income under paragraph (d)(1) of this section.

• (ii) If the fair market value (as defined in paragraph (g)(2) of this section) of the automobile is greater than $16,500, the inclusion amount is determined by multiplying the average of the business/investment use (as defined in paragraph (g)(3) of this section) by the appropriate dollar amount from the table in paragraph (d)(3)(iii) of this section. If the fair market value (as defined in paragraph (g)(2) of this section) of the automobile is $16,500 or less, the inclusion amount is the product of the fair market value of the automobile, the average business/investment use, and the applicable percentage from the table in paragraph (d)(3)(iv) of this section.

• (iii) The dollar amount is determined under the following table: ------------------------ ------------------------------------------------------- If a passenger automobile is not The dollar amount: predominantly used in a qualified business use during-- ---------- --------------------------------------------------------------------- Lease term (years) --- ---------------------------------------------------------------------------- 1 2 3 4 or more ------------------------------------------------------------------------------- The first taxable year of the lease term ................................... $350 $700 $1,350 $1,850 The second taxable year of the lease term ............................... -------- -------- 650 1,250 The third taxable year of the lease term ............................... -------- -------- --------- 650 -------------------------------------------------------------------------------

• (iv) The applicable percentage is determined under the following table: --------------- ---------------------------------------------------------------- If a passenger automobile is not The applicable percentage: predominantly used in a qualified business use during-- ------------------------------------------------------------------------------- Lease term (years) ------------------------------------------------------------------------- ------ 1 2 3 4 or more ---------------------------------------------------------------------- --------- The first taxable year of the lease term ...................................... 3.0 6.0 10.2 13.2 The second taxable year of the lease term ................................. -------- 1.25 6.2 10.4 The third taxable year of the lease term ................................. ------ -- -------- 2.25 6.5 The fourth taxable year of the lease term ................................. -------- -------- -------- 1.7 The fifth taxable year of the lease term ................................. -------- -------- -------- 0.5 ------------------------------------- ------------------------------------------

• (e) Inclusions in income of lessees of listed property other than passenger automobiles-(1) In general. If listed property other than a passenger automobile is not used predominantly in a qualified business use in any taxable year in which such property is leased, the lessee must add to gross income in the first taxable year in which such property is not so predominantly used (and only in that year) an inclusion amount determined under this paragraph (e).

(2) Inclusion amount.

The inclusion amount is the product of the following amounts:

• (i) The fair market value (as defined in paragraph (g)(2) of this section) of the property,

• (ii) The average business/investment use (as defined in paragraph (g)(3) of this section), and

• (iii) The applicable percentage (as determined under paragraph (e)(3) of this section).

(3) Applicable percentages.

The applicable percentages for 3-, 5-, and 10-year recovery property are determined according to the following tables:

• (i) In the case of 3-year recovery property: ---------------------------------------------- --------------------------------- Taxable year For the first taxable year in which the business use during lease percentage is 50 percent or less, the applicable term percentage for such taxable year is-- ----------------------------------------------------- -------------------------- 1 2 3 4 5 6 and later -------------------------------------------- ----------------------------------- For a lease term of: 1 year ................ 3.0 -------- - ------- --------- -------- --------- 2 years ............... 6.0 1.25 -------- --------- -------- --------- 3 years .............. 10.2 6.2 2.25 --------- -------- --------- 4 or more years ...... 13.2 10.4 6.5 1.7 0.5 0 -------------------------------------------------------------- -----------------

• (ii) In the case of 5-year recovery property: [Note: The following TABLE/FORM is too wide to be displayed on one screen. You must print it for a meaningful review of its contents. The table has been divided into multiple pieces with each piece containing information to help you assemble a printout of the table. The information for each piece includes: (1) a three line message preceding the tabular data showing by line # and character # the position of the upper left-hand corner of the piece and the position of the piece within the entire table; and (2) a numeric scale following the tabular data displaying the character positions.] * **** **** This is piece 1. -- It begins at character 1 of table line 1. **** * **** ---------------------------------------- Taxable year For the first taxable year during lease term ---------------------------------------- 1 2 3 ------------ ---------------------------- For a lease term of: 1 year .......... 2.7 ------- ------- 2 years ......... 5.3 1.2 ------- 3 years ......... 9.9 6.1 1.6 4 years ........ 14.4 11.1 7.3 5 years ........ 18.4 15.7 12.4 6 or more years ........ 21.8 19.6 16.7 -------------------- -------------------- 1...+...10....+...20....+...30....+...40 ***** **** * This is piece 2. -- It begins at character 41 of table line 1. **** *** **** ---------------------------------------------------------------------------- in which the business use percentage is 50 percent or less, the applicable percentage for such taxable year is-- ------------------------------------------------------------------ ---------- 4 5 6 7 8 9 10 11 12 ------------------------------------------------------------ ---------------- ------- ------ ------- ------ ------ ------- ------- ------- ------ ------- ---- -- ------- ------ ------ ------- ------- ------- ------ ------- ------ ------- ------ ------ ----- -- ------- ------- ------ 2.3 ------ ------- ------ ------ ------- ------- ------- ------ 8.2 3.0 ------- ------ ------ ------- ------- ------- ------ 13.5 9.6 5.25 4.4 3.6 2.8 1.8 1.0 0 ---------------------------------------------------------------------------- 41..+...50....+...60....+...70....+...80....+...90....+....0....+...10....+.

• (iii) In the case of 10-year recovery property: [Note: The following TABLE/FORM is too wide to be displayed on one screen. You must print it for a meaningful review of its contents. The table has been divided into multiple pieces with each piece containing information to help you assemble a printout of the table. The information for each piece includes: (1) a three line message preceding the tabular data showing by line # and character # the position of the upper left-hand corner of the piece and the position of the piece within the entire table; and (2) a numeric scale following the tabular data displaying the character positions.] * **** **** This is piece 1. -- It begins at character 1 of table line 1. **** * **** ------------------------------------------------------------------ Taxable year For the first taxable year in which the business use during lease term ----------- ------------------------------------------------------- 1 2 3 4 5 6 -------------------------- ---------------------------------------- For a lease term of: 1 year .......... 2.5 ------- -- ----- ------- ------- ------- 2 years ......... 5.1 .6 ------- ------- ------- ------- 3 years ......... 9.8 5.6 1.0 ------- ------- ------- 4 years ........ 14.0 10.3 6.2 1.4 ------- ------ - 5 years ........ 17.9 14.5 10.9 6.7 1.8 ------- 6 years ........ 21.3 18.3 15.1 11.4 7.1 2.1 7 years ........ 21.9 19.0 15.9 12.4 8.4 3.9 8 years ........ 22.4 19.6 16.7 13.4 9.7 5.5 9 years ........ 22.9 20.2 17.4 14.3 10.9 7.0 10 years ....... 23.5 20.9 18.2 15.2 11.9 8.3 11 years ....... 23.9 21.4 18.8 16.0 12.8 9.3 12 years ....... 24.3 21.9 19.3 16.5 13.4 10.1 13 years ....... 24.7 22.2 19.7 16.9 14.0 10.7 14 years ....... 25.0 22.5 20.1 17.3 14.4 11.1 15 or more years ........ 25.3 22.8 20.3 17.5 14.7 11.5 ------------------------------------------------------------------ 1...+...10....+...20....+...30....+...40....+...50....+...60....+. ***** **** * This is piece 2. -- It begins at character 67 of table line 1. **** * **** ----------------------------------------------------------------- percentage is 50 pct or less, the applicable percentage for such ----------------------- ------------------------------------------ 7 8 9 10 11 12 13 ------------------------------- ---------------------------------- ------- ------- -------- -------- ------- ------- ------- --- ---- ------- -------- -------- ------- ------- ------- ------- ------- -------- -------- ------- ------- ------- ------- ------- -------- -------- ------- ------- ------- ------- ------- ------- - -------- ------- ------- ------- ------- ------- -------- -------- ------- ------- ------- 2.4 ------- -------- -------- ------- ------- ------- 4.5 2.7 -------- -------- ------- ------- ---- --- 6.4 5.1 3.0 -------- ------- ------- ------- 8.1 7.2 5.7 3.3 ------- ------- ------- 9.4 8.9 7.7 5.9 3.1 ------- ------- 10.3 10.0 9.3 7.8 5.5 2.9 ------- 11.1 11.0 10.4 9.2 7.4 5.2 2.7 11.6 11.7 11.3 10.3 8.8 6.9 4.8 12.0 12.2 11.9 11.1 9.8 8.2 6.5 --------- -------------------------------------------------------- 67......+...80....+...90....+....0....+...10....+...20....+...30. * **** This is piece 3. -- It begins at character 132 of table line 1. *** **** ------------------ taxable year is-- ------------------ 14 15 ------------- ----- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- --- ---- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ---- --- ------- ------- 2.5 ------- 4.5 2.3 ------------------ 132....40....+...5

• (f) Special rules applicable to inclusions in income of lessees. This paragraph (f) applies to the inclusions in gross income of lessees prescribed under paragraphs (d)(2) or (e) of this section.

(1) Lease term commences within 9 months of the end of lessee's taxable year.

If-

• (i) The lease term commences within 9 months before the close of the lessee's taxable year,

• (ii) The property is not predominantly used in a qualified business use during that portion of the taxable year, and

• (iii) The lease term continues into the lessee's subsequent taxable year, then the inclusion amount is added to gross income in the lessee's subsequent taxable year and the amount is determined by taking into account the average of the business/investment use for both taxable years and the applicable percentage for the taxable year in which the lease term begins (or, in the case of a passenger automobile with a fair market value greater than $16,500, the appropriate dollar amount for the taxable year in which the lease term begins).

(2) Lease term less than one year.

If the lease term is less than one year, the amount which must be added to gross income is an amount that bears the same ratio to the inclusion amount determined before the application of this paragraph (f)(2) as the number of days in the lease term bears to 365.

(3) Maximum inclusion amount.

The inclusion amount shall not exceed the sum of all deductible amounts in connection with the use of the listed property properly allocable to the lessee's taxable year in which the inclusion amount must be added to gross income.

• (g) Definitions-(1) Lease term. In determining the term of any lease for purposes of this section, the rules of section 168(j)(6)(B) shall apply.

(2) Fair market value.

For purposes of this section, the fair market value of listed property is such value on the first day of the lease term. If the capitalized cost of listed property is specified in the lease agreement, the lessee shall treat such amount as the fair market value of the property.

(3) Average business/investment use.

For purposes of this section, the average business/investment use of any listed property is the average of the business/investment use for the first taxable year in which the business use percentage is 50 percent or less and all preceding taxable years in which such property is leased. See paragraph (f)(1) of this section for special rule when lease term commences within 9 months before the end of the lessee's taxable year.

• (h) Examples. This section may be illustrated by the following examples. Example (1). On January 1, 1985, A, a calendar year taxpayer, leases and places in service a passenger automobile with a fair market value of $55,000. The lease is to be for a period of four years. During taxable years 1985 and 1986, A uses the automobile exclusively in a trade or business. Under paragraph (d)(1) of this section, A must include in gross income in both 1985 and 1986, $2,887.50 (i.e., ($55,000- $16,500)×7.5%). Example (2). The facts are the same as in example (1), and in addition, A uses the automobile only 45 percent in a trade or business during 1987. Under paragraph (d)(1) of this section for 1987, A must include in gross income $1,299.38 (i.e., ($55,000-$16,500)×7.5%×45%). In addition, under paragraph (d)(2) of this section, A must also include in gross income in 1987, $530.85 (i.e., $650×81.67%, average business/investment use). Example (3). On August 1, 1985, B, a calendar year taxpayer, leases and places in service an item of listed property which is 5-year recovery property, with a fair market value of $10,000. The lease is to be for a period of 5 years. B's qualified business use of the property is 40 percent in 1985, 100 percent in 1986, and 90 percent in 1987. Under paragraphs (e)(1) and (f)(1) of this section, before the application of paragraph (f)(3) of this section, B must include in gross income in 1986, $1,288.00 (i.e., $10,000×70%×18.4%, the product of the fair market value, the average business use for both taxable years, and the applicable percentage for year one from the table in paragraph (e)(3)(ii) of this section). Example (4). On October 1, 1985, C, a calendar year taxpayer, leases and places in service an item of listed property which is 3-year recovery property with a fair market value of $15,000. The lease term is 6 months (ending March 31, 1986) during which C uses the property 45 percent in a trade or business, the only business/investment use. Under paragraphs (e)(1) and (f) (1) and (2) of this section, before the application of paragraph (f)(3) of this section, C must include in gross income in 1986, $100.97 (i.e., $15,000×45%×3%×182/365, the product of the fair market value, the average business use for both taxable years, and the applicable percentage for year one from the table in paragraph (e)(3)(i) of this section, prorated for the length of the lease term).

(a) Deductions of employee-(1) In general.

Employee use of listed property shall not be treated as business/investment use (as defined in paragraph (d)(3) of this section) for purposes of determining the amount of any credit allowable under section 38 to the employee or the amount of any recovery deduction allowable (including any deduction under section 179) to the employee unless that use is for the convenience of the employer and required as a condition of employment.

(2) "Convenience of the employer" and "condition of employment" requirements-(i) In general.

The terms "convenience of the employer" and "condition of employment" generally have the same meaning for purposes of section 280F as they have for purposes of section 119 (relating to the exclusion from gross income for meals or lodging furnished for the convenience of the employer).

• (ii) "Condition of employment. In order to satisfy the "condition of employment" requirement, the use of the property must be required in order for the employee to perform the duties of his or her employment properly. Whether the use of the property is so required depends on all the facts and circumstances. Thus, the employer need not explicitly require the employee to use the property. Similarly, a mere statement by the employer that the use of the property is a condition of employment is not sufficient.

• (iii) "Convenience of employer". [Reserved]

(3) Employee use.

For purposes of this section, the term "employee use" means any use in connection with the performance of services by the employee as an employee.

(4) Examples.

The principles of this paragraph are illustrated in the following examples: Example (1). A is employed as a courier with W, which provides local courier services. A owns and uses a motorcycle to deliver packages to downtown offices for W. W does not provide delivery vehicles and explicitly requires all of its couriers to own a car or motorcycle for use in their employment with the company. A's use of the motorcycle for delivery purposes is for the convenience of W and is required as a condition of employment. Example (2). B is an inspector for X, a construction company with many construction sites in the local area. B is required to travel to the various construction sites on a regular basis; B uses her automobile to make these trips. Although X does not furnish B an automobile, X does not explicitly require B to use here own automobile. However, X reimburses B for any costs she incurs in traveling to the various job sites. B's use of here automobile in here employment is for the convenience of X and is required as a condition of employment. Example (3). Assume the same facts as in example (2), except that X makes an automobile available to B who chooses to use her own automobile and receive reimbursement. B's use of her own automobile is not for the convenience of X and is not required as a condition of employment. Example (4). C is a pilot for Y, a small charter airline. Y requires its pilots to obtain x hours of flight time annually in addition to the number of hours of flight time spent with the airline. Pilots can usually obtain these hours by flying with a military reserve unit or by flying part-time with another airline. C owns his own airplane. C's use of his airplane to obtain the required flight hours is not for the convenience of the employer and is not required as a condition of employment. Example (5). D is employed as an engineer with Z, an engineering contracting firm. D occasionally takes work home at night rather than working late in the office. D owns and uses a computer which is virtually identical to the one she uses at the office to complete her work at home. D's use of the computer is not for the convenience of here employer and is not required as a condition of employment.

(b) Listed property-(1) In general.

Except as otherwise provided in paragraph (b)(5) of this section, the term "listed property" means-

• (i) Any passenger automobile (as defined in paragraph (c) of this section),

• (ii) Any other property used as a means of transportation (as defined in paragraph (b)(2) of this section),

• (iii) Any property of a type generally used for purposes of entertainment, recreation, or amusement, and

• (iv) Any computer or peripheral equipment (as defined in section 168(j)(5)(D)), and

• (v) Any other property specified in paragraph (b)(4) of this section.

(2) "Means of transportation"-(i) In general.

Except as otherwise provided in paragraph (b)(2)(ii) of this section, property used as a "means of transportation" includes trucks, buses, trains, boats, airplanes, motorcycles, and any other vehicles for transporting persons or goods.

• (ii) Exception. The term "means of transportation" does not include any vehicle or property that is of a type ordinarily not susceptible to personal use. Examples of such property are forklifts, cement mixers, and trucks specially designed for specific business purposes, such as refrigerated delivery trucks. This paragraph (b)(2)(ii) does not apply with respect to any vehicle used by any individual for commuting purposes.

(3) Property used for entertainment, etc.

Property of a type generally used for purposes of entertainment, recreation, or amusement includes property such as photographic, phonographic, communication, and video recording equipment.

(4) Other property.

[Reserved]

(5) Exception for computers.

The term "listed property" shall not include any computer (including peripheral equipment) used exclusively at a regular business establishment. For purposes of the preceding sentence, a portion of a dwelling unit shall be treated as a regular business establishment if (and only if) the requirements of section 280A(c)(1) are met with respect to that portion.

(c) Passenger automobile-(1) In general.

Except as provided in paragraph (c)(3) of this section, the term "passenger automobile" means any 4-wheeled vehicle which is-

• (i) Manufactured primarily for use on public streets, roads, and highways, and

• (ii) Rated at 6,000 pounds gross vehicle weight or less.

(2) Parts, etc.

of automobile. The term "passenger automobile" includes any part, component, or other item that is physically attached to the automobile or is traditionally included in the purchase price of an automobile. The term does not include repairs that are not capital expenditures within the meaning of section 263.

(3) Exception for certain vehicles.

The term "passenger automobile" shall not include any-

• (i) Ambulance, hearse, or combination ambulance-hearse used by the taxpayer directly in a trade or business,

• (ii) Vehicle used by the taxpayer directly in the trade or business of transporting persons or property for compensation or hire, or

• (iii) Commuter highway vehicle as defined in section 46(c)(6)(B).

(d) Business use percentage-(1) In general.

The term "business use percentage" means the percentage of the use of any listed property which is qualified business use as described in paragraph (d)(2) of this section.

(2) Qualified business use-(i) In general.

Except as provided in paragraph (d)(2)(ii) of this section, the term "qualified business use" means any use in a trade or business of the taxpayer. The term "qualified business use" does not include use for which a deduction is allowable under section 212. Whether the amount of qualified business use exceeds 50 percent is determinative of whether the investment tax credit and the accelerated percentages under section 168 are available for listed property (or must be recaptured). See §1.280F-3T.

• (ii) Exception for certain use by 5-percent owners and related persons) (A) In general. The term "qualified business use" shall not include-

(1) Leasing property to any 5-percent owner or related person,

(2) Use of property provided as compensation for the performance of services by a 5-percent owner or related person, or

(3) Use of property provided as compensation for the performance of services by any person not described in paragraph (d)(2)(ii)(A)(2) of this section unless an amount is properly reported by the taxpayer as income to such person and, where required, there was withholding under chapter 24.

Paragraph (d)(2)(ii)(A)(1) of this section shall apply only to the extent that the use of the listed property is by an individual who is a related party or a 5-percent owner with respect to the owner or lessee of the property.

• (B) Special rule for aircraft. Paragraph (d)(2)(ii)(A) of this section shall not apply with respect to any aircraft if at least 25 percent of the total use of the aircraft during the taxable year consists of qualified business use not described in paragraph (d)(2)(ii)(A).

• (C) Definitions. For purposes of this paragraph-

(1) 5-percent owner.

The term "5-percent owner" means any person who is a 5- percent owner with respect to the taxpayer (as defined in section 416 (i)(1)(B)(i)).

(2) Related person.

The term "related person" means any person related to the taxpayer (within the meaning of section 267(b)).

(3) Business/investment use-(i) In general.

The term "business/investment use" means the total business or investment use of listed property that may be taken into account for purposes of computing (without regard to section 280F(b)) the percentage of investment tax credit or cost recovery deduction for a passenger automobile or other listed property for the taxable year. Whether the investment tax credit and the accelerated percentages under section 168 (as opposed to use of the straight line method of cost recovery) are available with respect to listed property or must be recaptured is determined, however, by reference to qualified business use (as defined in paragraph (d)(2) of this section) rather than by reference to business/investment use. Whether a particular use of property is a business or investment use shall generally be determined under the rules of section 162 or 212.

• (ii) Entertainment use. The use of listed property for entertainment, recreation, or amusement purposes shall be treated as business use to the extent that expenses (other than interest and property tax expenses) attributable to that use are deductible after application of section 274.

• (iii) Employee use. See paragraph (a) of this section for requirements to be satisfied for employee use of listed property to be considered business/investment use of the property.

• (iv) Use of taxpayer's automobile by another person. Any use of the taxpayer's automobile by another person shall not be treated, for purposes of section 280F, as use in a trade or business under section 162 unless that use-

  • (A) Is directly connected with the business of the taxpayer,

  • (B) Is properly reported by the taxpayer as income to the other person and, where required, there was withholding under chapter 24, or

  • (C) Results in a payment of fair market rent. For purposes of this paragraph (d)(4)(iv)(C), payment to the owner of the automobile in connection with such use is treated as the payment of rent.

(4) Predominantly used in qualified business use-(i) Definition.

Property is predominantly used in a qualified business use for any taxable year if the business use percentage (as defined in paragraph (d)(1) of this section) is greater than 50 percent.

• (ii) Special rule for transfers at death. Property does not cease to be used predominantly in a qualified business use by reason of a transfer at death.

• (iii) Other dispositions of property. [Reserved]

(5) Examples.

The following examples illustrate the principles set forth in this paragraph. Example (1). E uses a home computer 50 percent of the time to manage her investments. The computer is listed property within the meaning of section 280F(d)(4). E also uses the computer 40 percent of the time in her part-time consumer research business. Because E's business use percentage for the computer does not exceed 50 percent, the computer is not predominantly used in a qualified business use for the taxable year. Her aggregate business/investment use for purposes of determining the percent of the total allowable straight line depreciation that she can claim is 90 percent. Example (2). Assume that E in example (1) uses the computer 30 percent of the time to manage her investments and 60 percent of the time in her consumer research business. E's business use percentage exceeds 50 percent. Her aggregrate business/investment use for purposes of determining her allowable investment tax credit and cost recovery deductions is 90 percent. Example (3). F is the proprietor of a plumbing contracting business. F's brother is employed with F's company. As part of his compensation, F's brother is allowed to use one of the company automobiles for personal use. The use of the company automobiles by F's brother is not a qualified business use because F and F's brother are related parties within the meaning of section 267(b). Example (4). F, in example (3), allows employees unrelated to him to use company automobiles as part of their compensation. F, however, does not include the value of these automobiles in the employees' gross income and F does not withhold with respect to the use of these automobiles. The use of the company automobiles by the employees in this case is not business/investment use. Example (5). X Corporation owns several automobiles which its employees use for business purposes. The employees are also allowed to take the automobiles home at night. However, the fair market value of the use of the automobile for any personal purpose, e.g., commuting to work, is reported by X as income to the employee and is withheld upon by X. The use of the automobile by the employee, even for personal purposes, is a qualified business use the respect to X.

(e) Method of allocating use of property-(1) In general.

For purposes of section 280F, the taxpayer shall allocate the use of any listed property that is used for more than one purpose during the taxable year to the various uses in the manner prescribed in paragraph (e) (2) and (3) of this section.

(2) Passenger automobiles and other means of transportation.

In the case of a passenger automobile or any other means of transportation, the taxpayer shall allocate the use of the property on the basis of mileage. Thus, the percentage of use in a trade or business for the year shall be determined by dividing the number of miles the vehicle is driven for purposes of that trade or business during the year by the total number of miles the vehicle is driven during the year for any purpose.

(3) Other listed property.

In the case of other listed property, the taxpayer shall allocate the use of that property on the basis of the most appropriate unit of time the property is actually used (rather than merely being available for use). For example, the percentage of use of a computer in a trade or business for a taxable year is determined by dividing the number of hours the computer is used for business purposes during the year by the total number of hours the computer is used for any purpose during the year. There is need for immediate guidance with respect to the subject matter of this Treasury decision. For this reason, it is found impracticable to issue this Treasury decision with notice and public hearing procedures under subsection (b) of section 553 of title 5 of the United States Code or subject to the effective date limitation of subsection (d) of that section. This Treasury decision is issued under the authority contained in sections 280F and 7805 of the Internal Revenue Code of 1954 (98 Stat. 494, 26 U.S.C. 280F; 68A Stat. 917, 26 U.S.C. 7805). Roscoe L. Egger, Jr., Ronald A. Pearlman, Acting Assistant Secretary of Treasury.

November 30, 1984

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary regulations relating to deductions, timing of deductions, and losses in certain transactions between related taxpayers. The temporary regulations provide guidance to taxpayers subject to the provisions of section 267 of the Internal Revenue Code. This action is necessary because of changes to the applicable tax law made by the Tax Reform Act of 1984. The text of a portion of the temporary regulations set forth in this document also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

DATES

Effective after December 31, 1983, these temporary regulations are generally applicable to amounts otherwise allowable as deductions for taxable years beginning after 1983 and to losses on transactions after 1983.

FOR FURTHER INFORMATION CONTACT

Keith E. Stanley (for rules under section 267(f)) and John G. Schmalz or Robert H. Ginsburgh (for other rules) of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, D.C. 20224 (Attention: CC:LR:T) (Telephone: 202-566-3458 for Keith E. Stanley or 202-566-3297 for John G. Schmalz and Robert H. Ginsburgh; not toll-free numbers).

SUPPLEMENTARY INFORMATION

Background

Section 174 of the Tax Reform Act of 1984 (Pub. L. No. 98-369; 98 Stat. 494) amends section 267 of the Internal Revenue Code of 1954 (relating to losses, expenses, and interest with respect to transactions between related taxpayers). This document adds temporary regulations to Part 1 of Title 26 of the Code of Federal Regulations to reflect the amendments to section 267. More specifically, temporary regulations are added in question and answer form under section 267 (a), (b), and (e) and section 706, dealing with deferral of certain deductions generally and application of that deferral and the disallowance of certain losses to partnerships. See §§1.267 (a)-2T and 1.706-2T, added by this document. The temporary regulations are added in standard format under section 267(f), dealing with losses between members of a controlled group of corporations. See §§1.267(f)-1T and 1.267(f)-2T added by this document. The temporary regulation added by this document will stay in effect until superseded by later temporary or final regulations relating to these matters. Cross Reference Notice The text of the temporary regulations at §§1.267(a)-2T, 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13T also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register. Limited Scope of Temporary Regulations These temporary regulations are not intended to address comprehensively all the issues raised by the amendments to section 267. Taxpayers may rely for guidance on the temporary regulations in this document, which the Internal Revenue Service will follow in resolving issues arising under section 267. No inference, however, should be drawn regarding questions not expressly raised and answered. Topics This preamble is divided into two topics. Topic I deals with the temporary regulations under section 267 (a), (b), and (e) and section 706. Topic II deals with the temporary regulations under section 267(f). Topic I Sections 267 (a), (b), and (e) and 706 Before the enactment of the Tax Reform Act of 1984, section 267(a)(2) of the Code denied a deduction for certain expenses and for interest owed by a taxpayer to a related taxpayer if payment was not made within 21/2 months after the close of the taxable year of the payor in which the amount otherwise would have been deductible and if, by reason of the accounting method of the person to whom the payment was to be made, the amount was not included in the income of that person unless paid. Also, section 267(a)(2) did not apply to transactions between a partner and a partnership because they were not related persons under section 267(b). The Act revised section 267(a)(2) by providing that a deduction for an otherwise deductible amount may not be taken by the payor until the day the amount is includible in the gross income of the person to whom payment of the amount is made if that person and the payor are persons described in section 267(b) on the last day of the taxable year of the payor in which such amount otherwise would have been deductible. In addition, the Act extends this deferral to transactions between a partner and a partnership (excluding certain expenses and interest of partnerships owning low- income housing). Explanation of section 267 (a), (b), and (e). The regulations under section 267(a) deal with issues that are of general application as well as issues that arise with respect to the application of section 267 to partnerships. The rules of general application concern transactions in which the person to whom the payment is owed uses the completed contract method of accounting and transactions in which the original issue discount rules under sections 1271 through 1275 or the imputed interest rules under section 483 apply. The rules of general application also deal with the situation in which the persons involved are related persons under section 267(b) at the end of the taxable year but cease to be so related in a subsequent year that ends before payment is made. The rules of general application also distinguish between amounts owed for the purchase of property versus amounts owed for the performance of services. See S. Rep. No. 98-169, 98th Cong., 2d Sess. 495 (1984). With respect to the regulations under section 267(a) that deal with the application of section 267 to partnerships, the regulations make clear that section 267(a) applies to the partnership, rather than to the partners individually. In addition, the regulations provide that the disallowance rule of section 267(a)(1) and the deferral rule of section 267(a)(2) apply (subject to a de minimis exception) to property exchanged and amounts owed between partnerships that are not related persons for purposes of section 267 if the partnerships have one or more common partners or if any of the partners in either partnership is related to one or more partners in the other partnership. In such cases, the regulations require disallowance under section 267(a)(1) and deferral under section 267(a)(2) to the extent that they would have been required had the transaction occurred between the payor partnership and the partners of the payee partnership or, if the amount disallowed or deferred would be greater, between the payee partnership and the partners of the payor partnership. This rule ensures that section 267 will not be avoided by use of a partnership as an intermediary in related party transactions, and is thus consistent with the general approach suggested in the legislative history, see S. Rep. No. 98-169, 98th Cong., 2d Sess. 496, n.17 (1984), as well as with the rule of the regulations under section 267 prior to amendment. Consideration was given to extending this rule to transactions between other pass-through entities (for example, S corporations) and between such an entity and a partnership, and comments are invited concerning the appropriateness of such an extension. Explanation of section 706. The regulations also address the interrelationship of section 706(d)(2) with section 267(a)(2). The regulations provide that a deduction for any expense that is deferred under section 267 constitutes an allocable cash basis item under section 706(d)(2)(B)(iv). Topic II Section 267(f) A new section 267(f) was enacted by the Tax Reform Act of 1984. Section 267(f)(2) relates to the deferral and restoration of loss on the sale or exchange of property between two members of a controlled group. These temporary regulations provide guidance under new section 267(f). Explanation of section 267(f). Under new section 267(f)(2), a loss of the sale or exchange of property from one member of a controlled group of corporations (a 50- percent-common-control test) to another member "shall be deferred until the property is transferred outside such controlled group and there would be recognition of loss under consolidated return principles or until such other time as may be prescribed in regulations." The primary rationale for deferring loss on transfers between members of the same group is to prevent the premature recognition of loss merely because the property is transferred to a related person. Although the temporary regulations provide that the principles of section 482 and the regulations thereunder are to be applied before section 267(f)(2) is applied, an ancillary rationale for deferring loss is to prevent artifically increasing the amount of a loss taken by a member on the sale or exchange of property at less than fair market value to another member in cases where section 482 is not easy to apply. Section 267(f)(2) provides for deferral of loss on such transfers until such time as the property is transferred outside the group (presumably at its fair market value), at which time that loss will be recognized in conjunction with the gain or loss recognized by the member transferring the property outside the group. At that time the sales price of property to an independent party can be used as a bench mark in applying section 482 to an intercompany sale of the same goods. 1. Rules for Groups Not Filing Consolidated Returns If loss is deferred on a sale of property from one member of a controlled group not included in a consolidated return to another member, these temporary regulations generally apply the principles for restoring losses that are set forth in §1.1502-13 for members that join in filing a consolidated return. a. Selling Member Ceases To Be a Member Section 1.1502-13(f)(1)(iii) provides for loss restoration when either the selling member or the owning member ceases to be a member. In certain cases such a restoration rule could provide a way of easily thwarting the intent of section 267(f)(2). Accordingly, the temporary regulations provide that if a member (M1) sells property to another member (M2), and thereafter, while M2 still holds the property, M1 ceases to be a member of the group, then M1's unrestored deferred loss for property at the time M1 ceases to be a member will never be restored to M1. Instead, M2's basis in the property will be increased by the amount of M1's unrestored deferred loss at the time M1 leaves the group. However, a special rule is provided to prevent the resourcing of deferred loss in the hands of the owning member through either increased depreciation deductions or reduced gain (or increased loss) upon resale of the property. See §1.267(f)-1T (c) (6) and (7). Thus, the loss is preserved in the group because no member of a group should under section 267(f) be able to recognize a loss while the group continues to hold property it purchased from itself. If, after the application of this rule, M2 keeps the property and is subsequently liquidated, the loss is forever lost. This is the normal consequence of the operation of sections 336 and 337. b. Depreciable Property For purposes of determining when a deferred loss on the sale of depreciable property is restored, §1.267(f)-1T(d) replaces the rule of §1.1502-13(d) of the consolidated returns regulations. The purpose of this rule is to prevent rapid restoration of the deferred loss in cases where the purchasing member depreciates the property more rapidly than did the selling member. Loss will not be periodically restored under §1.267(f)-1T(d) to the extent the selling member's (M1's) selling price is less than the salvage value that was assumed by M1. Mechanically this is accomplished by limiting the restoration amount to the lesser of the amount of M1's deferred loss for the property on the date of its sale or the total amount of depreciation that would have been allowable to M1 for the property after the date of its sale had it not been sold. Restoration of the portion of the loss that is not periodically restored can occur under other provisions of §1.267(f)-1T. Such a restoration will occur, for example, upon the purchasing member's subsequent sale of the property outside the group. c. Transfer of a Receivable The temporary regulations at §1.267(f)-1T (e) provide an exception to section 267(f)(2) for a member (M1) selling a receivable at "fair market value" at a loss to another member. The amount of that loss, not in excess of M1's gain on the sale to a nonmember of the property that generated the receivable, is excepted from the section 267(f)(2) loss deferral rules on the rationale that the group has recognized offsetting income. This treatment is in response to language in the Conference Committee Report for the Tax Reform Act of 1984, H.R. Rep. No. 98-861, 98th Cong., 2d Sess. 1033 (1984). Section 44(b)(2) of the Tax Reform Act of 1984 mandates a regulations project under section 482. The Service may study the issue of the appropriate "fair market value" of a receivable in connection with this regulations project. d. Inventory Sales As is the case with sales of other kinds of property, the temporary regulations generally provide for the deferral and restoration of loss on the sale of inventory from one member (M1) to another member (M2) in accordance with the rules for deferred intercompany transactions in §1.1502-13 of the consolidated returns regulations. It is uncertain whether §1.1502-13 of the consolidated returns regulations properly determines the amount of deferred gain or loss on intercompany inventory sales and the timing of the restoration of that gain or loss. The Service and the Treasury have the problem under study and invite comments on this problem. Under section 267(f)(3)(B), except to the extent provided in regulations, section 267(f)(2) does not apply to the sale of inventory in the ordinary course of the transferor's trade or business if either the transferor or the transferee is a foreign corporation. Under §1.267(f)-1T(g)(3), evidence of a sale of inventory outside the ordinary course of business includes a sale made for the purpose of accelerating losses and an abnormally large volume of sales near the end of the taxable year. Use of these items of evidence responds to language in the Conference Committee Report for the Tax Reform Act of 1984, H.R. Rep. No. 98-861, 98th Cong., 2d Sess. 1033 (1984). The temporary regulations at §1.267-1T(g)(2) specifically provide for two cases in which section 267(f)(2) is applicable to the sale of inventory at a loss from one member (M1) to another member (M2) even though M1 or M2 is a foreign corporation. In the first case, M1 is a domestic corporation and M2 is a foreign corporation whose income from the resale of the inventory is taxable under section 882 (relating to effectively connected income). In the second case, M1 is a foreign corporation whose income from the sale of the inventory is taxable under section 882, and M2 either is a domestic corporation or is a foreign corporation whose income from the resale of the inventory is also taxable under section 882. This rule prevents a group's use of a foreign corporation for purposes of selling inventory in the domestic market while avoiding the application of section 267(f)(2). Furthermore, this rule preserves the fairness of competition between groups that include such foreign corporations and similar groups including only domestic corporations. e. Earnings and Profits Adjustments The temporary regulations at §1.267 (f)-1T(c)(3) provide that if a member (M1), that does not join in filing a consolidated return with another member (M2), has deferred a loss on the sale of property to M2, M1's earnings and profits are not reduced until its deferred loss is restored. If this rule in the temporary regulations issued by this document is issued in final regulations, §§1.312-6 and 1.312-7 will be amended to reflect this earnings and profits treatment. 2. Rules Applicable if Consolidated Returns Are Filed The temporary regulations provide that section 267(f)(2) generally does not apply to a loss on the sale of property between two members of a controlled group that join in filing a consolidated return. The consolidated returns regulations under §1.1502- 13 provide for the deferral and restoration of such losses. a. Exceptions to General Consolidated Return Rule Notwithstanding the fact that the selling member (M1) of loss property and the purchasing member (M2) join in filing a consolidated return at the time of the sale, problems arise in certain cases with permitting a restoration of deferred loss under §1.1502-13. The temporary regulations ensure that a member not be permitted to escape the loss deferral provisions of section 267(f)(2) merely because it joins or has joined with another member in filing a consolidated return. Thus, for example, even though M1's deferred loss would ordinarily be restored under §1.1502-13(f)(1)(iii) upon M2 leaving the affiliated group but still remaining a member of the same controlled group, the temporary regulations provide the deferred loss is not restored in that case. Provisions of the temporary regulations that could prevent the restoration of deferred loss that otherwise would occur under §1.1502-13 include §1.267(f)-1T(c)(4) (which provides that two members of the same group are not, with respect to each other, considered to cease to be members of the group as long as they are both members of any one group), §1.267(f)-1T(c)(5) (which prevents restoration when a member that is both the selling member and the owning member ceases to be a member), §1.267(f)-1T(c) (6) and (7) (which prevents restoration when the selling member ceases to be a member), §1.267(f)-1T(c)(8) (which prevents restoration upon the purchasing member's disposition of the property to a person having a section 267(b) relationship with the selling member), and §1.267-2T(e) (which prevents restoration when property upon which loss has been deferred is disposed of outside the affiliated group to a member of the controlled group). When depreciable property that was subject to the restoration rule of the consolidated returns regulations becomes subject to the restoration rule of these temporary regulations, §1.267(f)-2T (g) and (h) provides special rules for determining the amount and the timing of the restoration that occurs. Similarly, the temporary regulations provide a special rule for determining the amount of deferred loss for a receivable that is restored at the time the deferred loss would otherwise have been fully restored under the consolidated returns regulations. See §1.267(f)- 2T(j). b. Section 267(f)(2) Overrides Election Not To Defer The selling member must defer under section 267(f)(2) loss realized on the sale or exchange of property to the purchasing member, notwithstanding the fact that the group with which these members join in filing a consolidated return has made an election under §1.1502-13(c)(3) not to defer gain or loss on intercompany transactions. See §1.267(f)-2T(c). To eliminate hardship that otherwise could possibly occur as a result of this exception, it is anticipated that a group will have the Commissioner's consent to revoke that election beginning during its taxable year ending in 1984. However, any revocation must be in such form and subject to such terms and conditions as the Commissioner may prescribe by revenue procedure or ruling. c. Consolidated Return Regulations Cross-Reference In some cases, the rules of section 267(f) and the regulations implementing section 267(f) apply to affiliated groups filing consolidated returns. Accordingly, a temporary regulations section is added to the consolidated returns regulations at §1.1502-13T to cross-reference to §1.267(f)-2T. If the temporary regulation §1.267(f)-2T becomes final, then §1.1502-13T(k) will also become final. Executive Order 12291, Regulatory Flexibility Act, and Paperwork Reduction Act The Commissioner of Internal Revenue has determined that this final rule is not a major rule as defined in Executive Order 12291 and that a Regulatory Impact Analysis is therefore not required. A general notice of proposed rulemaking is not required by 5 U.S.C. 553 for temporary regulations. Accordingly, the temporary regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6). The collection of information contained in this regulation has been submitted to the Office of Management and Budget (OMB) in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB under control number 1545-0885.

Drafting Information

The principal authors of these temporary regulations are Keith E. Stanley (for rules under section 267(f)) and John G. Schmalz and Robert H. Ginsburgh (for other rules) of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, both on matters of substance and style.

List of Subjects

26 CFR 1.61-1-1.281-4 Income taxes, Taxable income, Deductions, Exemptions. 26 CFR 1.701-1-1.771-1 Income taxes, Partnerships. 26 CFR 1.1501-1-1.1564-1 Income taxes, Controlled group of corporations, Consolidated returns.

Adoption of Amendments to the Regulations

Accordingly, the following amendments are made to Part 1 of Title 26.

Paragraph 1. Immediately after §1.267(a)-1, there is added a new §1.267(a)-2T.

§1.267(a)-2T Temporary regulations; questions and answers arising under

§1.267(b)-1(b) does not apply. If the two partnerships have one or more common

Par. 2. Immediately after §1.267(d)-1, there are added new §§1.267(f)-1T and

§1.267(f)-1T Temporary regulations for deferring certain losses of

§1.267(f)-2T Temporary regulations for deferring certain losses of members

§1.1502-13(f)(1), were it applicable.

§1.267(f)-1T(d) for that M1 taxable year (or, if M2 has the first separate return year,

§1.267-1T(d) for that year had M1 and M2 never joined in filing a consolidated

Par. 3. Immediately after §1.706-1, there is added a new §1.706-2T. The new

§1.706-2T Temporary regulations; question and answer under the Tax

Par. 4. Immediately after §1.1502-13, there is added a new §1.1502-13T. The new

§1.1502-13T Temporary regulations for certain intercompany transactions.

Commissioner of Internal Revenue.

Approved: November 14, 1984. The new section reads as follows: the Tax Reform Act of 1984.

(a) Introduction-(1) Scope.

This section prescribes temporary question and answer regulations under section 267(a) and related provisions as amended by section 174 of the Tax Reform Act of 1984, Pub. L. No. 98-369.

(2) Effective date.

Except as otherwise provided by Answer 2 or Answer 3 in paragraph (c) of this section, the effective date set forth in section 174(c) of the Tax Reform Act of 1984 applies to this section.

(b) Questions applying section 267(a)(2) and (b) generally.

The following questions and answers deal with the application of section 267(a)(2) and (b) generally: Question 1: Does section 267(a)(2) ever apply to defer the deduction of an otherwise deductible amount if the person to whom the payment is to be made properly uses the completed contract method of accounting with respect to such amount? Answer 1: No. Section 267(a)(2) applies only if an otherwise deductible amount is owed to a related person under whose method of accounting such amount is not ncludible in income unless paid to such person. Regardless of when payment is made, an amount owed to a contractor using the completed contract method of accounting is includible in the income of the contractor in accordance with §1.451- 3(d) in the year in which the contract is completed or in which certain disputes are resolved. Question 2: Does section 267(a)(2) ever apply to defer the deduction of otherwise deductible original issue discount as defined in sections 163(e) and 1271 through 1275 ("the OID rules")? Answer 2. No. Regardless of when payment is made, an amount owed to a lender that constitutes original issue discount is included in the income of the lender periodically in accordance with the OID rules. Similarly, section 267(a)(2) does not apply to defer an otherwise deductible amount to the extent section 467 or section 7872 requires periodic inclusion of such amount in the income of the person to whom payment is to be made, even though payment has not been made. Question 3: Does section 267(a)(2) ever apply to defer the deduction of otherwise deductible unstated interest determined to exist under section 483? Answer 3: Yes. If section 483 recharacterizes any amount as unstated interest and the other requirements of section 267(a)(2) are met, a deduction for such unstated interest will be deferred under section 267. Question 4: Does section 267(a)(2) ever apply to defer the deduction of otherwise deductible cost recovery, depreciation, or amortization? Answer 4: Yes, in certain cases. In general, section 267(a)(2) does not apply to defer the deduction of otherwise deductible cost recovery, depreciation, or amortization. Notwithstanding this general rule, if the other requirements of section 267(a)(2) are met, section 267(a)(2) does apply to defer deductions for cost recovery, depreciation, or amortization of an amount owed to a related person for interest or rent or for the performance or nonperformance of services, which amount the taxpayer payor capitalized or treated as a deferred expense (unless the taxpayer payor elected to capitalize or defer the amount and section 267(a)(2) would not have deferred the deduction of such amount if the taxpayer payor had not so elected). Amounts owed for services that may be subject to this provision include, for example, amounts owed for acquisition, development, or organizational services or for covenants not to compete. In applying this rule, payments made between persons described in any of the paragraphs of section 267(b) (as modified by section 267(3)) will be closely scrutinized to determine whether they are made in respect of capitalized costs (or costs treated as deferred expenses) that are subject to deferral under section 267(a)(2), or in respect of other capitalized costs not so subject. Question 5: If a deduction in respect of an otherwise deductible amount is deferred by section 267(a)(2) and, prior to the time the amount is includible in the gross income of the person to whom payment is to be made, such person and the payor taxpayer cease to be persons specified in any of the paragraphs of section 267(b) (as modified by section 267(e)), is the deduction allowable as of the day on which the relationship ceases? Answer 5: No. The deduction is not allowable until the day as of which the amount is includible in the gross income of the person to whom payment of the amount is made, even though the relationship ceases to exist at an earlier time. Question 6: Do references in other sections to persons described in section 267(b) incorporate changes made to section 267(b) by section 174 of the Tax Reform Act of 1984? Answer 6: Yes. References in other sections to persons described in section 267(b) take into account changes made to section 267(b) by section 174 of the Tax Reform Act of 1984 (without modification by section 267(e)(1)). For example, a transfer after December 31, 1983 (the effective date of the new section 267(b)(3) relationship added by the Tax Reform Act of 1984) of section 1245 class property placed in service before January 1, 1981, from one corporation to another corporation, 11 percent of the stock of which is owned by the first corporation, will not constitute recovery property (as defined in section 168) in the hands of the second corporation by reason of section 168(e)(4) (A)(i) and (D).

(c) Questions applying section 267(a) to partnerships.

The following questions and answers deal with the application of section 267(a) to partnerships: Question 1: Does section 267(a) disallow losses and defer otherwise deductible amounts at the partnership (entity) level? Answer 1: Yes. If a loss realized by a partnership from a sale or exchange of property is disallowed under section 267(a)(1), that loss shall not enter into the computation of the partnership's taxable income. If an amount that otherwise would be deductible by a partnership is deferred by section 267(a)(2), that amount shall not enter into the computation of the partnership's taxable income until the taxable year of the partnership in which falls the day on which the amount is includible in the gross income of the person to whom payment of the amount is made. Question 2: Does section 267(a)(1) ever apply to disallow a loss if the sale or exchange giving rise to the loss is between two partnerships even though the two partnerships are not persons specified in any of the paragraphs of section 267(b)? Answer 2: Yes. If the other requirements of section 267(a)(1) are met, section 267(a)(1) applies to such losses arising as a result of transactions entered into after December 31, 1984 between partnerships not described in any of the paragraphs of section 267(b) as follows, and §1.267(b)-1(b) does not apply. If the two partnerships have one or more common partners (i.e., if any person owns directly, indirectly, or constructively any capital or profits interest in each of such partnerships), or if any partner in either partnership and one or more partners in the other partnership are persons specified in any of the paragraphs of section 267(b) (without modification by section 267(e)), a portion of the selling partnership's loss will be disallowed under section 267(a)(1). The amount disallowed under this rule is the greater of: (1) The amount that would be disallowed if the transaction giving rise to the loss had occurred between the selling partnership and the separate partners of the purchasing partnership (in proportion to their respective interests in the purchasing partnership); or (2) the amount that would be disallowed if such transaction had occurred between the separate partners of the selling partnership (in proportion to their respective interests in the selling partnership) and the purchasing partnership. Notwithstanding the general rule of this paragraph (c) Answer 2, no disallowance shall occur if the amount that would be disallowed pursuant to the immediately preceding sentence is less than 5 percent of the loss arising from the sale or exchange. Question 3: Does section 267(a)(2) ever apply to defer an otherwise deductible amount if the taxpayer payor is a partnership and the person to whom payment of such amount is to be made is a partnership even though the two partnerships are not persons specified in any of the paragraphs of section 267(b) (as modified by section 267(e))? Answer 3: Yes. If the other requirements of section 267(a)(2) are met, section 267(a)(2) applies to such amounts arising as a result of transactions entered into after December 31, 1984 between partnerships not described in any of the paragraphs of section 267(b) (as modified by section 267(e)) as follows, and partners (i.e., if any person owns directly, indirectly, or constructively any capital or profits interest in each of such partnerships), or if any partner in either partnership and one or more partners in the other partnership are persons specified in any of the paragraphs of section 267(b) (without modification by section 267(e)), a portion of the payor partnership's otherwise allowable deduction will be deferred under section 267(a)(2). The amount deferred under this rule is the greater of: (1) The amount that would be deferred if the transaction giving rise to the otherwise allowable deduction had occurred between the payor partnership and the separate partners of the payee partnership (in proportion to their respective interests in the payee partnership); or (2) the amount that would be deferred if such transaction had occurred between the separate partners of the payor partnership (in proportion to their respective interests in the payor partnership) and the payee partnership. Notwithstanding the general rule of this paragraph (c) Answer 3, no deferral shall occur if the amount that would be deferred pursuant to the immediately preceding sentence is less than 5 percent of the otherwise allowable deduction. Example. On May 1, 1985, partnership AB enters into a transaction whereby it accrues an otherwise deductible amount to partnership AC. AC is on the cash receipts and disbursements method of accounting. A holds a 5 percent capital and profits interest in AB and a 49 percent capital and profits interest in AC, and A's interest in each item of the income, gain, loss, deduction, and credit of each partnership is 5 percent and 49 percent, respectively. B and C are not related. Notwithstanding that AB and AC are not persons specified in section 267(b), 49 percent of the deduction in respect of such amount will be deferred under section 267(a)(2). The result would be the same if A held a 49 percent interest in AB and a 5 percent interest in AC. However, if A held more than 50 percent of the capital or profits interest of either AB or AC, the entire deduction in respect of such amount would be deferred under section 267(a)(2). Question 4: What does the phrase "incurred at an annual rate not in excess of 12 percent" mean as used in section 267(e)(5)(C)(ii)? Answer 4: The phrase refers to interest that accrues but is not includible in the income of the person to whom payment is to be made during the taxable year of the payor. Thus, in determining whether the requirements of section 267(e)(5) (providing an exception to certain provisions of section 267 for certain expenses and interest of partnerships owning low income housing) are met with respect to a transaction, the requirement of section 267(e)(5)(C)(ii) will be satisfied, even though the total interest (both stated and unstated) paid or accrued in any taxable year of the payor taxpayer exceeds 12 percent, if the interest in excess of 12 percent per annum, compounded semi-annually, on the outstanding loan balance (principal and accrued but unpaid interest) is includible in the income of the person to whom payment is to be made no later than the last day of such taxable year of the payor taxpayer. 1.267(f)-2T. These new sections read as follows: controlled groups.

(a) Scope-(1) In general.

This section and §1.267(f)-2T prescribe temporary regulations under section 267(f) as added by section 174(b)(2) of the Tax Reform Act of 1984, Pub. L. No. 98-369.

(2) Effective date.

Section 267(f) is effective for the sale of property after 1983 except that section 267(f) does not apply to a sale of property to a foreign corporation on or before March 1, 1984.

(3) Effect of consolidated return.

This section applies to loss on the sale of property between two members of a controlled group that do not join in filing a consolidated return for the taxable year the loss is incurred. Section 1.267(f)-2T applies to such a loss if the members join in filing a consolidated return for that year.

(4) Coordination with section 482.

The principles of section 482 and the regulations thereunder apply before section 267(f) and the regulations thereunder apply.

(b) Definitions.

For purposes of this section and §1.267(f)-2T:

(1) Group.

The term "group" means "controlled group." The term "controlled group" is defined in section 267(f)(1). Thus, excluded members referred to in section 1563(b), such as foreign corporations and exempt corporations, are not excluded from a group.

(2) Member.

The term "member" means a corporation included in a controlled group.

(3) M1 and M2.

The terms "M1" and "M2" refer, respectively, to the selling member and the purchasing member of property sold from one to the other. Unless otherwise specified, M1 and M2 are members of the same group at all relevant times.

(4) Sale.

The term "sale" includes "exchange."

(5) Depreciation and depreciable property.

The term "depreciation" means the deduction under section 167 or 168 or the deduction for amortization or depletion. The term "depreciable property" means any property subject to depreciation as so defined.

(6) Inventory.

"Inventory" is property described in section 1221 (1).

(7) Separate return year.

The term "separate return year" is defined in §1.1502-1 (e).

(c) Deferral and restoration of loss under consolidated returns principles-(1) General rule.

Except as otherwise provided in this section, the rules for deferred intercompany transactions in §1.1502-13 of the consolidated return regulations apply under section 267(f)(2) to the deferral and restoration of loss on the sale of property directly or indirectly between M1 and M2 as if-

• (i) the taxable year in which the sale occurred were a consolidated return year (as defined in §1.1502-1(d)) and

• (ii) all references to a "group" or an "affiliated group" were to a controlled group.

(2) Elections not to deter loss not applicable.

Section 1.1502-13(c)(13) (relating to an election not to defer gain or loss) does not apply for purposes of this section.

(3) Earnings and profits.

If, under this section, a loss is deferred by M1 on the sale of property to M2, then such loss shall not be reflected in earnings and profits until that amount is restored. See §1.312-6(a).

(4) General rule for continuation of membership.

Two corporations that are members of the same group are not, with respect to each other, considered to cease to be members of the group as long as they are both members of any one group. Thus, for example, if P owns all the stock of M1 and M1 owns all the stock of M2, and if loss on the sale of property from M1 to M2 has been deferred under this section, P's transfer of all the stock to M1 to a nonmember will not result in a restoration of the deferred loss under section 267(f)(2) and §1.1502-13(f)(1)(iii) because M1 and M2 remain members of one group. The result is the same whether the stock transfer is taxable or nontaxable and whether the transferee is an individual or a corporation.

(5) Exception to restoration rule for selling member that is also owning member.

Section 1.1502-13(f)(2)(ii)(b) generally provides an exception to the restoration rule of §1.1502-13(f)(1)(iii) (relating to a member ceasing to be a member) when the common parent of an affiliated group is both the selling and the owning member. For purposes of this section, the principles of §1.1502-13(f)(2)(ii)(b) are extended to any member of a controlled group that is, at the time it ceases to be a member of the group, both the selling member and the owning member of property for which loss has been deferred. Thus, for example, if M1 defers a loss on its sale of property to M2 and M2 subsequently sells the property back to M1, then even M1 ceases to be a a member of the group, M1's loss will continue to be deferred. If M2 had deferred a loss as a result of its resale of the property to M1, that loss will be restored under section 267(f)(2) and §1.1502-13(f)(1)(iii) when M1 ceases to be a member. If the property is depreciable property, see paragraph (d) of this section.

(6) Exception to restoration rule for selling member that ceases to be a member.

If a selling member of property for which loss has been deferred ceases to be a member when the property is still owned by another member, then, for purposes of this section, §1.1502-13(f)(1)(iii) shall not apply to restore that deferred loss and that loss shall never be restored to the selling member.

(7) Basis adjustment and holding period.

If paragraph (c)(6) of this section precludes a restoration for property, then the following rules apply:

• (i) On the date the selling member ceases to be a member, the owning member's basis in the property shall be increased by the amount of the selling member's unrestored deferred loss at the time it ceased to be a member ("increase amount").

• (ii) If the property is depreciable property, then the amount of the owning member's depreciation for a taxable year attributable to the increase amount shall be equal to the amount of deferred loss for the property which the selling member would have restored under paragraph (d) of this section for its taxable year ending with or within the owning member's taxable year had the selling member not ceased to be a member.

• (iii) The owning member's holding period for the property shall be increased by the selling member's holding period.

• (iv) Annual depreciation attributable to the increase amount shall be deemed to have the same source (as within or without the United States) as the selling member had for its deferred loss. If gain or loss upon sale of the property by the owning member would have a different source than the selling member had for its deferred loss, then the owning member shall recognize a loss equal to the increase amount (as reduced by any depreciation attributable thereto) having the same source that the selling member had for its deferred loss, and the owning member shall adjust its gain or loss attributable to the other source by that amount.

(8) No restoration on sale to a section 267(b) related person.

If property for which loss was deferred by M1 is sold by M2 to any person having a relationship to M1 specified in any paragraph of section 267(b) (other than a member of the same group), the remaining balance of the deferred loss, to the extent it is in excess of the amount of the gain (if any) recognized on the sale, shall never be restored and shall be treated as a loss referred to in section 267(d)(1).

(9) Deconsolidation provisions not applicable.

The restoration rules under §1.1502- 13(f)(1)(iv) (relating to deferred loss on inventory) and §1.1502-13(f)(1)(vii) (relating generally to filing consolidated returns for fewer than 3 years) are not applicable for purposes of this section.

(10) Deleted examples.

For purposes of this section, the examples of §1.1502-13(h) are not applicable.

(d) Restoring deferred loss on depreciable property-(1) General rule.

Solely for purposes of this section, this paragraph (d) replaces §1.1502-13(d) (relating to the restoration of gain or loss deferred on the sale of depreciable property from M1 to M2). Under this paragraph (d), for each of its taxable years ending after depreciable property was sold to M2, M1 shall restore a portion of the loss it deferred on that sale. The portion so restored is equal to the "restoration amount" multiplied by a fraction. The numerator of the fraction is the amount of the depreciation that would have been allowable to M1 that year (or for the portion of the year after the sale) had M1 not sold the property. The denominator equals the total amount of depreciation for all taxable years that would have been allowable to M1 after the date of the property's sale had the property not been sold. The "restoration amount" equals the lesser of-

• (i) the amount of M1's deferred loss on the date of the sale or

• (ii) the amount of the denominator.

(2) Reduction for deferred loss.

The amount of M1's deferred loss for an item of depreciable property shall be reduced each taxable year by the amount restored relating to that item under paragraph (d)(1) of this section.

(3) Examples.

This paragraph (d) is illustrated by the following examples: Example (1). M1 and M2 use the calendar year. On January 1, 1980, M1 purchases depreciable property from a third party for $1,200 and begins depreciating it on the straight-line method (with $200 salvage value) over 10 years. On January 1, 1985, when its adjusted basis in the property is $700, M1 sells the property to M2 for $500 and realizes a deferred loss of $200. M2 owns the property until 1990. The portion of M1's $200 deferred loss that is restored in 1985 equals the amount of that loss ($200) multiplied by a fraction. Its numerator equals the depreciation that would have been allowable to M1 in 1985 had it not sold the property ($100). Its denominator equals the total amount of depreciation for all taxable years that would have been allowable to M1 after the date of the property's sale had the property not been sold ($500). Thus, the amount restored in 1985 equals $40 (i.e., $200 x $100/$500). M1 will also restore $40 in 1986, 1987, 1988, and 1989. Thus, if M2 owns the property through the end of 1989, M1 will restore the entire deferred loss of $200, i.e., $40 x 5. (Note that in this example the restoration amount equals the amount of M1's deferred loss ($200) since this amount is less than the amount of the denominator ($500).) Example (2). Assume the same facts as in example (1) except that on January 1, 1987, when M1's unrestored deferred loss equals $120, M2 sells the property outside the group. Under section 267(f)(2) and §1.1502-13(f)(1)(i), M1 will restore the $120 deferred loss on its 1987 return. Example (3). Assume the same facts as in example (1) except that M1's sale of the property to M2 is for $150 rather than for $500. Thus, M1's deferred loss realized on the sale is $550. The numerator and the denominator of the fraction remain at $100 and $500 respectively. The restoration amount is $500 (i.e., the lesser of the amount of the deferred loss ($550) or the amount of the denominator ($500)). The amount of M1's deferred loss restored in 1985 equals $100 (i.e., $500 x $100/$500). M1 will also restore $100 in 1986, 1987, 1988, and 1989. Example (4). (i) Assume the same facts as in example (3) except that on January 1, 1987, when M1's unrestored deferred loss equals $350, M2 sells the property outside the group. Under section 267(f)(2) and §1.1502-13(f)(1)(i), M1 will restore the $350 deferred loss on its 1987 return.

• (ii) If M2 instead abandons the property after 1989, when M1's unrestored deferred loss would equal $50, M1 would restore that $50 deferred loss under section 267(f)(2) and §1.1502-13(f)(1)(i) on its return for the taxable year during which M2 abandoned the property.

(e) Receivables-(1) Transfer of receivable.

If M1 owns a receivable which it had acquired as a result of its sale at a gain of goods or services to any person other than a member, and if M1 transfers that receivable in a sale at fair market value at a loss to M2, then notwithstanding any other provisions in this section, so much of the loss as does not exceed the gain from the sale of the underlying goods or services shall not be deferred.

(2) Example.

This paragraph (e) is illustrated by the following example: Example. A member (M1), a calendar year taxpayer, uses the accrual method. In 1985, M1 sells to a nonmember property having a basis of $60 for a receivable of $100. M1 reports the gain of $40 on its tax return for 1985. In 1986, M1 sells the receivable for its fair market value of $90 to another member for a $10 loss. M1 reports the $10 loss on the sale of the receivable on its 1986 tax return. If the sale is not at fair market value, this paragraph (e) does not apply and the $10 loss is deferred. See also paragraph (a)(4) of this section (relating to coordination with section 482).

(f) Loss deferral rules not to apply to DISC.

Under section 267(f)(3)(A), a group does not include a DISC. However, a group does include a FSC. "DISC" and "FSC" are defined in sections 992 and 922, respectively.

(g) Sales of inventory involving foreign corporations-(1) General rule.

Under section 267(f)(3)(B), except to the extent provided in regulations, section 267 (a)(1) and (f)(2) does not apply to the sale by M1 to M2 of property which is inventory in the hands of both M1 and M2 if the sale is in the ordinary course of M1's trade or business and if either M1 or M2 is a foreign corporation.

(2) Exception.

Section 267(f)(2) is applicable to the sale of inventory at a loss from M1 to M2 in the following cases:

• (i) M1 is a domestic corporation, M2 is a foreign corporation, and M2's income from the resale of the inventory is taxable under section 882 (relating to effectively connected income).

• (ii) M1 is a foreign corporation, M1's income from the sale of the inventory is taxable under section 882, and M2 either is a domestic corporation or is a foreign corporation whose income from the resale of the inventory is taxable under section 882.

(3) Sales outside ordinary course.

For purposes of paragraph (g)(1) of this section, whether a sale is outside the ordinary course of business is to be determined under the facts and circumstances. Evidence of a sale of inventory by M1 to M2 outside the ordinary course of business includes-

• (i) A sale made for the purpose of accelerating losses,

• (ii) An abnormally large volume of sales near the end of the taxable year, and

• (iii) A sale by M1 at a loss of inventory to M2 if, had that inventory not been sold, a write-down to a value equal to the price for which it was sold would not have been proper (for example under §1.471-2(c) and §1.471-4(b), as affirmed by Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979)).

(h) Certain foreign currency losses.

Under section 267(f)(3)(C), section 267 (a)(1) and (f)(2) does not apply to a loss on the repayment of a loan if all of the following conditions are met:

(1) The loss is sustained by a member on the repayment to it of a loan made to another member,

(2) The loan is payable or denominated solely in a foreign currency, and

(3) The loss is attributable to a reduction in value of the foreign currency in which the loan is payable or denominated.

(Approved by the Office of Management and Budget under control number 1545- 0885.) that join in filing consolidated returns.

(a) Scope.

This section applies to loss on the sale of property between two members of a controlled group that join in filing a consolidated return for the year the loss is incurred. For effective dates, see §1.267(f)-1T(a). For definitions, see §1.267(f)- 1T(b).

(b) General rule.

If a loss is incurred on a sale by M1 to M2 in a taxable year during which they join in filing a consolidated return, §1.1502-13 applies, except as provided in this section.

(c) Election not to defer loss not applicable.

For purposes of section 267(f), an election under §1.1502-13(c)(3) has no effect. Thus, even though M1 and M2 join in filing a consolidated return with a group for which an election under §1.1502- 13(c)(3) is in effect, M1's loss on a sale of property to M2 will be deferred as if that election had not been made.

(d) Unrestored deferred loss adjustments if separate return year-(1) Occurrence of a separate return year.

If M1 joins in filing a consolidated return with M2 for a taxable year during which M1 sells property (after the effective date of section 267(f)) to M2 at a loss, and if either M1 or M2 (or both) later has a separate return year, then the event that results in that separate return year does not alone result in restoration of M1's deferred loss under §1.1502-13(f) except to the extent either of the following provisions is applicable:

• (i) That event alone would have resulted in restoration under §1.267(f)-1T had M1 and M2 not joined in filing a consolidated return. See, for example, §1.267(f)-1T(c) (4), (5), (6), and (7).

• (ii) That event would have resulted in a one-time restoration under either paragraph (g) (2), (5), or (6) of this section (for depreciable property) or paragraph (j)(2) of this section (for receivables).

(2) Subsequent restorations-(i) Any amount that was not restored after applying paragraph (d)(1) of this section shall be restored under §1.

267(f)-1T (applied without paragraph (a)(3) thereof) and, if applicable, under paragraph (g) (3), (5), or

(6) of this section.

• (ii) If paragraph (g)(3) of this section applies and if M1 subsequently ceases to be a member, §1.267 (f)-1T(c)(7) applies by deeming the increase amount to be equal to M1's unrestored deferred loss on the date M1 ceases to be a member.

(e) Unrestored deferred loss adjustments if property disposed of outside consolidated group but not outside controlled group-(1) Occurrence of disposition.

If M1 and M2 join in filing a consolidated return for a taxable year during which M1 sells property (after the effective date of section 267(f)) to M2 at a loss, then M2's later disposition of that property to a member (M3) that does not join in filing a consolidated return with M1 and M2 will not result in restoration of M1's deferred loss under §1.1502-13 unless paragraph (h) of this section (relating to depreciable property) or paragraph (j)(2) of this section (relating to certain receivables) applies. Thus, for example, that loss will not be restored on the disposition to M3, notwithstanding §1.1502-13(e)(2) and (f)(1)(i) and (ii).

(2) Subsequent restorations-(i) Restoration of M1's deferred loss for the property subsequent to M2 disposing of the property to M3 shall be made under §1.

267(f)-1T (applied without paragraph (a)(3) thereof) and, if applicable, under paragraph (h) of this section.

• (ii) If paragraph (h) of this section applies and if M1 subsequently ceases to be a member, §1.267(f)-1T(c)(7) applies by deeming the increase amount to be equal to M1's unrestored deferred loss on the date M1 ceases to be a member.

(f) No restoration on sale to a section 267(b) related person.

Section 1.267(f)- 1T(c)(8) applies whether or not M1 and M2 join or have ever joined in filing a consolidated return.

(g) Restoring deferred loss on depreciable property after deconsolidation-(1) Conditions of application.

Except as otherwise provided, this paragraph (g) applies only if all the following conditions are met:

• (i) M1 defers a loss on the sale of depreciable property to M2 that occurs after the effective date of section 267(f) during a taxable year in which M1 and M2 join in filing a consolidated return.

• (ii) Either M1 or M2 (or both) has a later separate return year that would result in restoring M1's deferred loss if this section were not applicable.

• (iii) For that separate return year, both M1 and M2 remain members of the same controlled group under §1.267(f)-1T(c)(4).

(2) One-time restoration.

If this paragraph (g) applies and the amount of the loss restored by M1 under §1.1502-13(d) prior to the date either M1 or M2 began its first separate return year is less than the amount of the loss that would have been restored to M1 had M1 and M2 never joined in filing a consolidated return, then M1 shall restore an amount equal to the difference between those two amounts. This amount shall be restored by M1 when restoration would have occurred under

(3) Annual adjustments.

If this paragraph (g) applies, then for each M1 taxable year during which M1 and M2 remain members of the same controlled group and which ends after the beginning of the first M1 or first M2 separate return year (whichever occurs first), M1 shall restore an amount equal to the amount of M1's "adjusted deferred loss" (as defined in paragraph (g)(4) of this section) multiplied by a fraction. The numerator of the fraction is the amount M1 would have restored under for the portion of the M1 taxable year after the first M2 separate return year) had M1 and M2 never joined in filing consolidated returns. The denominator is the total amount M1 would have restored beginning with the first such separate return year had M1 and M2 never joined in filing consolidated returns.

(4) Adjusted deferred loss.

The "adjusted deferred loss" is an amount equal to-

• (i) the amount of M1's deferred loss immediately prior to the one-time restoration of this paragraph (g), reduced by

• (ii) the amount (if any) of that one-time restoration.

(5) M1 leaves group while owning property.

If M1 is the owning member of the property for which M1 has deferred loss, and if the conditions of paragraph (g)(1) of this section are met except that the separate return year occurs as a result of M1 leaving the group, then the principles of paragraph (g) (2) and (3) of this section are applied as if M1 and M2 remain members of the same controlled group.

(6) M1 leaves group while property still in group.

If the conditions of paragraph (g)(1) of this section are met except that M1 leaves the group when the property is still owned by a member, then-

• (i) A one-time restoration is made under the principles of paragraph (g)(2) of this section (if applicable),

• (ii) The adjusted deferred loss is determined under paragraph (g)(4) of this section, and

• (iii) Section 1.267(f)-1T(c)(7) applies by deeming the increased amount to be equal to the adjusted deferred loss.

(7) Example.

This paragraph (g) is illustrated by the following examples: Example (1). (i) M1 and M2 join in filing a consolidated return for the calendar year. On January 1, 1980, M1 purchases depreciable property from a third party for $1,400 and begins depreciating it on the straight line method (with $200 salvage value) over 12 years. On January 1, 1985, when its adjusted basis in the property is $900, M1 sells the property to M2 for $800 for a loss of $100. Under §1.1502- 13(c)(1) the $100 loss is deferred. M2 depreciates the property on the straight line method (with zero salvage value) over 4 years. On January 1, 1987, all of the stock of M2 is transferred to M1's sole individual shareholder. Thus, M2 has a separate return year beginning January 1, 1987, and M2 remains a member of the same controlled group in which M1 is a member.

• (ii) While M1 and M2 continue to join in filing a consolidated return, M1's $100 deferred loss is restored under §1.1502-13(d)(1) as shown in the following table: 1985 1986 1. Consolidated return fraction under sec. 1.1502-13 (d) (1) (ii) (b): a. Numerator (M2's depreciation) $200 $200 b. Denominator (M2's depreciable basis) 800 800 c. Fraction ............................................... 200/800 200/800 2. M1's deferred loss at time of deferred intercompany transaction 100 100 3. Amount of M1's loss restored 25 25 Thus, as of January 1, 1987, M1 has restored $50 (i.e., $25+$25) of its loss and $50 (i.e., $100-$50) of its loss remains deferred.

• (iii) If §1.267(f)-1T(d) were applicable when M1 sold the property to M2, M1 would have restored $14.29 of its $100 deferred loss for each of its taxable years 1985- 1991. That is, for each of those years, M1's restoration amount ($100) would have been multiplied by a fraction having a numerator of $100 (the amount of depreciation that would have been allowable to M1 that year had M1 not sold the property) and a denominator of $700 (the total depreciation that would have been allowable to M1 for all taxable years after 1984 had M1 not sold the property). Thus, M1 could have restored $28.58 (i.e., $14.29 × 2 years) as of the end of 1986. Since the amount ($50) M1 restored in 1985 and 1986 under §1.1502-13(d) is not less than the amount ($28.58) M1 would have restored under $1.267(f)-1T(d), there is no "one-time restoration" under paragraph (g)(2) of this section.

• (iv) In 1987, M1 will restore $10 of the $50 unrestored deferred loss. This 1987 restoration is determined by multiplying M1's adjusted deferred loss ($50) by a fraction. The numerator is $14.29 (the amount M1 would have restored under return). The denominator is $71.45 (the total amount M1 would have restored for its taxable years 1987-1991 had M1 and M2 never joined in filing a consolidated return, i.e., $14.29×5 years). Similarly, M1 will restore $10 in 1988, 1989, 1990, and 1991. Example (2). (i) The facts are the same as in example (1) except that M2 depreciates the property on the straight line method (with zero salvage value) over 8 Years.

• (ii) While M1 and M2 continue to join in filing a consolidated return, M1's $100 deferred loss is restored under §1.1502-13(d)(1) as shown in the following table: 1985 1986 1. Consolidated return fraction under sec. 1.1502-13(d)(1)(ii)(b): a. Numerator (M2's depreciation) ............................. $100 $100 b. Denominator (M2's depreciable basis) ....................... 800 800 c. Fraction ............................................... 100/800 100/800 2. M1's deferred loss at time of deferred intercompany transaction.......................................... 100 100 3. Amount of M1's loss restored ............................. 12.50 12.50 -------------------- ----------------------------------------------------------- Thus, as of Janaury 1, 1987, M1 has restored $25 (i.e., $12.50+$12.50 of its loss and $75 (i.e., $100-$25) of its loss remains deferred.

• (iii) As in example (1), if §1.267(f)-1T(d) were applicable when M1 sold the property to M2, M1 would restore $14.29 of its deferred loss for each of its taxable years 1985-1991. Thus, M1 would have restored $28.58 (i.e., $14.29×2 years) as of the end of 1986. Because the amount restored by M1 under §1.1502-13(d) for 1985 and 1986 ($25) is less than the total amount M1 would have restored for these years had M1 never filed a consolidated return with M2 ($28.58), M1 restores as a "one-time restoration" under paragraph (g)(2) of this section the $3.58 difference (i.e., $28.58- $25) on December 31, 1986 (i.e., immediately before M2's separate return year begins).

• (iv) In 1987, M1 will restore $14.284 of the deferred loss. This restoration is determined by multiplying M1's adjusted deferred loss of $71.42 (i.e., $75-$3.58) by a fraction. As in example (1), the numerator of this fraction is $14.29 and the denominator is $71.45. Similarly, M1 will restore $14.284 in 1988, 1989, 1990, 1991. Thus, by the end of 1991, M1 will have restored the entire amount of the loss that remained deferred ($75) as of the time immediately prior to M2's separate return year (i.e., $3.58+($14.284×5 years)).

• (h) Depreciable property disposed of outside consolidated group but not outside controlled group. If, after the effective date of section 267(f); M1 defers a loss on a sale of depreciable property to M2 during a taxable year for which M1 and M2 join in filing a consolidated return, then M2's disposition of that property to a member that does not join in filing the consolidated return will result in restoring M1's deferred loss under the principles of paragraph (g) (2) and (3) of this section.

• (i) [Reserved]

• (j) Restoring deferred loss for a receivable after deconsolidation-(1) Conditions of application. This paragraph (j) applies only if all of the following conditions are met:

• (i) M1 defers a loss on the sale of a receivable to M2 that occurs after the effective date of section 267(f) and during a taxable year in which M1 and M2 join in filing a consolidated return.

• (ii) If M1 and M2 had not joined in filing a consolidated return that year, all or a portion of the loss would not have been deferred under §1.267(f)-1T(e).

• (iii) An event occurs ("restoration event") which in the absence of applying this section would result in restoring all or a portion of M1's deferred loss under §1.1502- 13 but which, as a result of applying this section (as if this paragraph (j) did not apply), would not result in restoring that deferred loss.

(2) One-time restoration.

If this paragraph (j) applies, then at the time M1 would have restored its deferred loss under §1.1502-13 were this section not applicable, M1 shall restore an amount equal to the lesser of-

• (i) The amount of the loss that would not have been deferred under §1.267(f)-1T(e) had M1 and M2 not joined in filing a consolidated return for the taxable year in which M1 sold the receivable to M2 or

• (ii) The amount of the loss that would have been restored under §1.1502-13 as a result of the restoration event were it not for this section. section reads as follows: Reform Act of 1984. Question 1: For purposes of section 706(d), how is an otherwise deductible amount that is deferred under section 267(a)(2) treated? Answer 1: In the year the deduction is allowed, the deduction will constitute an allocable cash basis item under section 706(d)(2)(B)(iv). section reads as follows: (a)-(j) [Reserved]

• (k) Priority of sections 267(f). For application of section 267(f) when a consolidated return is filed, see §1.267(f)-2T. There is a need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason, it is found impracticable to issue this Treasury decision with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection

• (d) of that section. This Treasury decision is issued under the authority contained in sections 267 (f)(2)(B), 706(d)(2)(B)(iv), 1502, and 7805 of the Internal Revenue Code of 1954 (98 Stat. 704, 26 U.S.C. 267; 98 Stat. 589, 26 U.S.C. 706; 68A Stat. 367, 26 U.S.C. 1502; 68A Stat. 917, 26 U.S.C. 7805, respectively). Roscoe L. Egger, Jr., Ronald A. Pearlman, Acting Assistant Secretary of the Treasury.

December 12, 1984

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary income tax regulations relating to the tax exempt status of interest on mortgage subsidy bonds. This action is necessary because of changes to the applicable tax law made by the Tax Reform Act of 1984. These regulations affect all purchasers and governmental issuers of mortgage subsidy bonds.

DATES

The temporary regulations relating to qualified mortgage bonds are effective for governmental obligations issued after December 31, 1984, except that the amendments to the regulations in §6a.103A-2(a)(2) are effective for obligations issued after December 31, 1983. The temporary regulations relating to qualified veterans' mortgage bonds (including the requirement that qualified veterans' mortgage bonds satisfy the requirements of section 103A(j)(3)) are effective for obligations issued after July 18, 1984, except that the volume limitation provided in §6a.103A-3(g) applies to obligations issued after June 22, 1984.

FOR FURTHER INFORMATION CONTACT

Mitchell H. Rapaport of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, D.C. 20224 (Attention: CC:LR:T) (202-566-3740).

SUPPLEMENTARY INFORMATION

Background

This document contains amendments to the temporary regulations relating to mortgage subsidy bonds under section 103A of the Internal Revenue Code of 1954 as amended by section 611 of the Tax Reform Act of 1984 ("the Act") (Pub. L. 98- 369; 98 Stat. 901). The temporary regulations provided by this document will remain in effect until superseded by final regulations on this subject.

Explanation of Provisions

Section 103A of the Internal Revenue Code provides that a mortgage subsidy bond shall be treated as an obligation not described in section 103(a). Thus, the interest on a mortgage subsidy bond is not excludable from gross income. However, qualified mortgage bonds and qualified veterans' mortgage bonds are not treated as mortgage subsidy bonds. Section 611 of the Act amended section 103A in several respects. The amendments made by this document conform the temporary regulations to those amendments and provide guidance to issuers and purchasers of qualified mortgage bonds and qualified veterans' mortgage bonds. Section 6a.103A-2(a)(2) is amended to provide that the term "qualified mortgage bond" does not include obligations issued after December 31, 1987. The Act added three new requirements that must be met by any issue in order to be treated as an issue of qualified mortgage bonds. Section 6a.103A-2(k) provides that an obligation is not a qualified mortgage bond unless the issue of which the obligation is a part complies with the information reporting requirement. Generally, this requirement will be met if the issuer submits on Form 8038 the information required therein and files an annual report containing information regarding the extent to which the proceeds of an issue have been made available to low-income individuals. For any issue, the Form 8038 must be filed not later than the 15th day of the 2nd calendar month after the close of the calendar quarter in which the obligations are issued. The annual report regarding the use of proceeds is to be filed not later than February 15 of each year. Section 6a.103A-2(l) provides that an issue of obligations will not constitute qualified mortgage bonds unless the applicable elected representative of the governmental unit publishes, after a public hearing following reasonable public notice, an annual policy statement. The policy statement must include a statement of the policies with respect to housing, development, and low-income housing assistance which such governmental unit is to follow in issuing qualified mortgage bonds and mortgage credit certificates and an assessment of the governmental unit's compliance with (i) the statement of the governmental unit's policies as set forth in its previous policy statement (if any) and (ii) the intent of Congress that State and local governments are expected to use their authority under section 103A and section 25, relating to mortgage credit certificates, to the greatest extent feasible to assist lower income families before assisting higher income families. Section 6a.103A-2(l) (4) through (6) provides the requirements with respect to the public hearing that must be held prior to the publication of a policy statement. Section 6a.103A-2(m) provides that in order for an issue to meet the requirements of §6a.103A-2 the applicable State official must certify that the issue meets the requirements of §6a.103A-2(g), relating to the limitation on the aggregate amount of qualified mortgage bonds issued during any calendar year. The temporary regulations provide procedures for certifying officials to follow in making certifications. In order to prevent unreasonable delays in the issuance of qualified mortgage bonds, §6a.103A-2(m)(3) provides that if the certification is not provided within 30 days of the date that the issuing authority files a request for certification the issuing authority may, instead, submit an affidavit stating that the issue meets the requirements of §6a.103A-2(g) and that the State did not provide the requested certification. The certification does not ensure that the issue meets the requirements of §6a.103A-2(g). Although the requirements of §6a.103A-2 (k), (l), and (m) also apply to qualified mortgage credit certificate programs under section 25, these regulations do not provide specific rules relating to mortgage credit certificates. Regulations to be issued under section 25 will contain such rules. Section 6a.103A-3 has been amended to reflect the changes made by the Act to the requirements applicable to qualified veterans' mortgage bonds. Section 6a.103A-3(b) provides that substantially all of the proceeds of a qualified veterans' mortgage bond must be used to provide financing for qualified veterans. The term "qualified veteran" is defined in §6a.103A-3(c). Section 103A(c)(3) requires that qualified veterans' mortgage bonds issued after July 18, 1984, satisfy the information reporting requirement of section 103A(j)(3). With respect to obligations issued prior to January 1, 1985, §6a.103A-2(k)(3)(iv) provides issuers with additional time to file Form 8038; in addition, the annual report concerning use of the proceeds need not be filed with respect to such issues. Section 6a.103A-3(g) places a limit on the aggregate amount of qualified veterans' mortgage bonds that a State may issue in a calendar year, A State's limit is determined by dividing the aggregate amount of bonds that it issued during the period January 1, 1979, through June 22, 1984 (not including the amount of qualified veterans' mortgage bonds issued during the calendar year or applicable portion of 1984 for which the amount of bonds was the lowest), by the number of years (not to exceed five) that the State issued bonds during that period. The regulations provide that the year in which the amount of bonds was the lowest may be a year in which the State did not issue qualified veterans' mortgage bonds. A State that did not issue qualified veterans' mortgage bonds during the period January 1, 1979, through June 22, 1984, may not issue qualified veterans' mortgage bonds after June 22, 1984. Finally, §6a.103A-3(h) provides good faith compliance rules for qualified veterans' mortgage bonds. These rules are similar to those provided in §6a.103A-2(c).

Non-Applicability of Executive Order

12291 The Commissioner of Internal Revenue has determined that this temporary rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis is not required.

Regulatory Flexibility Act

A general notice of proposed rulemaking is not required by 5 U.S.C. 553 for temporary regulations. Accordingly, the temporary regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. Chapter 6).

Paperwork Reduction Act

The collection of information requirements contained in these regulations has been submitted to the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB under control number 1545-0720.

Drafting Information

The principal author of these temporary regulations is Mitchell H. Rapaport of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, on matters of both substance and style.

List of Subjects

in 26 CFR Part 6a Bonds, Income taxes, Mortgages, Veterans, Foreign investment in United States real property interests.

Amendments to the Regulations

Sections 6a.103A-2 and 6a.103A-3 of Part 6a of Title 26 of the Code of Federal Regulations are amended as follows:

PART 6a-[AMENDED]

Paragraph 1. Section 6a.103-2 is amended by revising paragraph (a)(2) and by

§6a.103A-2 Qualified mortgage bond.

Commissioner (or other authorized officer or employee of the Internal Revenue

Commissioner may waive the requirement that information be submitted on

§6a.103A-2(b)(3)),

§6a.103A-2(f)(3) without adjustments for the number of residences),

Commissioner on or before such last day. The Commissioner may grant an extension

Commissioner.

Commissioner prior to such issuance.

§6a.103A-2(b)(3)); (ii) a description of the areas to which the proceeds will be

Par. 2. Section 6a.103A-3 is amended by revising paragraphs (b) and (c) and by

§6a.103A-3 Qualified veterans' mortgage bonds.

§6a.103A-1(b)(6) and §6a.103A-2(d)) for veterans; and

Approved: December 4, 1984. adding new paragraphs (k), (l), and (m). These revised and added provisions read as follows:

(a) In general.

(2) Termination date.

No obligation issued after December 31, 1987, shall be treated as part of a qualified mortgage bond issue.

• (k) Information reporting requirement-(1) In general. An issue meets the requirements of this paragraph only if the issuer substantially satisfies the information reporting requirement of this paragraph with respect to the issue. Except as otherwise provided in paragraph (k)(3)(iv), the requirements of this paragraph apply to qualified veterans' mortgage bonds issued after July 18, 1984, and to qualified mortgage bonds issued after December 31, 1984.

(2) Information required.

(i) The issuer must, based on information and reasonable expectations determined as of the date of issue, submit on Form 8038 the information required therein, including-

• (A) The name, address, and employer identification number of the issuer,

• (B) The date of issue,

• (C) The face amount of each obligation which is part of the issue,

• (D) The total purchase price of the issue,

• (E) The amount allocated to a reasonably required reserve or replacement fund,

• (F) The amount of lendable proceeds,

• (G) The stated interest rate of each maturity,

• (H) The term of each maturity,

• (I) In the case of an issue of qualified mortgage bonds, whether the issuer has elected under §6a.103A-2(i)(4)(v) to pay arbitrage to the United States,

• (J) In the case of an issue of qualified mortgage bonds, the issuer's market limitation (as defined in §6a.103A-2(g)), the amount of qualified mortgage bonds that the issuer has elected not to issue under section 25(c)(2) and the regulations thereunder, and the aggregate amount of qualified mortgage bonds issued by the issuer during the calendar year and prior to the date of issue of the issue for which the Form 8038 is being submitted, and

• (K) In the case of an issue of qualified veterans' mortgage bonds, the issuer's State veterans limit (as defined in section 103A(o)(3)(B) and §6a.103A-3(g)) and the aggregate amount of qualified veterans' mortgage bonds issued by the issuer during the calendar year and prior to the date of issue of the issue for which the Form 8038 is being submitted.

• (ii) The issuer must submit a report compiled on a calendar year basis containing information on the beneficiaries of the proceeds of the issue. The report must be filed for each year in which the proceeds of the issue are used to provide mortgages. The information must be submitted in the format prescribed by the Internal Revenue Service. The information required to be submitted shall be submitted on magnetic media in accordance with applicable revenue procedures. The consent of the Service) to the magnetic medium on which the issuer intends to submit the information shall be obtained prior to submitting such information on magnetic media. An application for consent shall be in writing and must be filed with the Magnetic Media Coordinator of the Internal Revenue Service Center at which the report is required to be filed at least 90 days before the due date of the first report for which consent is requested. If an issuer reasonably expects to submit information with respect to fewer than 50 beneficiaries for a calendar year, then the issuer may submit such information for that calendar year on machine-readable paper instead of magnetic media if the applicable revenue procedures provide a machine-readable paper form. If no such machine-readable paper form is provided, the issuer may submit such information on paper form that is not machine readable. The magnetic media if hardship is shown on the issuer's application. The report must include the following information:

  • (A) For each issue of qualified mortgage bonds and qualified veterans' mortgage bonds-

(1) The name, address, and TIN of the issuer,

(2) The date of issue, and

(3) The face amount of the issue; and

• (B) For each beneficiary of the proceeds of the issue (i.e., each recipient of a mortgage provided with the proceeds of the issue)-

(1) The name and TIN of the beneficiary,

(2) The date, amount, and term of the mortgage,

(3) The effective interest rate of the mortgage (as defined in §6a.

103A-2(i)(2)(ii)),

(4) Whether the mortgage is a qualified home improvement loan or a qualified rehabilitation loan (as defined in §6a.

103A-2(b) (9) and (10)),

(5) Whether the residence being financed is a previously occupied residence,

(6) Whether the residence being financed is a targeted area residence (as defined in

(7) Whether the residence being financed is a one-, two-, three-, or four-family residence,

(8) The acquisition cost (as defined in §6a.

103A-2(b)(8)) of the residence being financed,

(9) The average area purchase price applicable to such residence (as defined in

(10) Whether the mortgagor had a present ownership interest in a principal residence at any time during the 3-year period prior to the date on which the mortgage is executed,

(11) The number of the mortgagor's family members that occupy the residence being financed,

(12) The adjusted income (as defined in §1.

167 (k)-3 (b)(3)) of the mortgagor's family for the previous calendar year, and

(13) The adjusted income of the mortgagor's family for the previous calendar year as a percentage of the median income for the area, as determined under section 8 of the United States Housing Act of 1937, as amended, with adjustments for smaller and larger families (or, in the event programs under section 8(f) of the Housing Act of 1937, as amended, are terminated, the applicable method of determining adjusted income and median income in effect immediately prior to the date of such termination).

(3) Time for filing.

(i) The statement required by subparagraph (2)(i) of this paragraph shall be filed not later than the 15th day of the 2nd calendar month after the close of the calendar quarter in which the obligation is issued. The statement may be filed at any time before such date but must be complete based on facts and reasonable expectations as of the date of issue. The statement need not be amended to report information learned subsequent to the date of issue.

• (ii) The report required by subparagraph (2)(ii) of this paragraph (relating to use of proceeds) shall be filed by February 15th of the year following the calendar year to which the report relates.

• (iii) The Commissioner may grant an extension of time for the filing of a report required by subparagraph (2) if there is reasonable cause for the failure to file such report in a timely fashion.

• (iv) An issue of qualified veterans' mortgage bonds issued after July 18, 1984, and prior to January 1, 1985, will be treated as satisfying the information reporting requirement of this paragraph if a Form 8038 with respect to the issue is properly filed not later than February 15, 1985; the report described in paragraph (k)(2)(ii) need not be filed with respect to such issues.

(4) Place for filing.

Form 8038 and the report required by paragraph (k)(2)(ii) are to be filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255.

(5) Definitions.

(i) See the regulations under section 103(l) for the definitions of the terms "date of issue", "maturity", and "term of an issue".

• (ii) The term "family" means two or more persons related by blood, marriage, or operation of law.

• (l) Policy statement-(1) In general. (i) For obligations issued after December 31, 1984, an issue meets the requirements of this paragraph only if the applicable elected representative of the governmental unit which is the issuer (or on behalf of which the issuing authority is empowered to issue qualified mortgage bonds) has published (after a public hearing following reasonable public notice) the report described in paragraph (l)(3) by the last day of the year preceding the year in which such issue is issued and a copy of such report has been submitted to the of time for publishing and filing the report if there is reasonable cause for the failure to publish and file such report in a timely fashion. The requirements of this paragraph will be treated as met if the issuer substantially satisfies such requirements.

• (ii) With respect to reports required by paragraph (l)(1)(i) to be published and submitted to the Commissioner not later than December 31, 1984, the Commissioner has determined that there is reasonable cause for the failure to publish and file such reports in a timely fashion; such a report will be considered published and filed in a timely fashion if, not later than March 11, 1985, the report is published (after a public hearing following reasonable public notice) and a copy is submitted to the

(2) Definitions and special rules.

(i) In the case of an issuer that issues qualified mortgage bonds on behalf of two or more governmental units, a single report may be filed provided that such report is signed (A) by the applicable elected representative of each governmental unit on whose behalf obligations have been issued during any preceding calendar year or (B) by the Governor of the State in which the issuer is located.

• (ii) See section 103(k)(2)(E) and the regulations thereunder for the definition of the term "applicable elected representative".

• (iii) In the case of qualified mortgage bonds issued by, or on behalf of, a governmental unit that did not-

  • (A) Issue, or have issued on its behalf, qualified mortgage bonds during the preceding calendar year, and

  • (B) Reasonably expect during the preceding calendar year to issue (or have issued on its behalf) qualified mortgage bonds during the current calendar year, the requirements of this paragraph will be treated as met if the applicable governmental unit which is the issuer (or on behalf of which the issuing authority is empowered to issue qualified mortgage bonds) has published (after a public hearing following reasonable public notice) the report described in paragraph (l)(3) prior to the issuance of any qualified mortgage bonds and a copy of such report has been submitted to the

• (iv) For purposes of this paragraph a report will be considered to be "published" when the applicable elected representative of the governmental unit has made copies of the report available for distribution to the public. Reasonable public notice of the manner in which copies of the report may be obtained must be provided; such notice may be included as part of the public notice required by paragraph (l)(4).

(3) Report.

(i) A report is described in this subparagraph only if it contains the following:

• (A) The issuer's name, TIN, and the title "Policy Report Under Section 103A" stated on the cover page of the report;

• (B) A specific statement of the policies and goals with respect to housing, development, and low-income housing assistance which the issuer is to follow in issuing qualified mortgage bonds and mortgage credit certificates, including a statement as to-

(1) With respect to housing policies and goals, (i) whether the proceeds will be used to provide financing for the acquisition of residences, to provide qualified home improvement loans, or to provide qualified rehabilitation loans; (ii) whether all or a portion of the proceeds will be targeted to new, existing, or any other particular class or type of housing; (iii) how the existence of a need or absence of a need for such targeting has been determined; (iv) the method by which the proceeds will be targeted; (v) any other pertinent information relating to the issuer's housing policies; and (vi) how the housing policies relate to the issuer's development and low-income housing assistance policies;

(2) With respect to development policies and goals, (i) whether all or a portion of the proceeds will be targeted to specific areas (including targeted areas as described in targeted; (iii) the reasons for selecting such areas; (iv) whether proceeds targeted to each area are to be used to finance redevelopment of existing housing or new construction; (v) any other pertinent information relating to the issuer's development policies; and (vi) how the development policies relate to the issuer's housing and low-income housing assistance policies; and

(3) With respect to low-income housing assistance policies and goals, (i) whether all or a portion of the proceeds will be targeted to low-income (i.

e., 50 percent of median income), moderate-income (i.e., 80 percent of median income), and median income (i.e., 100 percent of median income), families; (ii) the method by which the proceeds will be targeted to such families; (iii) any other pertinent information relating to the issuer's low-income housing assistance policies; and (iv) how the low- income housing assistance policies relate to the issuer's housing and development policies (see §6a.103A-2(k)(5) for the definition of the term "family" and §1.167(k)- 3(b)(2) for the definition of the term "median income");

• (C) An assessment of the compliance of the governmental unit or issuing authority during the twelve-month period ending with the date of the report (as defined in paragraph (l)(3)(ii)) with the statement of housing, development, and low-income housing assistance policies with respect to qualified mortgage bonds and mortgage credit certificates that were set forth in the report, if any, published in the preceding year with respect to such governmental unit, including a statement as to whether the governmental unit or issuing authority successfully implemented its policies and achieved its goals and, if not, an analysis of the reasons for such failure;

• (D) An assessment of the compliance of the governmental unit or issuing authority during the twelve-month period ending with the date of the report (as defined in paragraph (l)(3)(ii)) with the intent of Congress that State and local governments are expected to use their authority to issue qualified mortgage bonds and mortgage credit certificates to the greatest extent feasible (taking into account prevailing interest rates and conditions in the housing market) to assist lower income families to afford home ownership before assisting higher income families, including a description of (1) the method used by the governmental unit or issuing authority to distribute proceeds, (2) whether and how that method enabled the governmental unit or issuing authority to assist lower income families before higher income families, and (3) any income levels that have been defined and used by the governmental unit or issuing authority in connection with distribution of the proceeds (no specific definition of lower income and higher income is imposed on governmental units or issuing authorities); and

• (E) A summary of the comments on the proposed report received at the public hearing required by subparagraph (4).

• (ii) For purposes of the assessments of compliance required by paragraph (l)(3)(i) (C) and (D) to be included in the report, the "date of the report" means the last day of the twelve-month period for which such assessments of compliance are to be made. The date of the report must be the last day of September, October, or November; an issuer must use the same date of the report each year. The date of the report is not, for this purpose, the date that the report is published or filed.

(4) Public hearing.

The public hearing required by subparagraph (1) of this paragraph means a forum providing a reasonable opportunity for interested individuals to express their views, both orally and in writing, on the report that the applicable representative proposes to publish to satisfy the requirements of this paragraph (l). In general, a governmental unit may select its own procedure for the hearing, provided that interested individuals have a reasonable opportunity to express their views. Thus, it may impose reasonable requirements on persons who wish to participate in the hearing, such as a requirement that persons desiring to speak at the hearing so request in writing at least 24 hours before the hearing or that they limit their oral remarks to 10 minutes. For purposes of this public hearing requirement, it is not necessary that the applicable elected representative who will publish the report be present at the hearing, that a report on the hearing be submitted to that official, or that State administrative procedural requirements for public hearings in general be observed. However, compliance with such State procedural requirements (except those at variance with a specific requirement set forth in this paragraph) will generally assure that the hearing satisfies the requirements of this paragraph. The hearing may be conducted by any individual appointed or employed to perform such function by the governmental unit, its agencies, or by the issuer. Thus, for example, for a report to be issued by an issuing authority that acts on behalf of a county, the hearing may be conducted by the issuing authority, the county, or an appointee or employee of either.

(5) Reasonable public notice.

(i) The reasonable public notice required by subparagraph (1) of this paragraph means published notice which is reasonably designed to inform residents of the geographical area within the jurisdiction of the governmental unit that will publish the report. The notice must state the time and place for the hearing and contain the information required by paragraph (l)(5)(ii) of this section. Notice is presumed reasonable if published no fewer than 14 days before the hearing. Notice is presumed reasonably designed to inform affected residents only if published in one or more newspapers of general circulation available to residents of that locality or if announced by radio or television broadcast to those residents.

• (ii) The notice of hearing described in this subparagraph must state-

  • (A) The time and place for the hearing,

  • (B) Any applicable limitations regarding participation in such hearing,

  • (C) The manner in which affected residents may obtain copies of the proposed report prior to the hearing, and

  • (D) A description, in brief and summary terms, of the contents of the proposed report.

(6) Procedure for public hearings of multiple jurisdiction issuers.

In the case of an issuer that issues qualified mortgage bonds on behalf of two or more governmental units, each governmental unit on whose behalf qualified mortgage bonds were issued during the preceding calendar year and each governmental unit on whose behalf the issuer reasonably expects to issue qualified mortgage bonds during the succeeding calendar year must hold a public hearing following reasonable public notice prior to the publication of the report required by this paragraph. A multiple jurisdiction issuer may hold a combined hearing as long as the combined hearing is a joint undertaking that provides all residents of the participating governmental units (i.e., each governmental unit on whose behalf qualified mortgage bonds were issued by the authority and each governmental unit on whose behalf the authority reasonably expects to issue qualified mortgage bonds during the succeeding calendar year) a reasonable opportunity to be heard. The location of any combined hearing is presumed to provide a reasonable opportunity for all affected residents to be heard if it is no farther than 100 miles from the seat of government of each participating governmental unit beyond whose geographic jurisdiction the hearing is conducted.

(7) Place for filing.

The report is to be filed with the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255.

• (m) State certification requirements-(1) In general. An issue meets the requirements of this paragraph only if the certification requirement of this paragraph is substantially satisfied. The requirements of this paragraph apply to obligations issued after December 31, 1984.

(2) Certification.

(i) An issue satisfies the requirements of section 103A(j)(4) and this subparagraph only if the State official designated by law (or, if there is no State official, the Governor) certifies, following a request for such certification by the issuer, that the issue meets the requirements of section 103A(g) and §6a.103A-2(g) (relating to volume limitation). In the case of any constitutional home rule city, the certification shall be made by the chief executive officer of the city.

• (ii) The certifying official need not perform an independent investigation in order to determine whether the issue meets the requirements of section 103A(g). In determining the aggregate amount of qualified mortgage bonds issued by an issuer during a calendar year, the certifying official may rely on copies of the reports submitted by the issuer pursuant to section 103A(j)(3) for such year and copies of any elections made pursuant to section 25(c)(2) not to issue qualified mortgage bonds, together with an affidavit executed by an officer of the issuer responsible for issuing the bonds stating that the issuer did not issue any other qualified mortgage bonds during the calendar year, the amount, if any, of the issuer's market limitation that it surrendered to other issuing authorities during the calendar year, and that it did not make any other elections not to issue qualified mortgage bonds. If, based on such information, the certifying official determines that the issue will not exceed the issuer's market limitation for the year, the official may certify that the issue meets the requirements of section 103A(g).

(3) Special rule.

If 30 days elapse after the issuer files a proper request for the certification described in paragraph (m)(2) and the issuer has not received from the State official designated by law (or, if there is no State official, the Governor) certification that the issue meets the requirements of section 103A(g) and §6a.103A- 2(g) or, in the alternative, a statement that the issue does not meet such requirements, the issuer may, instead, submit an affidavit executed by an officer of the issuer responsible for issuing the bonds stating that-

• (i) The issue meets the requirements of section 103A(g) and §6a.103A-2(g),

• (ii) At least 30 days before the execution of the affidavit the issuer filed a proper request for the certification described in paragraph (m)(2), and

• (iii) The State official designated by law (or, if there is no State official, the Governor) as not provided the certification described in paragraph (m)(2) of this section. For purposes of this paragraph, a request for certification is proper if the request includes the reports and affidavits described in paragraph (m)(2) (ii) of this section.

(4) Filing.

The certification (or affidavit) required by this paragraph shall be filed with the Internal Revenue Service Center, Philadelphia, PA 19255. The certification (or affidavit) shall be submitted with the Form 8038 required to be filed by section 103A(j)(3) and paragraph (k) of this §6a.103A-2. The Commissioner may grant an extension of time for filing the certification (or affidavit) if there is a reasonable cause for the failure to file such statement in a timely fashion.

(5) Effect of certification.

The fact that an issuer obtains the certification (or affidavit) described in this paragraph does not ensure that the requirements of paragraph (g) of this section are met. Obligations that do not meet the requirements of paragraph (g) of this section are not described in section 103(a). (Approved by the Office of Management and Budget under OMB Control Number 1545-0720) adding new paragraphs (g) and (h). These revised and added provisions read as follows:

• (b) Qualified veterans' mortgage bond. (1) With respect to obligations issued prior to July 19, 1984, the term "qualified veterans' mortgage bond" means any issue of obligations-

• (i) Which meets the requirements of §6a.103A-1, §6a.103A-2(j) (1) and (2), and this section;

• (ii) Substantially all of the proceeds of which are to be used to provide financing for single-family, owner-occupied residences (which meet the requirements of

• (iii) Payment of the principal and interest on which is secured by a pledge of the full faith and credit of the issuing State. A qualified veterans' mortgage bond does not include any bond that is an industrial development bond under section 103(b).

(2) With respect to obligations issued after July 18, 1984, the term "qualified veterans' mortgage bond" means any issue of obligations-

• (i) Which meets the requirements of §6.103A-1, §6a.103A-2(d) (relating to residence requirements), (j) (1) and (2) (relating to new mortgage requirement), and (k) (relating to information reporting requirement), and this section;

• (ii) Substantially all of the proceeds of which are to be used to provide financing for qualified veterans; and

• (iii) Payment of the principal and interest on which is secured by a pledge of the full faith and credit of the issuing State. A qualified veterans' mortgage bond does not include any bond that is an industrial development bond under section 103(b).

• (c) Qualified veteran. (1) An issue meets the requirements of this paragraph only if each of the mortgagors to whom owner financing is provided is a qualified veteran.

(2) With respect to obligations issued prior to July 19, 1984, the term "qualified veteran" means any veteran.

(3) With respect to obligations issued after July 18, 1984, the term "qualified veteran" means any veteran who-

• (i) Served on active duty at some time before January 1, 1977, and

• (ii) Applied for financing before the later of-

  • (A) The date 30 years after the date on which such veteran left active service, or

  • (B) January 1, 1985.

(4) The term "veteran" shall have the same meaning as in 38 U.

S.C. 101(2) , that is, a person who served in the active military, naval, or air service, and who was discharged or released therefrom under conditions other than dishonorable.

• (g) Volume limitation-(1) In general. In the case of obligations issued after June 22, 1984, an issue meets the requirements of this paragraph only if the aggregate amount of obligations issued pursuant thereto, when added to the aggregate amount of qualified veterans' mortgage bonds previously issued by the State during the calendar year, does not exceed the State veterans limit for such calendar year. In determining the aggregate amount of qualified veterans' mortgage bonds issued in calendar year 1984, obligations issued prior to June 23, 1984, shall not be taken into account.

(2) State veterans limit.

(i) The State veterans limit for any State is the amount equal to-

• (A) The aggregate amount of qualified veterans' mortgage bonds issued by the State during the period beginning on January 1, 1979, and ending on June 22, 1984 (not including the amount of any qualified veterans' mortgage bonds actually issued during the calendar year, or the applicable portion of 1984, in such period for which the amount of such bonds was the lowest), divided by

• (B) The number (not to exceed 5) of calendar years after 1978 and before 1985 during which the State issued qualified veterans' mortgage bonds. In determining the number of calendar years after 1978 and before 1985 during which the State issued qualified veterans' mortgage bonds, any qualified veterans' mortgage bonds issued after June 22, 1984, shall not be taken into account. A State that did not issue qualified veterans' mortgage bonds during the period beginning on January 1, 1979, and ending on June 22, 1984, may not issue qualified veterans' mortgage bonds after June 22, 1984.

• (ii) In the case of any obligation which has a term of 1 year or less and which was issued to provide financing for property taxes, the amount taken into account under this paragraph with respect to such obligation shall be 1/15 of its principal amount.

(3) Examples.

The following examples illustrate the provisions of this paragraph: Example (1). State R issued the following issues of qualified veterans' mortgage bonds: a $200 million issue on March 31, 1979, a $150 million issue on May 1, 1980, a $75 million issue on September 1, 1981, a $200 million issue on June 5, 1982, a $125 million issue on March 1, 1983, a $60 million issue on April 1, 1984, and a $100 million issue on September 1, 1984. R issued no other issues of qualified veterans' mortgage bonds during the period beginning January 1, 1979, and ending on December 31, 1984. The aggregate amount of qualified veterans' mortgage bonds issued during the period January 1, 1984, through June 22, 1984 ($60 million), is not taken into account in determining R's State veterans limit because that is the lowest aggregate amount of qualified veterans' mortgage bonds issued during the calendar year or the applicable portion of 1984, in the period beginning on January 1, 1979, and ending on June 22, 1984. Thus, R's State veterans limit is $150 million ($750 million (which is the sum of $200 million, $150 million, $75 million, $200 million, and $125 million) divided by 5). The September 1, 1984, issue is not included in determinig the State veterans limit because that issue was issued after June 22, 1984. The September 1, 1984, issue of qualified veterans' mortgage bonds meets the requirements of §6a. 103A-3 (g) since the aggregate amount of qualified veterans' mortgage bonds issued in calendar year 1984 (not including obligations issued prior to June 23, 1984), does not exceed the State veterans limit. Example (2). State S issued a $100 million issue of qualified veterans' mortgage bonds on March 31, 1984. S issued no other issues of qualified veterans' mortgage bonds during the period beginning on January 1, 1979, and ending on June 22, 1984. The aggregate amount of qualified veterans' mortgage bonds issued in the calendar year, or the applicable portion of 1984, in the period January 1, 1979, through June 22, 1984, for which the amount of bonds was the lowest is zero. Thus, the State veterans limit for S is $100 million (($100 million minus $0) divided by 1).

• (h) Good faith compliance efforts-(1) Mortgage eligibility requirements. An issue of qualified veterans' mortgage bonds issued after July 18, 1984, which fails to meet the requirements of section 103A(o)(1), §6a.103A-2(d) relating to residence requirements), and §6a.103A-2(j) (1) and (2) (relating to new mortgage requirements) shall be treated as meeting such requirements if each of the following provisions is complied with:

• (i) The issuer in good faith attempted to meet all such requirements before the mortgages were executed. Good faith requires that the trust indenture, participation agreements with loan originators, and other relevant instruments contain restrictions that permit the financing of residences only in accordance with such requirements. in addition, the issuer must establish reasonable procedures to ensure compliance with such requirements. Such procedures include reasonable investigations by the issuer to satisfy such requirements.

• (ii) Ninety-five percent or more of the lendable proceeds (as defined in §6a.103A- 2(b)(1)) that were devoted to owner-financing were devoted to residences with respect to which, at the time the mortgages were executed, all such requirements were met. In determining whether a person is a qualified veteran the issuer may rely on copies of the mortgagor's certificate of discharge indicating that the mortgagor served on active duty at some time before January 1, 1977, and stating the date on which the mortgagor left active service provided that neither the issuer nor its agent knows or has reason to believe that such affidavit is false. Where a particular mortgage fails to meet more than one of these requirements, the amount of the mortgage will be taken into account only once in determining whether the 95- percent requirement is met. However, all of the defects in the mortgage must be corrected pursuant to subdivision (iii).

• (iii) Any failure to meet such requirements is corrected within a reasonable period after such failure is discovered. For example, failures can be corrected by calling the nonqualifying mortgage or by replacing the nonqualifying mortgage with a qualifying mortgage.

(2) Nonmortgage eligibility requirements.

An issue of qualified veterans' mortgage bonds issued after July 18, 1984, which fails to meet the requirements of paragraph

• (g) of this section shall be treated as meeting such requirements if each of the requirements of §6a.103A-2(c)(2) (i) and (ii) is met. (Approved by the Office of Management and Budget under OMB Control Number 1545-0720) There is a need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason it is found impracticable to issue it with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection (d) of that section. This Treasury decision is issued under the authority contained in section 103A(j) (3) and (4) and 7805 of the Internal Revenue Code of 1954 (98 Stat. 901, 26 U.S.C. 103A(j) (3) and (4); 68A Stat. 917, 26 U.S.C. 7805). Roscoe L. Egger, Jr., Commission of Internal Revenue. Ronald A. Pearlman, Acting Assistant Secretary of the Treasury.

July 02, 1985

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document provides temporary regulations regarding tax-exempt entity leasing. Changes to the applicable tax law were made by the Tax Reform Act of 1984 ("TRA"). These regulations provide guidance to persons executing lease agreements involving tax-exempt entities under section 168 (j) of the Internal Revenue Code of 1954. In addition, the text of the temporary regulations set forth in this document serves as the comment document for the notice of proposed rulemaking published in the notices section of this issue of the Federal Register.

DATE

In general, the regulations apply to leases involving tax-exempt entities entered into after May 23, 1983, and to property placed in service by the taxypayer after May 23, 1983. The revision to the safe harbor lease reporting requirements is effective with respect to such lease agreements executed after June 30, 1985.

ADDRESS

Address inquiries to Robert Beatson (Attn: LR-124-84), Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, D.C. 20224 (202-566-3590).

FOR FURTHER INFORMATION CONTACT

Robert Beatson, 202-566-3590. SUPPLEMENTARY INFORMATION: . Background This document contains temporary regulations regarding tax-exempt entity leasing under section 168(j) of the Internal Revenue Code of 1954, as enacted by section 31 of TRA. Since the tax-exempt entity leasing provisions generally became effective with respect to certain lease agreements entered into after May 23, 1983, there is a need for immediate guidance relating to basic issues regarding these provisions so taxpayers leasing property to certain tax-exempt entities can comply with these new provisions. These regulations will remain in effect until superseded by final regulations on this subject. Explanation of Provisions Section 31 of TRA enacts a number of limitations regarding cost recovery deductions and tax credits applicable to certain property leased (or provided under a similar arrangement) to a tax-exempt entity such as a State or local governmental unit, an organization exempt from Federal taxation under section 501(c), or a foreign person who is generally not subject to Federal taxation. These limitations are intended to ensure that tax-exempt entities do not indirectly receive investment tax incentives through a lease (in the form of lower rent) that they would be ineligible to receive if they owned such property. These provisions are generally intended to eliminate the ability of tax-exempt entities to effectively gain the advantage of income tax deductions and credits while having no corresponding liability to pay any tax on income from such property. TRA reduces the tax benefits of lease arrangements involving tax-exempt entitles by providing that the portions of real property constituting "tax-exempt use property" as defined by TRA which are leased to such entities generally must be depreciated over at least 40 years, and by providing that the portion of personal property constituting "tax-exempt use property" must generally be depreciated over at least a period defined by its ADR class mid-point life. TRA also provides clarification regarding when property is provided pursuant to a service contract rather than a lease. A number of basic issues regarding the tax-exempt leasing provisions are discussed in the following temporary regulations. In addition, provisions regarding the manner and times for making certain elections with respect to these provisions were published in Treasury Decision 7976 in the Federal Register for September 10, 1984 (49 FR 35486). These temporary regulations, presented in question and answer format, are intended to provide guidelines upon which taxpayers may rely to resolve the basic questions specifically set forth herein. No inference should be drawn regarding issues involving this or other Code sections not raised herein or reasons certain questions, and not others, are included in these regulations. This document also contains temporary regulations revising the information reporting requirements for safe harbor lease agreements (now only permissible for qualified mass commuting vehicles as defined in section 103(b)(9)) executed after June 30, 1985. Form 6793, pertaining to safe harbor lease agreements, is obsolete for lease agreements executed after that date. Non-Applicability of Executive Order 12291 The Commissioner of Internal Revenue has determined that these temporary regulations are not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required. Regulatory Flexibility Act No general notice of proposed rulemaking is required by 5 U.S.C. 553(b) because these are temporary regulations, and there is a need to provide the public with immediate guidance. Accordingly, the Regulatory Flexibility Act does not apply and no Regulatory Flexibility Analysis is required for this rule. Paperwork Reduction Act The collection of information requirements contained in this regulation have been submitted to the Office of Management and Budget (OMB) in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB. Drafting Information The principal author of these regulations is Robert Beatson of the Legislation and Regulations Division of the Office of the Chief Counsel, Internal Revenue Service. Personnel from other offices of the Internal Revenue Service and the Treasury Department participated, however, in developing the regulations on matters of both substance and style. Comments and Requests for a Public Hearing Before these proposed regulations are adopted, consideration will be given to any written comments that are submitted (preferably eight copies) to the Commissioner of Internal Revenue. All comments will be available for public inspection and copying. A public hearing will be held upon written request to the Commissioner by any person who has submitted written comments. If a public hearing is held, notice of the time and place will be published in the Federal Register. List of Subjects 26 CFR 1.61-1-1.281-4 Income taxes, Taxable income, Deductions, Exemptions, Leasing. 26 CFR Part 602 OMB control numbers, Paperwork reduction Act, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR Parts 1 and 602 are amended as follows: 1. The authority for Part 1 is amended by adding the following citations: Authority: 26 U.S.C. 7805 and 26 U.S.C. 168(j)(10) ; §1.168(f)(8)-1T also added under section 112(c), Black Lung Benefits Revenue Act of 1981 (Pub. L. 97-119); and §1.168(j)-1T also added under 26 U.S.C. 168(j)(10). 2. A new §1.48-12T is added immediately following §1.48-10(j) to read as follows: §1.48-12T Tax-exempt entity leasing (temporary). In general. For certain investment tax credit consequences for property which is tax- exempt use property under section 168(j), see §1.168(j)-1T. 3. A new §1.168(f)(8)-1T is added immediately following §1.168-7 to read as follows: §1.168(f)(8)-1T Safe-harbor lease information returns concerning qualified mass commuting vehicles (Temporary). In general. Form 6793, Safe Harbor Lease Information Return, is obsolete for safe harbor lease agreements executed after June 30, 1985. The parties to a safe harbor lease agreement under section 168(f)(8) executed after June 30, 1985 must file with their timely filed (including extensions) Federal income tax returns for the taxable year during which the lease term begins a statement containing the following information: (a) The name, address, and taxpayer identification number of the lessor and the lessee; (b) A description of the property with respect to which safe-harbor lease treatment is claimed; (c) The date on which the lessee places the property in service, the date on which the lease begins, and the term of the lease; (d) The recovery property class of the leased property under section 168(c)(2) (for example, 5-year); (e) The terms of the payments between the parties to the lease transaction; (f) The unadjusted basis of the property as defined in section 168(d)(1) and its adjusted basis as determined under §5c.168(f)(8)-6(b)(3); and (g) If the lessor is a partnership or grantor trust, the name, address, and taxpayer identification number of the partners or beneficiaries and the service center at which the income tax return of each partner or beneficiary is filed. The lessor's failure to file the above-described statement shall void such agreement as a safe-harbor lease under section 168(f)(8) as of the date of the execution of the lease agreement. For rules regarding extensions of time for filing elections, see §1.9100-1. 4. A new §1.168(j)-1T is added immediately following §1.168(f)(8)-1T to read as follows: §1.168(j)-1T Questions and answers concerning tax-exempt entity leasing rules (Temporary). The following questions and answers concern tax-exempt entity leasing under section 168(j) of the Internal Revenue Code of 1954, as enacted by section 31 of the Tax Reform Act of 1984 ("TRA") (Pub. L. 98-369): Consequences of Tax-Exempt Use Status Q-1. If recovery property is subject to the tax-exempt entity leasing provisions of section 168(j), how must the taxpayer compute the property's recovery deductions? A-1. The taxpayer must compute the property's recovery deductions in accordance with section 168(j) (1) and (2); that is, the taxpayer must use the straight line method and the specified recovery period. For property other than 18-year real property, the applicable recovery percentages for the specified recovery period are to be determined with reference to the tables contained in Prop. Treas. Reg. §1.168- 2(g)(3)(iv)(A). For 18-year real property for which a 40-year recovery period is required, the applicable recovery percentages are to be determined under the following table: [Note: The following TABLE/FORM is too wide to be displayed on one screen. You must print it for a meaningful review of its contents. The table has been divided into multiple pieces with each piece containing information to help you assemble a printout of the table. The information for each piece includes: (1) a three line message preceding the tabular data showing by line # and character # the position of the upper left-hand corner of the piece and the position of the piece within the entire table; and (2) a numeric scale following the tabular data displaying the character positions.] * **** **** This is piece 1. -- It begins at character 1 of table line 1. **** * **** -------------------- If the recovery year is-- -------------------- 1 ------ -------------- 1 ............ 2.4 2 ............ 2.5 3 ............ 2.5 4 ............ 2.5 5 ............ 2.5 6 ............ 2.5 7 ............ 2.5 8 ............ 2.5 9 ............ 2.5 10 ........... 2.5 11 ........... 2.5 12 ........... 2.5 13 ........... 2.5 14 ........... 2.5 15 ........... 2.5 16 ........... 2.5 17 ........... 2.5 18 ........... 2.5 19 ........... 2.5 20 ........... 2.5 21 ........... 2.5 22 ........... 2.5 23 ........... 2.5 24 ........... 2.5 25 ........... 2.5 26 ........... 2.5 27 ........... 2.5 28 ........... 2.5 29 ........... 2.5 30 ........... 2.5 31 ........... 2.5 32 ........... 2.5 33 ........... 2.5 34 ........... 2.5 35 ........... 2.5 36 ........... 2.5 37 ........... 2.5 38 ........... 2.5 39 ........... 2.5 40 ........... 2.5 41 ........... 0.1 -------------------- 1...+...10....+...20 ***** **** * This is piece 2. -- It begins at character 21 of table line 1. **** * **** 40-Year Straight Line Method (Assuming Mid-Month Convention) ----- ---------------------------------------------------------------------- And the month in the first recovery year the property is placed in service ------------------------------------- -------------------------------------- 2 3 4 5 6 7 8 9 10 ----------------------------------- ---------------------------------------- The applicable recovery percentage is-- 2.2 2.0 1.8 1.6 1.4 1.1 0.9 0.7 0.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 0.3 0.5 0.7 0.9 1.1 1.4 1.6 1.8 2.0 --------------------------------------------------- ------------------------ 21..+...30....+...40....+...50....+...60....+...70....+...80....+...90....+ * **** * This is piece 3. -- It begins at character 96 of table line 1. **** ***** **** --------------- is-- --------------- 11 12 --------------- 0.3 0.1 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.2 2.4 --------------- 96.......+...10 Q-2. If recovery property that was placed in service after December 31, 1980 by a taxable entity subsequently becomes tax-exempt use property, how are such property's cost recovery deductions under section 168 affected? A-2. A change to tax-exempt use property, as defined in section 168(j)(3), will cause the cost recovery deductions under the accelerated cost recovery system (ACRS) to be recomputed. The allowable recovery deduction for the taxable year in which the change occurs (and for subsequent taxable years) must be determined as if the property had originally been tax-exempt use property. Proper adjustment must be made under the principles of Prop. Treas. Reg. §1.168-2(j)(3)(i)(B) to account for the difference between the deductions allowable with respect to the property prior to the year of change and those which would have been allowable had the taxpayer used the recovery period and method for tax-exempt use property under section 168(j) (1) and (2). However, no adjustment is made pursuant to the provisions of this A-2 if section 168 (j)(2) (C) applies, that is, if the taxpayer had selected a longer recovery period in the year the property was placed in service than the recovery period prescribed for such property under section 168(j)(1). Example (1). On July 1, 1983, X, a calendar year taxpayer, places in service 5-year recovery property with an unadjusted basis of $100. For 1983, X's allowable deduction is $15 (i.e., .15 × $100). In 1984, the property becomes tax-exempt use property. Under section 168(j), assume the prescribed recovery period is 12 years. For 1984 (and subsequent taxable years), X's allowable deduction is determined as if the property had been tax-exempt use property since 1983, that is, the year it was placed in service. Thus, taxable year 1984 is the property's second recovery year of its 12-year recovery period. Additionally, X must account for the excess allowable recovery deduction of $11 (i.e., the difference between the recovery allowance for 1983 ($15) and the allowance for that year had the property been tax-exempt use property ($4)) in accordance with the principles of Prop. Treas. Reg. §1.168- 2(j)(3)(i)(B). Thus, the recovery allowances in 1984 and 1985 are $7.97, determined as follows: Unadjusted basis multiplied by the applicable recovery percentage for second recovery year ($100x.09 ........................................ $9.00 Excess allowable recovery deduction multiplied by the applicable recovery percentage for second recovery year divided by the sum of the remaining unused applicable percentages for tax-exempt use property existing as of the taxable year of change (1984) (($11x.09)/.96) ....................................................... -1.03 Difference-- allowable deduction for 1984 ................................ $7.97 Unadjusted basis multiplied by the applicable recovery percentage for third recovery year ($100x.09) ........................................ $9.00 Excess allowable recovery deduction multiplied by the applicable recovery percentage for third recovery year divided by the sum of the remaining unused applicable percentages for tax-exempt use property existing as of the taxable year of change (1984) (($11x.09)/.96) ....................................................... -1.03 Difference--allowable deduction for 1985 ................................ $7.97 Additionally, X must make a similar adjustment for the taxable years 1986 through 1995, that is, his fourth through thirteenth recovery years. Example (2). Assume the same facts as in Example (1) except that in 1983, X elected under section 168 (b) (3) with respect to the 5-year property to use the optional recovery percentages over a 25-year recovery period. Based on these facts, the provisions of this A-2 do not apply. Definition of Tax-Exempt Use Property Mixed Leases of Real and Personal Property Q-3. How is a mixed lease of real property and personal property (e.g., a building with furniture) to be treated for purposes of applying the rules of section 168(j)(3) defining which property constitutes tax-exempt use property? A-3. The general rule is that 18-year real property and property other than 18-year real property are tested separately to determine whether each constitutes tax- exempt use property. However, if a lease of section 1245 class property is incidental to a lease of 18-year real property, and the 18-year real property is not tax-exempt use property, then the section 1245 class property also does not constitute tax- exempt use property. A lease of section 1245 class property will be considered incidental if the adjusted basis of all section 1245 class property leased in the same transaction is 1 percent or less of the adjusted basis of all 18-year real property leased in such transaction. Buildings Which Are Partially Tax-Exempt Use Property Q-4. If part of a building is leased to a tax-exempt entity in a disqualified lease and part of the building is leased other than to a tax-exempt entity in a disqualified lease, to what extent do the tax-exempt entity leasing rules apply to such building? A-4. The taxpaper must determine the amount of the building's unadjusted basis that is properly allocable to the portion of the building that is tax-exempt use property; the section 168(j) rules apply to the allocated amount. Solely for purposes of determining what percentage of the building's basis is subject to the tax-exempt entity leasing rules, no part of the basis is allocated to common areas. Example. A constructs a 3-story building in 1984 at a cost of $900,000. Each floor consists of 30,000 square feet. The only common area (10,000 square feet) in the building is on the first floor. A leases the first floor (other than the common areas) to a firm that is not a tax-exempt entity. A leases the top two floors to a tax-exempt entity in a 25-year lease. The top two floors constitute tax-exempt use property. Assume that square footage is the appropriate method for allocating basis in this case. Thus, A must allocate $675,000 of the $900,000 basis to the tax-exempt use portion, determined as follows: square footage of building which is tax-exempt = 60,000 sq. = 3/4 use property (excluding common areas) feet ------------------------- ------------------------ -------------- total square footage in the building (excluding 80,000 sq. common areas) feet3/4 ×$900,000=$675,000 A must compute his recovery deductions on this portion of the basis ($675,000) in accordance with the rules of section 168(j) (1) and (2). Requirement of a Lease Q-5. Can the use of property by a party other than a tax-exempt entity result in the property being treated as tax-exempt use property within the meaning of section 168(j)(3)? A-5. Yes, if based on all the facts and circumstances it is more appropriate to characterize the transaction as a lease to a tax-exempt entity. A transaction can be characterized as a lease to a tax-exempt entity under section 168(j)(6)(A), which provides that "the term "lease" includes any grant of a right to use property"; or under the service contract rules of section 7701(e). See Q&A 18 for rules regarding service contracts. Example. A trust is executed on January 1, 1984, to create a pooled income fund (P) that meets the requirements of section 642(c)(5). A university (U) that is tax- exempt under section 501(c)(3) is the remainderman of the pooled income fund. P's purpose is to construct and operate an athletic center on land adjacent to U's campus. Construction of the athletic center, which has a 50-year useful life, was completed and the center was placed in service on February 1, 1985. The athletic center is managed for a fee by M, an unrelated taxable organization which operates athletic facilities open to the public. Office space at the facility is occupied rent-free by both the U athletic department and M. Scheduling of activities at the center is handled jointly by members of U's athletic department and M. General operating expenses of the athletic center are paid by P. Although the athletic center is open to the public for a membership fee, the majority of members are U's students who pay membership fees as part of their tuition. These fees are remitted by U to P. This arrangement is in substance a grant to U of a right to use the facility, and therefore a lease to U under section 168(j)(6)(A). U, as remainderman, will have obtained title to the entire building when the last pooled income fund donor dies. This arrangement is a disqualified lease because either (1) U has the equivalent of a fixed price purchase option under section 168(j)(3)(B)(ii)(II) (if U receives title as remainderman before the end of the useful life of the building), or (2) the lease has a term in excess of 20 years under section 168(j)(3)(B)(ii)(III) (if U does not receive title as remainderman until 20 years have elapsed), or both. Therefore, the allowable recovery deductions (without regard to salvage value) must be computed in accordance with section 168(j) (1) and (2). In addition, because this arrangement is treated as a lea se under section 168(j), the facility is used by U for purposes of section 48(a)(4), and thus no investment tax credit is permitted with respect to any portion of the facility. This arrangement also may be treated as a lease to U for all purposes of chapter 1 of the Internal Revenue Code under section 7701 (e). "More Than 35 Percent of the Property" Test Q-6. How is the percentage of 18-year real property leased to a tax-exempt entity in a disqualified lease to be determined for purposes of the "more than 35 percent of the property" test of section 168(j)(3)(B)(iii)? A-6. The phrase "more than 35 percent of the property" means more than 35 percent of the net rentable floor space of the property. The net rentable floor space in a building does not include the common areas of the building, regardless of the terms of the lease. For purposes of the "more than 35 percent of the property" rule, two or more buildings will be treated as separate properties unless they are part of the same project, in which case they will be treated as one property. Two or more buildings will be treated as part of the same project if the buildings are constructed, under a common plan, within a reasonable time of each other on the same site and will be used in an integrated manner. Q-7. Are disqualified leases to different tax-exempt entities (regardless of whether they are related) aggregated in determining whether 18-year real property is tax- exempt use property? A-7. Yes. Example. A tax-exempt entity participates in industrial development bond financing for the acquisition of a new building by a taxable entity. The tax-exempt entity leases 60 percent of the net rentable floor space in the building for 5 years. Sixty percent of the building is tax-exempt use property. If the same tax-exempt entity leased only 19 percent of the net rentable floor space in the building for 5 years, no portion of the building would be tax-exempt use property because not more than 35 percent of the property is leased to a tax-exempt entity pursuant to a disqualified lease. If such tax-exempt entity leased only 19 percent of the net rentable floor space in the building for 5 years and another tax-exempt entity leased 20 percent of the net rentable floor space in the building for a term in excess of 20 years (or a related entity leased 20 percent of the building for 5 years), 39 percent of the building would be tax-exempt use property. See A-4 regarding the determination of the amount of the building's unadjusted basis that is properly allocable to the portion of the building that is tax-exempt use property. "Predominantly Used" Test Q-8. What does the term "predominantly used" mean for purposes of the section 168(j)(3)(D) exception to the tax-exempt use property rules? A-8. "Predominantly used" means that for more than 50 percent of the time used, as determined for each taxable year, the real or personal property is used in an unrelated trade or business the income of which is subject to tax under section 511 (determined without regard to the debt-financed income rules of section 514). If only a portion of property is predominantly used in an unrelated trade or business, the remainder may nevertheless be tax-exempt use property. Q-9. How is the "predominantly used" test of section 168(j)(3)(D) to be applied to a building? A-9. The "predominantly used" test is to be applied to a building in the following manner: (i) Identify the discrete portions (excluding common areas) of the building which are leased to a tax-exempt entity in a disqualified lease under section 168(j)(3)(B)(ii). A discrete portion of a building is an area physically separated from other areas. An area is physically separated from other areas if separated by permanent walls or by partitions serving as room dividers if such partitions remain in place throughout the taxable year. A discrete portion can be the entire building, floors, wings, offices, rooms, or a combination thereof. For example, a building whose entire internal space consists of a single large room used as a gymnasium has only one discrete portion. On the other hand, if the building has 3 stories with 10 offices on each floor, each of the 30 offices is a discrete portion. (ii) Determine whether each discrete portion is predominantly used in an unrelated trade or business subject to tax under section 511. See A-8 for the rules regarding how to make this determination. (iii) Once the discrete portions of the building that constitute tax-exempt use property have been identified, an appropriate allocation of basis must be made to such discrete portions. See A-4 for rules regarding how to make such allocation. (iv) The application of these rules is illustrated by the following example: Example. A building, constructed in 1985, is leased in its entirety to a tax-exempt entity (E) pursuant to a 25-year lease. The building has 25,000 square feet of net rentable floor space and consists of an auditorium (15,000 square feet), a retail shop (10,000 square feet), plus common area of 5,000 square feet. E uses the auditorium 80 percent of the time in its exempt activity and 20 percent of the time in an unrelated trade or business subject to tax under section 511. The retail shop is used 90 percent of the time in an unrelated trade or business subject to tax under section 511 and 10 percent of the time in an exempt activity. Thus, the auditorium is tax- exempt use property; the retail shop is not. An appropriate allocation of basis to the auditorium must be made. See A-4. Definition of Tax-Exempt Entity Q-10. What elections must be made in order to avoid the "5-year lookback" rule of section 168(j)(4)(E)(i)? A-10. Only organizations which were exempt from tax under section 501(a) as organizations described in section 501(c)(12) (and which are no longer tax-exempt) may avoid the 5-year lookback rule of section 168(j)(4)(E)(i). In order to avoid the 5-year lookback rule with respect to any property, two elections are required. First, the organization must elect not to be exempt from tax under section 501(a) during the tax-exempt use period (as defined in section 168(j)(4)(E)(ii)(II)) with respect to the property. Second, the organization must elect to be taxed on the exempt arbitrage profits as provided in section 31(g)(16) of the Tax Reform Act of 1984. See Temp. Treas. Reg. §5h.4(a) for the time and manner of making these elections. These elections, once made, are irrevocable. Q-11. Does the term "tax-exempt entity" include tax-exempt plans of deferred compensation and similar arrangements? A-11. Yes. For purposes of section 168 (j), the term "tax-exempt entity" includes trusts or other entities that are tax-qualified under section 401 (a), individual retirement accounts, simplified employee pensions, and other tax-exempt arrangements described in subchapter D of chapter 1 of the Internal Revenue Code. Special Rules for High Technology Equipment Q-12. What effect do the tax-exempt entity leasing provisions have on "qualified technological equipment"? A-12. "Qualified technological equipment" which is leased to a tax-exempt entity for a term of 5 years or less shall not constitute tax-exempt use property. If "qualified technological equipment" which is leased to a tax-exempt entity for a term of more than 5 years constitutes tax-exempt use property (as defined in section 168(j)(3)) and is not used predominantly outside the United States, the rules of section 168(j) (1) and (2) apply except that the recovery period to be used for such equipment shall be 5 years regardless of the length of the lease term. For purposes of section 168(j)(5), "qualified technological equipment" means (1) any computer or peripheral equipment, (2) any high technology telephone station equipment installed on the customer's premises, and (3) any high technology medical equipment. For definitions of these terms, see A-13 through A-16. Q-13. What is a "computer" as that term is used in section 168(j)(5)(C)(i)(I)? A-13. Computers are electronically activated devices that are programmable by the user and that are capable of accepting information, applying prescribed processes to it, and supplying the results of those processes with or without human intervention. Computers consist of a central processing unit containing extensive storage, logic, arithmetic, and control capabilities. A computer does not include any equipment which is an integral part of property that is not a user-programmable device, any video games or other devices used by the user primarily for amusement or entertainment purposes, or any typewriters, calculators, adding or accounting machines, copiers, duplicating equipment, or similar equipment. A computer does not include any equipment that is not tangible personal property. Q-14. What is "peripheral equipment" as that term is used in section 168(j)(5)(C)(i)(I)? A-14. Peripheral equipment means tangible personal property such as auxiliary machines, whether on-line or off-line, that are designed to be placed under the control of the central processing unit of the computer. Some examples of peripheral equipment are: card readers, card punches, magnetic tape feeds, high speed printers, optical character readers, tape cassettes, mass storage units, paper tape equipment, keypunches, data entry devices, teleprinters, terminals, tape drives, disc drives, disc files, disc packs, visual image projector tubes, card sorters, plotters, and collators. Peripheral equipment does not include equipment not included in Asset Depreciation Range (ADR) 00.12 listed in section 3 of Rev. Proc. 83-35, 1983-1 C.B. 745, 746. Peripheral equipment also does not include any equipment that is an integral part of property that is not a user-programmable device, any video games or other devices used by the user primarily for amusement or entertainment purposes, or any typewriters, calculators, adding or accounting machines, copiers, duplicating equipment, or similar equipment. Q-15. What does "high technology telephone station equipment" mean as that term is used in section 168(j)(5)(C)(i)(II)? A-15. High technology telephone station equipment includes only tangible personal property described in asset depreciation range (ADR) class 48.13 listed in section 3 of Rev. Proc. 83-35, 1983-1 C.B. 745, 758 that has a high technology content and which, because of such high technology content, can reasonably be expected to become obsolete before the expiration of its physical useful life. For example, telephone booths and telephones which include only a standard dialing feature are not high technology equipment. However, telephones with features such as an abbreviated dialing short program, an automatic callback, or conference call feature may qualify as high technology equipment. High technology telephone station equipment may include terminal equipment including such extra features but not terminal equipment used in conjunction with features offered through central office capacity. There are no current plans to utilize the regulatory authority provided in section 168(j)(5)(C)(iv). Q-16. What is "high technology medical equipment" as that term is used in section 168 (j)(5)(C)(i)(III)? A-16. High technology medical equipment is any electronic, electromechanical, or computer-based high technology equipment which is tangible personal property used in the screening, monitoring, observation, diagnosis, or treatment of human patients in a laboratory, medical, or hospital environment. High technology medical equipment includes only equipment that has a high technology content and which, because of such high technology content, can reasonably be expected to become obsolete before the expiration of its physical useful life. High technology medical equipment may include computer axial tomography (C.A.T.) scanners, nuclear magnetic resonance equipment, clinical chemistry analyzers, drug monitors, diagnostic ultrasound scanners, nuclear cameras, radiographic and fluoroscopic systems, Holter monitors, and bedside monitors. Incidental use of any such equipment for othe purposes, such as research, will not prevent it from qualifying as high technology medical equipment. There are no current plans to utilize the regulatory authority provided in section 168(j)(5)(C)(iv). Lease Term Q-17. What is included in determining the length of a lease term? A-17. (i) The lease term starts when the property is first made available to the lessee under the lease. The lease term includes not only the stated duration, but also any additional period of time which is within the "realistic contemplation of the parties at the time the property is first put into service. Hokanson v. Commissioner, 730 F.2d 1245, 1248 (9th Cir. 1984). A subsequent period of time is included in the term of the original lease if the circumstances indicate that the parties, upon entering into the original lease, had informally agreed that there would be an extension of the original lease. (ii) With respect to personal property, the lease term includes all periods for which the tax-exempt lessee or a related party (as defined under section 168(j)(7)) has a legally enforceable option to renew the lease, or the lessor has a legally enforceable option to compel its renewal by the tax-exempt entity or a related party. This is true regardless of the renewal terms of the lease agreement or whether the lease is in fact renewed. (iii) With respect to real property, the lease term includes all periods for which the tax-exempt lessee or a related party (as defined under section 168(j)(7)) has a legally enforceable option to renew the lease, or the lessor has a legally enforceable option to compel its renewal by the tax-exempt entity or a related party, unless the option to renew is at fair market value, determined at the time of renewal. The Hokanson facts and circumstances test (see (i) above) may cause the term of a fair market value renewal option to be treated as part of the original lease term. (iv) Successive leases that are part of the same transaction or a series of related transactions concerning the same or substantially similar property shall be treated as one lease. This rule applies if at substantially the same time or as part of one arrangement the parties enter into multiple leases covering the same or substantially similar property, each having a different term. If so, then the original lease term will be treated as running through the term of the lease that has the last expiration date of the multiple leases. The multiple lease rule will not apply merely because the parties enter into a new lease at fair market rental value at the end of the original lease term. (v) The application of the above rules is illustrated by the following examples: Example (1). On December 30, 1984, X, a taxable corporation, and Y, a tax-exempt entity, enter into a requirements contract for a period of 3 years. The requirements contract sets the terms and conditions under which X and Y will do business on those occasions when X actually leases items of personal property to Y. The requirements contract imposes no obligation on either party to actually enter into a lease agreement. Pursuant to this requirements contract, on January 1, 1985, X and Y enter into three separate leases. Under the leases, Y obtained the use of three identical items of personal property, each for a term of six months beginning on January 1, 1985. On March 1, 1985, Y entered into a fourth lease for the use of a fourth item of personal property substantially similar to the other three items for a term of 20 months beginning on that date. The mere fact that all 4 leases were entered into pursuant to the same requirements contract and involved the same or substantially similar property does not require aggregation of the terms of such leases under section 168(j)(6)(B). Example (2). Assume the same facts as in Example (1) except that, instead of the 4 leases entered into in Example (1), on January 1, 1985, pursuant to the requirements contract, X and Y enter into a lease for an item of personal property for one year. On January 10, 1986, after the end of the one-year lease term, X and Y enter into a second lease with respect to the same or substantially similar equipment. Assuming that the requirements contract itself is not a lease and assuming that the parties did not have any informal or implicit understanding (other than the general expectation of doing some business in the future) to enter into the second lease when the first lease was entered into, these two leases are not aggregated. The mere fact that the parties entered into two leases under the requirements contract does not result in the application of the section 168(j)(6)(B) rules for successive leases. Example (3). The facts are the same as in Example (2) except that the parties did have an understanding, informal or otherwise, at the time of the first lease that they would enter into a second lease of the same personal property. The terms of the leases are aggregated. Example (4). The facts are the same as in Example (2) except that, instead of the leases entered into in Example (2), on January 1, 1985, X and Y enter into two separate leases, each for a term of one year. One lease is for the period beginning on January 1, 1985 and ending on December 31, 1985. The other lease is for the period beginning on January 1, 1986 and ending on December 31, 1986. Both leases involve the same or substantially similar personal property. Under the successive lease rule, the terms of both leases are aggregated for purposes of determining the term of either lease under section 168(j)(6)(B). This result occurs because the two leases were entered into as part of the same transaction, and they relate to the same or substantially similar personal property. Service Contract Issues Q-18. How is the treatment of service contracts affected by the service contract rules set forth in section 7701(e)? A-18. If a contract which purports to be a service contract is treated as a lease under section 7701(e), such contract is to be treated as a lease for all purposes of Chapter 1 of the Internal Revenue Code (including, for example, section 168(j) and section 48(a) (4) and (5)). Q-19. Does a contract to provide heating, maintenance, etc. services in low-income housing come within the low-income housing exception in section 7701(e)(5) to the service contract rules set forth in section 7701(e)? A-19. No. Although certain low-income housing operated by or for an organization described in paragraphs (3) or (4) of section 501(c) is not subject to the service contract rules in section 7701(e), a contract, for instance, to provide heating services to low-income housing units, such as by installing and operating a furnace, does not constitute "low-income housing" within the meaning of section 7701(e)(5). Thus, the rules of section 7701(e) apply to such contracts in determining whether they are properly treated as leases. Partnership Issues Q-20. Do the provisions applicable to property leased to partnerships, set forth in section 168(j)(8), and the provisions applicable to property owned by partnerships, set forth in section 168(j)(9), apply to pass-through entities other than partnerships? A-20. Yes. Rules similar to those provided in paragraphs (8), (9)(A), (9)(B), and (9)(C) of section 168(j) and those provided in Q & A's 21-26 apply to pass-through entities other than partnerships. Q-21. What rules apply to property owned by a partnership in which one or more partners is a tax-exempt entity? A-21. If property is owned by a partnership having both taxable and tax-exempt entities as partners, and any allocation to a tax-exempt entity partner is not a "qualified allocation" under section 168(j)(9)(B), then such entity's proportionate share of the property is to be treated as tax-exempt use property for all purposes. However, the property will not be tax-exempt use property if it is predominantly used by the partnership in an activity which, with respect to the tax-exempt entity, is an unrelated trade or business. An activity is an unrelated trade or business with respect to a tax-exempt entity if such entity's distributive share of the partnership's gross income from the activity is includible in computing its unrelated business taxable income under section 512(c) (determined without regard to the debt- financed income rules of section 514). A tax-exempt entity partner's proportionate share of property of a partnership equals such partner's share of that item of the partnership's income or gain (excluding income or gain allocated under section 704(c)) in which the tax-exempt entity has the highest share. If the tax-exempt entity partner's share of any item of income or gain (excluding income or gain allocated under section 704(c)) may vary during the period it is a partner, the previous sentence shall be applied with reference to the highest share of any such item that it may receive at any time during such period. The application of these rules is illustrated by the following example: Example. A partnership (P) operates a factory, which consists of a building and various items of machinery. P has one tax-exempt entity (E) as a partner, and E's proportionate share is 10 percent (i.e., 10 percent is the largest share of any item of income or gain that E may receive during the time E is a partner). Unless P's allocations to E are qualified under section 168(j)(9)(B), 10 percent of each item of partnership property (including the building) is tax-exempt use property, notwithstanding the 35 percent threshold test of section 168(j)(3)(B)(iii) that is otherwise applicable to 18-year real property. However, the property will not be tax- exempt use property if it is predominantly used by the partnership in an activity which, with respect to E, is an unrelated trade or business (determined without regard to the debt-financed income rules of section 514). Q-22. What consititutes a "qualified allocation" under section 168(j)(9)(B)? A-22. (i) A "qualified allocation" means any allocation to a tax-exempt entity which is consistent with such entity's being allocated the same share (i.e., the identical percentage) of each and every item of partnership income, gain, loss, deduction, credit, and basis during the entire period such entity is a partner. Except as provided in A-23, an allocation is not qualified if it does not have substantial economic effect under section 704(b). However, for purposes of the two preceding sentences, items allocated under section 704(c) (relating to contributed property) are not taken into account. An allocation is not a "qualified allocation" under section 168(j)(9)(B) if the partnership agreement provides for, or the partners have otherwise formally or informally agreed to, any change (regardless of whether such change is contingent upon the happening of one or more events) in the tax-exempt entity's distributive share of income, gain, loss, deduction, credit, or basis at any time during the entire period the tax-exempt entity is a partner. (ii) A change in a tax-exempt entity's distributive share of income, gain, loss, deduction, credit, or basis which occurs as a result of a sale or redemption of a partnership interest (or portion thereof) or a contribution of cash or property to the partnership shall be disregarded in determining whether the partnership allocations are qualified, provided that such transaction is based on fair market value at the time of the transaction and that the allocations are qualified after the change. For this purpose, the consideration determined by the parties dealing at arm's length and with adverse interests normally will be deemed to satisfy the fair market value requirement. In addition, a change in a tax-exempt entity's distributive share which occurs as a result of a partner's default (other than a prearranged default) under the terms of the partnership agreement will be disregarded, provided that the allocations are qualified after the change, and that the change does not have the effect of avoiding the restrictions of section 168(j)(9). Any of the above-described transactions between existing partners (and parties related to them) will be closely scrutinized. Example (1). A, a taxable entity, and B, a tax-exempt entity, form a partnership in 1985. A contributes $800,000 to the partnership; B contributes $200,000. The partnership agreement allocates 95 percent of each item of income, gain, loss, deduction, credit, and basis to A; B's share of each of these items is 5 percent. Liquidation proceeds are, throughout the term of the partnership, to be distributed in accordance with the partner's capital account balances, and any partner with a deficit in his capital account following the distribution of liquidation proceeds is required to restore the amount of such deficit to the partnership. Assuming that these allocations have substantial economic effect within the meaning of section 704(b)(2), they are qualified because B's distributive share of each item of income, gain, loss, deduction, credit, and basis will remain the same during the entire period that B is a partner. The fact that the liquidation proceeds may be distributed in a ratio other than 95 percent/5 percent does not cause the allocations not to be qualified. Example (2). A, B, and E are members of a partnership formed on July 1, 1984. On that date the partnership places in service a building and section 1245 class property. A and B are taxable entities; E is a tax-exempt entity. The partnership agreement provides that during the first 5 years of the partnership, A and B are each allocated 40 percent of each item of income, gain, loss, deduction, credit, and basis; E is allocated 20 percent. Thereafter, A, B, and E are each allocated 331/3 percent of each item of income, gain, loss, deduction, credit, and basis. Assume that these allocations meet the substantial economic effect test of section 704(b)(2) and E's distributive share of the partnership's income is not unrelated trade or business income subject to tax under section 511. The allocations to E are not qualified allocations under section 168(j)(9)(B) because E's distributive share of partnership items does not remain the same during the entire period that E is a partner in the partnership. Thus, 331/3 percent of the building and 331/3 percent of the section 1245 class property are tax-exempt use property from the time each is placed in service by the partnership and are thus subject to the cost recovery rules of section 168(j) (1) and (2). In addition, no investment tax credit is allowed for 331/3 percent of the section 1245 class property because of section 48(a)(4). Q-23. In determining whether allocations constitute qualified allocations, what rules are applied to test allocations that are not governed by the substantial economic effect rules? A-23. A-22 provides the general rules to be used in determining whether an allocation is a qualified allocation, including the rule that the allocation must have substantial economic effect. However, certain allocations are not governed by the substantial economic effect rules (e.g., an allocation of basis of an oil and gas property is generally governed by section 613A(c)(7)(D), rather than section 704(b)), and other allocations cannot satisfy the substantial economic effect rules (e.g., allocations of credits, allocations of deduction and loss attributable to nonrecourse debt, and allocations of percentage depletion in excess of basis). Since allocations in either of these categories cannot be tested under the substantial economic effect test, these allocations, in order to be qualified, must comply with the relevant Code or regulation section that governs the particular allocation (e.g., in the case of an allocation of basis of an oil and gas property, section 613A(c)(7)(D)). Q-24. Will the Internal Revenue Service issue letter rulings on the issue of whether an allocation is a "qualified allocation" for purposes of section 168(j)(9)? A-24. The Internal Revenue Service will accept requests for rulings on the question of whether an allocation is a "qualified allocation" for purposes of section 168(j)(9). Such requests should be submitted in accordance with the appropriate revenue procedure. One requirement of a qualified allocation is that such allocation must have substantial economic effect under section 704(b)(2). Currently, the Service will not rule on the question of whether an allocation has substantial economic effect under section 704(b)(2). Therefore, unless and until this policy is changed, a ruling request regarding a qualified allocation must contain a representation that the subject allocation has substantial economic effect (or complies with A-23, if applicable). Q-25. Do priority cash distributions which constitute guaranteed payments under section 707(c) disqualify an otherwise qualified allocation? A-25. Priority cash distributions to partners which constitute guaranteed payments will not disqualify an otherwise qualified allocation if the priority cash distributions are reasonable in amount (e.g., equal to the Federal short-term rate described in section 1274(d)) and are made in equal priorities to all partners in proportion to their capital in the partnership. Other guaranteed payments will be closely scrutinized and, in appropriate cases, will disqualify an otherwise qualified allocation. Example. A and B form Partnership AB to operate a manufacturing business. A is a tax-exempt entity; B is a taxable person. A contributes $500,000 to the partnership; B contributes $100,000. The partnership agreement provides that A and B are each entitled to cash distributions each year, in equal priority, in an amount equal to 8 percent of their capital contribution. Assume that these payments are reasonable in amount and constitute guaranteed payments under section 707(c). Without taking into consideration the guaranteed payments, all allocations constitute qualified allocations under section 168(j)(9)(B) and A-22. These guaranteed payments will not disqualify such allocations. Q-26. Can property be treated as tax-exempt use property under both the general rule of section 168(j)(3) and the partnership provisions of section 168(j)(9)? A-26. Yes. For example, a tax-exempt entity may be a partner in a partnership that owns a building 60 percent of which is tax-exempt use property because it is leased to an unrelated tax-exempt entity under a 25-year lease. The status of the remaining 40 percent depends on whether or not allocations under the partnership agreement are qualified under section 168(j)(9). If the allocations are not qualified under section 168(j)(9), the tax-exempt entity's proportionate share (as determined under section 168(j)(9)(C)) of the remaining 40 percent will be tax-exempt use property. For example, if the tax-exempt entity's proportionate share is 30 percent, then 12 percent of the remaining 40 percent (i.e., .30 times .40) is tax-exempt use property and a total of 72 percent of the property (60 percent +12 percent) is tax- exempt use property. Effective Date Questions Q-27. Does an amendment to a lease (or sublease) to a tax-exempt entity of property which, pursuant to the effective date provisions of section 31(g) of TRA, is not subject to section 168(j) cause such property to be subject to the provisions of section 168(j)? A-27. An amendment to such a lease (or sublease) does not cause such property to be subject to the provisions of section 168(j) unless the amendment increases the term of the lease (or sublease). However, if the amendment increases the amount of property subject to the lease, the additional property must be tested independently under the effective date provisions of section 31(g) of TRA. See A-31 for special rules regarding improvements to property. Example. On May 1, 1983, X, a taxable entity, and E, a tax-exempt entity, enter into a lease whereby X will lease to E the top 4 floors of a ten-story building for a lease term of 25 years. In 1985, the lease is amended to provide that E will lease an additional floor for the balance of the lease term. At that time the annual rent due under the lease is increased. Pursuant to the provisions of section 31(g)(2)(A) of TRA, section 168(j) does not apply to the lease to E of the top 4 floors of the building. Assuming that no other provision of section 31(g) of TRA provides otherwise, the floor added to the lease in 1985 is subject to the provisions of section 168(j). Q-28. If property which is not subject to section 168(j) by virtue of the effective date provisions of section 31(g) of TRA is sold, subject to the lease to the tax-exempt entity, what are the consequences? A-28. Property to which section 168(j) does not apply by virtue of the effective date provisions set forth in section 31(g) (2), (3), and (4) of TRA will not become subject to section 168(j) merely by reason of a transfer of the property subject to the lease by the lessor (or a transfer of the contract to acquire, construct, reconstruct, or rehabilitate the property), so long as the lessee (or party obligated to lease) does not change. For purposes of the preceding sentence, the term "transfer" includes the sale-leaseback by a taxable lessor of its interest in the property, subject to the underlying lease to the tax-exempt entity. However, if property is transferred to a partnership or other pass-through entity after the effective date of section 168(j)(9) (see section 31(g) of TRA), such property is subject to the provisions of section 168(j)(9). Q-29. Can property which was leased to a tax-exempt entity after May 23, 1983 and acquired by a partnership before October 22, 1983 be tax-exempt use property? A-29. Yes. Because the property was leased to a tax-exempt entity after May 23, 1983, it may be tax-exempt use property under section 168(j)(3) and section 31(g)(1) of TRA. However, if the partnership included a tax-exempt entity as a partner, section 168(j)(9) would be inapplicable under section 31(g)(3)(B) of TRA because the partnership acquired the property before October 22, 1983. Q-30. What is a binding contract for purposes of the transitional rules in section 31(g) of TRA? A-30. (i) A contract is binding only if it is enforceable under State law against the taxpayer or a predecessor and does not limit damages to a specified amount, as for example, by a liquidated damages provision. A contract that limits damages to an amount equal to at least 5 percent of the total contract price will not be treated as limiting damages for this purpose. In determining whether a contract limits damages, the fact that there may be little or no damages because the contract price does not significantly differ from fair market value will not be taken into account. For example, if a taxpayer entered into an irrevocable contract to purchase an asset for $100 and the contract contained no provision for liquidated damages, the contract is considered binding notwithstanding the fact that the property had a fair market value of $99 and under local law the seller would only recover the difference in the event the purchaser failed to perform. If the contract provided for a refund of the purchase price in lieu of any damages allowable by law in the event of breach or cancellation, the contract is not considered binding. (ii) A contract is binding even if subject to a condition, so long as the condition is not within the control of either party or a predecessor in interest. A contract will not be treated as ceasing to be binding merely because the parties make insubstantial changes in its terms or because any term is to be determined by a standard beyond the control of either party. A contract which imposes significant obligations on the taxpayer (or a predecessor) will be treated as binding notwithstanding the fact that insubstantial terms remain to be negotiated by the parties to the contract. (iii) A binding contract to acquire a component part of a larger piece of property will not be treated as a binding contract to acquire the larger piece of property. For example, if a tax-exempt entity entered into a binding contract on May 1, 1983 to acquire a new aircraft engine, there would be a binding contract to acquire only the engine, not the entire aircraft. Q-31. If an improvement is made to a property that is "grandfathered" (i.e., property that is not subject to section 168(j) because of the effective date provisions of section 31(g) of TRA), to what extent will such improvement be grandfathered? A-31. Section 31(g)(20)(B) provides that a "substantial improvement" to property is treated as a separate property for purposes of the effective date provisions of section 31(g) of TRA. As a result, a "substantial improvement" will not be grandfathered unless such "substantial improvement" is grandfathered under a provision other than section 31(g)(20)(B). A property that is grandfathered will not become subject to section 168(j) merely because an improvement is made to such property, regardless of whether the improvement is a "substantial improvement". If an improvement other than a "substantial improvement" is made to property (other than land) that is grandfathered, that improvement also will be grandfathered. The determination of whether new construction constitutes an improvement to property or the creation of a new separate property will be based on all facts and circumstances. Furthermore, any improvement to land will be treated as a separate property. Example. On January 3, 1983, T, a taxable entity, entered into a lease of a parking lot to E, a tax-exempt entity. On January 1, 1985, T begins construction of a building for use by E on the site of the parking lot. The building is completed and placed in service in November 1985. The building is treated as a separate property, and is thus subject to the provisions of section 168(j), unless the building is grandfathered under a provision other than section 31(g)(20)(B) of TRA. Q-32. What is "significant official governmental action" for purposes of the section 31(g)(4) transitional rule of TRA? A-32. (i) "Significant official governmental action" involves three separate requirements. First, the action must be an official action. Second, the action must be specific action with respect to a particular project. Third, the action must be taken by a governmental entity having authority to commit the tax-exempt entity to the project, to provide funds for it, or to approve the project under State or local law. (ii) The first requirement of official action means that the governing body must adopt a resolution or ordinance, or take similar official action, on or before November 1, 1983. The action qualifies only if it conforms with Federal, State, and local law (as applicable) and is a proper exercise of the powers of the governing body. Moreover, the action must not have been withdrawn. There must be satisfactory written evidence of the action that was in existence on or before November 1, 1983. Satisfactory written evidence includes a formal resolution or ordinance, minutes of meetings, and binding contracts with third parties pursuant to which third parties are to render services in furtherance of the project. (iii) The second requirement of specific action is directed at the substance of the action taken. The action must be a specific action with respect to a particular project in which the governing body indicates an intent to have the project (or the design work for it) proceed. This requires that a specific project have been formulated and that the significant official action be a step toward consummation of the project. If the action does not relate to a specific project or merely directs that a proposal or recommendation be formulated, it will not qualify. The following set of actions with respect to a particular project constitute specific action: the hiring of bond counsel or bond underwriters necessary to assist in the issuance and sale of bonds to finance a particular project or the adoption of an inducement resolution relating to bonds to be issued for such a project; applying for an Urban Development Action Grant on behalf of the project described in the application, receiving such a grant concerning the project, or the recommendation of a city planning authority to proceed with a project; the enactment of a State law authorizing the sale, lease, or construction of the property; the appropriation of funds for the property or authorization of a feasibility study or a development services contract with respect to it; the approval of financing arrangements by a regulatory agency; the enactment of a State law designed to provide funding for a project; the certification of a building as a historic structure by a State agency and the Department of the Interior; or the endorsement of the application for a certification of need with respect to a medical facility by a regulatory agency other than the agency empowered to issue such a certificate. (iv) The third requirement for significant official governmental action is that the action must be taken by a Federal, State, or local governing body having authority to commit the tax-exempt entity to the project, to provide funds for it, or to approve the project under applicable law. If the chief executive or another representative of a governing body has such authority, action by such representative would satisfy the requirement of this (iv). A governing body may have the authority to commit the tax- exempt entity to a project notwithstanding the fact that the project cannot be consummated without other governmental action being taken. For example, a city council will be treated as having authority to commit a city to do a sale-leaseback of its city hall notwithstanding the fact that State law needs to be amended to permit such a transaction. Similarly, if a local project cannot be completed without Federal approval, either legislative or administrative, the obtaining of such approval satisfies the requirements of this (iv). (v) Routine governmental action at a local level will not qualify as significant official governmental action. Routine governmental action includes the granting of building permits or zoning changes and the issuance of environmental impact statements. (vi) In order to qualify under the transitional rule of TRA section 31(g)(4), a sale and leaseback pursuant to a binding contract entered into before January 1, 1985 must be part of the project as to which there was significant official governmental action. Except as provided in the following sentence, where there has been significant official governmental action on or before November 1, 1983 with respect to the construction, reconstruction or rehabilitation of a property, the sale and leaseback of such property pursuant to a binding contract entered into before January 1, 1985 will be treated as part of the project which was the subject of the significant official governmental action. However, if the construction, reconstruction or rehabilitation was substantially completed prior to January 1, 1983, the sale and leaseback of such property will be treated as a separate project, unless the sale and leaseback was contemplated at the time of the significant official governmental action. Nevertheless, where the sale and leaseback is treated as a separate project, section 31(g)(4) may apply if there was significant official governmental action on or before November 1, 1983, with respect to such sale and leaseback. The application of this provision is illustrated by the following example: Example. In the summer of 1927, the Board of Aldermen of City C passed a resolution authorizing the design and contruction of a new city hall and appropriated the funds necessary for such project. Construction was completed in 1928. At the time of the significant official governmental action, City C had no plan to enter into a sale-leaseback arrangement with respect to the facility. On December 15, 1984, City C entered into a binding sale-leaseback arrangement concerning the city hall. This transaction will not qualify for exclusion from section 168(j) under the section 31(g)(4) of TRA since construction of the facility in question was substantially completed before January 1, 1983. If, however, there had been significant official governmental action on or before November 1, 1983 with respect to the sale- leaseback project, then the transitional rule of section 31(g)(4) of TRA would apply.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

Authority:

§602.101 [Amended]

Commissioner of Internal Revenue.

Approved: June 19, 1985. ACT 5. The authority citation for Part 602 continues to read as follows: 26 U.S.C. 7805. 6. Section 602.101(c) is amended by inserting in the appropriate place in the table "§1.168(f)(8)-1T . . . 1545-0923". Roscoe L. Egger, Jr., Ronald A. Pearlman, Assistant Secretary of the Treasury.

September 03, 1985

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final regulations that relate to the tax exempt status of mortgage subsidy bonds. Changes to the applicable tax law were made by the Tax Reform Act of 1984. These regulations affect all purchasers, beneficiaries, and governmental issuers of tax exempt mortgage subsidy bonds.

DATES

These regulations are effective with respect to mortgage subsidy bonds issued after December 31, 1984, except that the regulations relating to qualified veterans' mortgage bonds (§1.103A-2(k)(5)(iv)) are effective for obligations issued after July 18, 1984.

FOR FURTHER INFORMATION CONTACT

Mitchell H. Rapaport of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, D.C. 20224 (Attention: CC:LR:T) (202-566-3740).

SUPPLEMENTARY INFORMATION

Background

On December 12, 1984, the Federal Register published proposed amendments to the Income Tax Regulations (26 CFR Part 1) under section 103A(j) (3), (4), and (5) of the Internal Revenue Code of 1954 (49 FR 48323). The amendments were, in part, proposed to conform the regulations to section 611(b) of the Tax Reform Act of 1984 (Pub. L. 98-369; 98 Stat. 901). A public hearing was held on April 30, 1985. After consideration of all comments regarding the proposed amendments, those amendments are adopted as revised by this Treasury decision. In addition, the regulations adopted by this Treasury decision supersede the temporary regulations under section 103A(j) (3), (4), and (5). Acccordingly, those portions of the Temporary Regulations under Title II of the Omnibus Reconciliation Act of 1980 relating to the changes made by section 611(b) of the Tax Reform Act are removed and replaced with a cross-reference to the rules adopted by this Treasury decision.

Explanation of Provisions

Section 103(a) provides that gross income does not include interest on the obligations of a State or political subdivision thereof. Section 103A provides that any mortgage subsidy bond shall be treated as an obligation not described in section 103(a). However, qualified mortgage bonds and qualified veterans' mortgage bonds are not treated as mortgage subsidy bonds. Section 611 of the Tax Reform Act added several requirements to the definition of qualified mortgage bond and qualified veterans' mortgage bond. Public Comments Many commentators objected to the extent of the information required to be reported with respect to each beneficiary of the proceeds of an issue (i.e., each recipient of a mortgage loan provided with the proceeds of an issue). In response to these comments, the regulations have been revised to require the reporting of significantly less information. In addition, the regulations adopt the suggestion that information be reported on an aggregate basis, rather than with respect to each recipient of a mortgage loan. It is believed that information collected with respect to each recipient of a mortgage loan may be useful to the government in assessing the mortgage bond and mortgage credit certificate programs. Nevertheless, due to practical considerations, including the requirement of section 611(d)(7) of the Tax Reform Act of 1984, that the Secretary of the Treasury, in consultation with the Secretary of Housing and Urban Development, submit a report concerning these programs to Congress by January 1, 1987, it has been decided to require the reporting of data on an aggregate basis. As revised, the regulations require information reporting with respect to the number of loans and aggregate principal amount of the loans categorized according to (1) the borrowers' income, (2) the acquisition cost of the residences acquired, (3) whether the borrowers have satisfied the 3-year requirement, and (4) whether the residences are located in targeted areas. With respect to qualified home improvement and rehabilitation loans, the only information required to be reported is the number and aggregate loan amount of such loans and whether the loans are with respect to residences located in targeted areas. Similar information is to be collected with respect to mortgage credit certificates. See §1.25-4T(e). This information is being collected in response to section 611(d)(7) of the Tax Reform Act of 1984 which requires that the Secretary of the Treasury submit a report to Congress by January 1, 1987, regarding the performance of issuers of qualified mortgage bonds and mortgage credit certificates relative to the intent of Congress described in section 103A(j)(5). Some commentators objected to the extent of information required to be reported with respect to qualified veterans' mortgage bonds on the grounds that such information is not relevant to qualified veterans' mortgage bonds because such bonds are not subject to all of the statutory requirements imposed on qualified mortgage bonds. Although information concerning income, acquisition cost, and the 3-year requirement is not relevant to any statutory requirement imposed on qualified veterans' mortgage bonds, the collection of such information pursuant to section 103A(j)(3)(A) is relevant to an evaluation of the qualified veterans' mortgage bond program. Accordingly, the final regulations require information reporting on qualified veterans' mortgage bonds with respect to the number of loans and the aggregate principal amounts of the loans categorized according to (1) the borrowers' income, (2) the acquisition cost of the residences acquired, and (3) whether the borrowers have satisfied the 3-year requirement. Several commentators stated that the regulations should be amended to make clear that the information required to be reported is information as of the date such information is required to be submitted and is not affected by later events. Similarly, it was suggested that the State certification requirement of section 103A(j)(4) should not require officials to certify as to matters that could change in the future. These suggestions have been adopted. Commentators suggested that the information reporting requirement should apply only to mortgages provided with the original proceeds of an issue. This suggestion has been adopted. Thus, for example, reporting would not be necessary with respect to assumptions of mortgage loans. Many commentators objected to the requirement that information be submitted on magnetic media. Accordingly, the regulations as revised do not require reporting on magnetic media. A number of commentators stated that the regulations did not define the term "beneficiary" and that the regulations implied that it was necessary to file more than one report where, for example, a husband and a wife jointly obtain a mortgage. In addition, commentators stated that only the income of the borrower, and not the income of all the members of the borrower's family, is the relevant information for purposes of section 103A. Accordingly, the regulations have been revised to require reporting with respect to the "borrowers" of the original proceeds. In response to public comments, the regulations no longer require data on borrower income to be collected under the definition used for purposes of section 8 of the Housing Act of 1937, as amended. Instead, annualized gross monthly income, as reported by borrowers on standard loan documents, is to be reported. In addition, issuers are not required to check the accuracy of information collected by examining borrowers' tax returns. Similarly, in determining whether a borrower acquiring a residence in a targeted area satisfies the 3-year requirement, the issuer may rely on a statement signed by the borrower. Commentators indicated that issuers should not be responsible for submitting false information provided to them by mortgagors. This suggestion has been adopted. A number of commentators stated that the regulations require excessive and redundant information to be included in the policy statement as described in section 103A(j)(5). In response to these comments, the regulations have been revised to make clear that the provisions describing the information to be included in the policy statement are intended merely as examples of the types of information that an issuer may include in its policy statement; thus, there is no requirement that all such information be provided. In addition, in response to comments, the definitions of "low", "moderate", and "median" income for purposes of providing information in the policy statement have been revised. Several commentators stated that there is no statutory requirement that issuers indicate in the policy statement their "goals" with respect to housing, development, and low-income housing assistance. Accordingly, the regulations as revised do not require issuers to indicate their goals with respect to these matters. The proposed regulations provided that issuers that did not issue qualified mortgage bonds in a particular year and did not reasonably expect to issue qualified mortgage bonds in the following year would not be precluded from issuing qualified mortgage bonds in the following year if a policy statement is filed prior to the date of issue. In response to public comments, the final regulations provide that this provision will apply if the issuer did not reasonably expect to issue qualified mortgage bonds during the following year, regardless of whether it issued bonds in the current year. Commentators stated that the requirement that the notice of hearing summarize the policy statement is unnecessary and adds to the expense of providing such notice. In response to this comment, the regulations have been revised to require only that the notice contain a statement that the hearing will involve the issuer's policies with respect to housing, development, and low-income housing assistance which the issuer is to follow in issuing qualified mortgage bonds and mortgage credit certificates. In response to public comments, the periods covered by the reports relating to the use of proceeds and the periods for assessing compliance with the statements of policy have been modified. In general, as modified, these periods end each year on June 30. With respect to the State certification requirement, commentators stated that the rule permitting an issuer, after a 30 day waiting period, to self-certify that an issue satisfies the requirements of section 103A(g) requires too long a period of time to elapse before the issuer may execute this certification. In response to this comment, this rule has been modified so as to permit the issuer to execute this certification after 15 days. In response to public comments, the regulations have been revised to make clear that the State certifications must be executed on or before the date of issue.

Non-Applicability of Executive Order

12291 The Commissioner of Internal Revenue has determined that this proposed rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required. Regulatory Flexibility Analysis Although a notice of proposed rulemaking that solicited public comment was issued, the Internal Revenue Service concluded when that notice was issued that the regulations are interpretative and that the notice and public procedure requirements of 5 U.S.C. 553 do not apply. Accordingly, the final regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6).

Paperwork Reduction Act

The collection of information requirements contained in these regulations have been submitted to the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB under control number 1545-0720.

Drafting Information

The principal author of these proposed regulations is Mitchell H. Rapaport of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, on matters of both substance and style.

List of Subjects

26 CFR Parts 1.61-1 through 1.281-4 Income taxes, Taxable income, Deductions, Exemptions. 26 CFR Part 6a Bonds, Income taxes, Mortgages, Veterans, Foreign investment in United States property interests. 26 CFR Part 602 Reporting and recordkeeping requirements.

Amendments to the Regulations

For the reasons set out in the preamble, Part 1, Part 6a, and Part 602 of Title 26 of the Code of Federal Regulations are amended as follows:

PART 1-[AMENDED]

Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority:

Par. 2. New §1.103A-2 is added immediately following §1.103(n)-7T to read as

§1.103A-2 Qualified mortgage bond.

Commissioner has determined that there is reasonable cause for the failure to

§6a.103A-2(g) or, in the alternative, a statement that the issue does not meet such

PART 6a-TEMPORARY REGULATIONS UNDER TITLE II OF THE OMNIBUS

Par. 3. The authority for Part 6a continues to read in part:

Authority:

Par. 4. Section 6a103A-2 is amended by revising paragraphs (k), (l), and (m). These

§6a.103A-2 Qualified mortgage bond.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

Par. 5. The authority citation for Part 602 continues to read as follows:

Authority:

Par. 6. Section 602.101 (c) is amended by inserting in the appropriate places in the

Approved: August 19, 1985. 26 U.S.C. 7805. §1.103A-2 (k), (l), and (m) also issued under 26 U.S.C. 103A(j) (3), (4), and (5). follows: (a)-(j) [Reserved]

• (k) Information reporting requirement-(1) In general. An issue meets the requirements of this paragraph only if the issuer in good faith attempted to meet the information reporting requirements of this paragraph. Except as otherwise provided in paragraph (k)(5)(iv) of this section, the requirements of this paragraph apply to qualified veterans' mortgage bonds issued after July 18, 1984, and to qualified mortgage bonds issued after December 31, 1984.

(2) Information required.

(i) The issuer must, based on information and reasonable expectations determined as of the date of issue, submit on Form 8038 the information required therein; the issuer need not however, include the information required by Form 8038 that is relevant only to obligations described in section 103(l)(1) and the regulations thereunder. The information that must be submitted includes-

• (A) The name, address, and employer identification number of the issuer,

• (B) The date of issue,

• (C) The face amount of each obligation which is part of the issue,

• (D) The total purchase price of the issue,

• (E) The amount allocated to a reasonably required reserve or replacement fund,

• (F) The amount of lendable proceeds,

• (G) The stated interest rate of each maturity,

• (H) The term of each maturity,

• (I) In the case of an issue of qualified mortgage bonds, whether the issuer has elected under §6a.103A-2(i)(4)(v) to pay arbitrage to the United States,

• (J) In the case of an issue of qualified mortgage bonds, the issuer's market limitation as of the date of issue (as defined in §6a.103A-2(g)), the amount of qualified mortgage bonds that the issuer has elected not to issue under section 25(c)(2) and the regulations thereunder, and the aggregate amount of qualified mortgage bonds issued to date by the issuer during the calendar year, and

• (K) In the case of an issue of qualified veterans' mortgage bonds, the issuer's State veterans limit (as defined in section 103A(o)(3)(B) and the regulations thereunder) and the aggregate amount of qualified veterans' mortgage bonds issued to date by the issuer during the calendar year and prior to the date of issue of the issue for which the Form 8038 is being submitted.

• (ii) With respect to issues issued after December 31, 1984, the issuer must submit a report containing information on the borrowers of the original proceeds of such issues. The report must be filed for each reporting period in which the original proceeds of any of such issues are used to provide mortgages. The issuer is not responsible for false information provided by a borrower if the issuer did not know or have reason to know that the information was false. The report must be filed on the form prescribed by the Internal Revenue Service. If no form is prescribed, or if the form prescribed is not readily available, the issuer may use its own form provided that such form is in the format set forth in paragraph (k)(3) of this section and contains the information required by this paragraph (k)(2)(ii). The report must be titled "Qualified Mortgage Bond Information Report" or "Qualified Veterans' Mortgage Bond Information Report", and must include the name, address, and TIN of the issuer, the reporting period for which the information is provided, and the following tables containing information concerning the borrowers of the original proceeds of the issues subject to the requirements of this paragraph (k)(2)(ii) with respect to mortgages provided during the reporting period for which the report is filed:

  • (A) A table titled "Number of Mortgage Loans by Income and Acquisition Cost" showing the number of mortgage loans (other than those issued in connection with qualified home improvement and rehabilitation loans) made during the reporting period according to the annualized gross income of the borrowers (categorized in the following intervals of income: $0-$9,999; $10,000-$19,999; $20,000-$29,999; $30,000-$39,999; $40,000-$49,999; $50,000-$74,999; and $75,000 or more) and according to the acquisition cost of each residence being financed (categorized in the following intervals of acquisition cost: $0-$19,999; $20,000-$39,999; $40,000- $59,999; $60,000-$79,999; $80,000-$99,999; $100,000-$119,999; $120,000- $149,999; $150,000-$199,999; and $200,000 or more). For each interval of income and acquisition cost the table must also be categorized according to the number of borrowers that-

(1) Did not have a present ownership interest in a principal residence at any time during the 3-year period ending on the date the mortgage is executed (i.

e., satisfied the 3-year requirement) and purchased residences in targeted areas,

(2) Satisfied the 3-year requirement and purchased residences not located in targeted areas,

(3) Did have a present ownership interest in a principal residence at any time during the 3-year period ending on the date the mortgage is executed (i.

e., did not satisfy the 3-year requirement) and purchased residences in targeted areas, and

(4) Did not satisfy the 3-year requirement and purchased residences not located in targeted areas.

With respect to issues of qualified veterans' mortgage bonds, for each interval of income and acquisition cost the table need only be categorized according to the number of borrowers that satisfied the 3-year requirement and the number of borrowers that failed to satisfy the 3-year requirement.

• (B) A table titled "Volume of Mortgage Loans by Income and Acquisition Cost" showing the total principal amount of the mortgage loans (other than qualified home improvement and rehabilitation loans) provided during the reporting period according to annualized gross income (categorized in the same intervals of income as the preceding table) and according to the acquisition cost of the residences acquired (categorized in the same acquisition cost intervals as the preceding table). For each interval of income and acquisition cost the table must also be categorized according to the total principal amount of the mortgage loans of borrowers that-

(1) Satisfied the 3-year requirement and purchased residences in targeted areas,

(2) Satisfied the 3-year requirement and purchased residences not located in targeted areas,

(3) Did not satisfy the 3-year requirement and purchased residences in targeted areas, and

(4) Did not satisfy the 3-year requirement and purchased residences not located in targeted areas.

With respect to issues of qualified verterans' mortgage bonds, for each interval of income and acquisition cost the table need only be categorized according to the total principal amount of the mortgage loans of borrowers that satisified the 3-year requirement and the total principal amount of the mortgage loans of borrowers that did not satisfy the 3-year requirement.

• (C) For issues other than qualified veterans' mortgage bonds, a table titled "Mortgage Subsidy Bonds for Qualified Home Improvement and Rehabilitation Loans" showing the number of borrowers obtaining qualified home improvement loans and qualified rehabilitation loans and the total of the principal amounts of such loans; the information contained in the table must also be categorized according to whether the residences with respect to which the loans were provided are located in targeted areas.

(3) Format.

(i) With respect to the report required by paragraph (k)(2)(ii) of this section, if no form is prescribed by the Internal Revenue Service, or if the prescribed form is not readily available, the issuer must submit the report in the format specified in this paragraph (k)(3).

• (ii) With respect to issues of qualified mortgage bonds, the format of the report specified in this paragraph (k)(3) is the following: Qualified Mortgage Bond Information Report Name of issuer: ADDRESS OF ISSUER: TIN of issuer: Reporting period: [Note: The following TABLE/FORM is too wide to be displayed on one screen. You must print it for a meaningful review of its contents. The table has been divided into multiple pieces with each piece containing information to help you assemble a printout of the table. The information for each piece includes: (1) a three line message preceding the tabular data showing by line # and character # the position of the upper left-hand corner of the piece and the position of the piece within the entire table; and (2) a numeric scale following the tabular data displaying the character positions.] * **** **** This is piece 1. -- It begins at character 1 of table line 1. **** * **** --------------------------------------------------------------------------- 3-year Satisfied Not Satisfied requirement: Annualized gross monthly income of borrowers --------------------------------------------------------------------------- Nontargeted area Targeted area Nontargeted area Targeted --------------------------- ------------------------------------------------ Number of Mortgage Loans by Income and Acquisition Cost $0 to $9,999 $10,000 to $19,999 $20,000 to $29,999 $30,000 to $39,999 $40,000 to $49,999 $50,000 to $74,999 $75,000 or more Total Acquisition Cost $0 to $19,999 $20,000 to $39,999 $40,000 to $59,999 $60,000 to $79,999 $80,000 to $99,999 $100,000 to $119,999 $120,000 to $149,999 $150,000 to $199,999 $200,000 or more Total ----------------------------------------------------- ---------------------- 1...+...10....+...20....+...30....+...40....+...50....+...60....+...70....+ ***** **** * This is piece 2. -- It begins at character 76 of table line 1. **** * **** ---------------- Totals ---------------- area ---------------- -------------- -- 76.......+...90.[Note: The following TABLE/FORM is too wide to be displayed on one screen. You must print it for a meaningful review of its contents. The table has been divided into multiple pieces with each piece containing information to help you assemble a printout of the table. The information for each piece includes: (1) a three line message preceding the tabular data showing by line # and character # the position of the upper left-hand corner of the piece and the position of the piece within the entire table; and (2) a numeric scale following the tabular data displaying the character positions.] * **** **** This is piece 1. -- It begins at character 1 of table line 1. **** * **** --------------------------------------------------------------------------- 3-year Satisfied Not Satisfied requirement: Annualized gross monthly income of borrowers --------------------------------------------------------------------------- Nontargeted area Targeted area Nontargeted area Targeted --------------------------- ------------------------------------------------ Volume of Mortgage Loans by Income and Acquisition Cost $0 to $9,999 $10,000 to $19,999 $20,000 to $29,999 $30,000 to $39,999 $40,000 to $49,999 $50,000 to $74,999 $75,000 or more Total Acquisition Cost $0 to $19,999 $20,000 to $39,999 $40,000 to $59,999 $60,000 to $79,999 $80,000 to $99,999 $100,000 to $119,999 $120,000 to $149,999 $150,000 to $199,999 $200,000 or more Total ----------------------------------------------------- ---------------------- 1...+...10....+...20....+...30....+...40....+...50....+...60....+...70....+ * **** * This is piece 2. -- It begins at character 76 of table line 1. **** ***** **** ---------------- Totals ---------------- area ---------------- -------------- -- 76.......+...90.Mortgage Subsidy Bonds for Qualified Home Improvement and Rehabilitation Loans ------------------------------------------------------------------------ ------- Nontargeted area Targeted area Totals ------------------------------------------- ------------------------------------ Number of qualified home improvement loans Volume of qualified home improvement loans Number of qualified rehabilitation loans Volume of qualified rehabilitation loans --------------------------------------------------- ----------------------------

• (iii) The format of the report specified in this paragraph (k)(3) for qualified veterans' mortgage bonds is the following: Qualified Veterans' Mortgage Bond Information Report Name of issuer: ADDRESS OF ISSUER: TIN of issuer: Reporting period: -------------------------------------------------------------------------- ----- 3-year requirement: annualized gross Satisfied Not Totals monthly income of borrowers satisfied ------------------------------------------------------------------------- ------ Number of Mortgage Loans by Income and Acquisition Cost $0 to $9,999 $10,000 to $19,999 $20,000 to $29,999 $30,000 to $39,999 $40,000 to $49,999 $50,000 to $74,999 $75,000 or more Total Acquistion Cost $0 to $19,999 $20,000 to $39,999 $40,000 to $59,999 $60,000 to $79,999 $80,000 to $99,999 $100,000 to $119,999 $120,000 to $149,999 $150,000 to $199,999 $200,000 or more Total Volume of Mortgage Loans By Income and Acquisition Cost $0 to $9,999 $10,000 to $19,999 $20,000 to $29,999 $30,000 to $39,999 $40,000 to $49,999 $50,000 to $74,999 $75,000 or more Total Acquistion Cost $0 to $19,999 $20,000 to $39,999 $40,000 to $59,999 $60,000 to $79,999 $80,000 to $99,999 $100,000 to $119,999 $120,000 to $149,999 $150,000 to $199,999 $200,000 or more Total ---------------- ---------------------------------------------------------------

(4) Definitions and special rules.

(i) For purposes of this paragraph the term "annualized gross income" means the borrower's gross monthly income muliplied by 12. Gross monthly income is the sum of monthly gross pay, any additional income from investments, pensions, Veterans Administration (VA) compensation, part-time employment, bonuses, dividends, interest, current overtime pay, net rental income, etc., and other income (such as alimony and child support, if the borrower has chosen to disclose such income). Information with respect to gross monthly income may be obtained from available loan documents, e.g., the sum of lines 23D and 23E on the Application for VA or FmHA Home Loan Guaranty or for HUD/FHA Insured Mortgage (VA Form 26-1802a, HUD 92900, Jan. 1982), or the total line from the Gross Monthly Income section of FHLMC Residential Loan Application form (FHLMC 65 Rev. 8/78). With respect to obligations issued prior to October 1, 1985, issuers may submit data based on annualized gross income or, instead, based on the adjusted income (as defined in §1.167(k)-3(b)(3)) of the mortgagor's family for the previous calendar year. If data is submitted based on adjusted income, the issuer must note this fact in the report.

• (ii) For purposes of this paragraph, the term "reporting period" means the following periods:

  • (A) The period beginning January 1, 1985, and ending on September 30, 1985,

  • (B) The period beginning on October 1, 1985, and ending on June 30, 1986, and

  • (C) After June 30, 1986, each 1-year period beginning July 1 and ending June 30.

• (iii) See the regulations under section 103(l) for the definitions of the terms "date of issue", "maturity", and "term of issue".

• (iv) For purposes of this paragraph, verification of information concernig a borrower's gross monthly income with other available information concerning the borrower's income (e.g., Federal income tax returns) is not required. In determining whether a borrower acquiring a residence in a targeted area satisfies the 3-year requirement, the issuer may rely on a statement signed by the borrower.

(5) Time for filing.

(i) The report required by paragraph (k)(2)(i) of this section shall be filed not later than the 15th day of the second calendar month after the close of the calendar quarter in which the obligation is issued. The statement may be filed at any time before such date but must be complete based on facts and reasonable expectations as of the date of issue. The statement need not be amended to report information learned subsequent to the date of issue or to reflect changed circumstances with respect to the issuer.

• (ii) The report required by paragraph (k)(2)(ii) of this section (relating to use of proceeds) shall be filed not later than the 15th day of the second calendar month after the close of the reporting period, except that the report for the reporting period ending September 30, 1985, is due not later than February 15, 1986. The report may be filed at any time before such date but must be complete based on facts and reasonable expectations as of the date the report is filed. The report need not be amended to reflect information learned subsequent to the date the report is filed or to reflect changed circumstances with respect to any borrower.

• (iii) The Commissioner may grant an extension of time for the filing of a report required by paragraph (k)(2) (i) or (ii) of this section if there is reasonable cause for the failure to file such report in a timely fashion.

• (iv) An issue of qualified veterans' mortgage bonds issued after July 18, 1984, and prior to January 1, 1985, will be treated as satisfying the information reporting requirement of this paragraph if a Form 8038 with respect to the issue is properly filed not later than February 15, 1985; the report described in paragraph (k)(2)(ii) of this section need not be filed with respect to such issues.

(6) Place for filing.

The reports required by paragraph (k)(2) (i) and (ii) of this section are to be filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255.

• (l) Policy statement-(1) In general. (i) For obligations issued after December 31, 1984, an issue meets the requirements of this paragraph only if the applicable elected representative of the governmental unit which is the issuer (or on behalf of which the issuing authority is empowered to issue qualified mortgage bonds) has published (after a public hearing following reasonable public notice) the report described in paragraph (l)(3) of this section by the last day of the year preceding the year in which such issue is issued and a copy of such report has been submitted to the Commissioner on or before such last day. The Commissioner may grant an extension of time for publishing and filing the report if there is reasonable cause for the failure to publish or file such report in a timely fashion. The requirements of this paragraph will be treated as met if the issuer in good faith attempted to meet the policy statement requirements of this paragraph.

• (ii) With respect to reports required by paragraph (l)(1)(i) of this section to be published and submitted to the Commissioner not later than December 31, 1984, the publish or file such reports in a timely fashion; such a report will be considered published and filed in a timely fashion if, not later than March 11, 1985, the report is published (after a public hearing following reasonable public notice) and a copy is submitted to the Commissioner. In addition, any report submitted not later than December 31, 1984, with respect to which an issuer in good faith attempted to satisfy the requirements of section 103A(j)(5) shall be treated as substantially satisfying the requirements of this paragraph. For example, with respect to a report submitted not later than December 31, 1984, an issuer shall not be treated as failing to satisfy the requirements of section 103A(j)(5) based on the fact that (A) the notice of public hearing failed to state the manner in which affected residents may obtain copies of the proposed report prior to the hearing, or (B) the proposed report was not available prior to or at the public hearing.

(2) Definitions and special rules.

(i) In the case of an issuer that issues qualified mortgage bonds on behalf of one or more governmental units, a single report may be filed provided that such report is signed (A) by the applicable elected representative of each governmental unit on whose behalf obligations have been issued during any preceding calendar year or (B) by the Governor of the State in which the issuer is located.

• (ii) See notice 103(k)(2)(E) and the regulations thereunder for the definition of the term "applicable elected representative".

• (iii) In the case of qualified mortgage bonds issued by, or on behalf of, a governmental unit that did not reasonably expect during the preceding calendar year to issue (or have issued on its behalf by any other issuer) qualified mortgage bonds during the current calendar year, the requirements of this paragraph will be treated as met if the applicable governmental unit which is the issuer (or on behalf of which the issuing authority is empowered to issue qualified mortgage bonds) has published (after a public hearing following reasonable public notice) the report described in paragraph (l)(3) of this section prior to the issuance of any qualified mortgage bonds and a copy of such report has been submitted to the Commissioner prior to such issuance.

• (iv) For purposes of this paragraph a report will be considered to be "published" when the applicable elected representative of the governmental unit has made copies of the report available for distribution to the public. Reasonable public notice of the manner in which copies of the report may be obtained must be provided; such notice may be included as part of the public notice required by paragraph (l)(4) of this section.

(3) Report.

(i) A report is described in this paragraph (l)(3) if it contains the issuer's name, TIN, and the title "Policy Report Under Section 103A" stated on the cover page of the report and if it includes-

• (A) A statement of the policies of the issuer with respect to housing, development, and low-income housing assistance which such issuer is to follow in issuing qualified mortgage bonds and mortgage credit certificates, and

• (B) An assessment of the compliance of such issuer during the 1-year period preceding the date of the report with-

(1) The statement of policy on qualified mortgage bonds and mortgage credit certificates that was set forth in the previous report, if any, of the issuer, and

(2) The intent of Congress that State and local governments are expected to use their authority to issue qualified mortgage bonds and mortgage credit certificates to the greatest extent feasible (taking into account prevailing interest rates and conditions in the housing market) to assist lower income families to afford home ownership before assisting higher income families.

• (ii) For example, a report described in this paragraph (l)(3) may (but is not required to) contain-

  • (A) A specific statement of the policies with respect to housing, development, and low-income housing assistance which the issuer is to follow in issuing qualified mortgage bonds and mortgage credit certificates, including, for example, a statement as to-

(1) With respect to housing policies, (i) whether the proceeds will be used to provide financing for the acquisition of residences, to provide qualified home improvement loans, or to provide qualified rehabilitation loans; (ii) whether all or a portion of the proceeds will be targeted to new, existing, or any other particular class or type of housing; (iii) how the existence of a need or absence of a need for such targeting has been determined; (iv) the method by which the proceeds will be targeted; (v) any other pertinent information relating to the issuer's housing policies; and (vi) how the housing policies relate to the issuer's development and low-income housing assistance policies;

(2) With respect to development policies, (i) whether all or a portion of the proceeds will be targeted to specific areas (including targeted areas as described in §6a.

103A- 2(b)(3)); (ii) a description of the areas to which the proceeds will be targeted; (iii) the reasons for selecting such areas; (iv) whether proceeds targeted to each area are to be used to finance redevelopment of existing housing or new construction; (v) any other pertinent information relating to the issuer's development policies; and (vi) how the development policies relate to the issuer's low-income housing assistance policies; and

(3) With respect to low-income housing assistance policies, (i) whether all or a portion of the proceeds will be targeted to low-income (i.

e., 80 percent of median income), moderate-income (i.e., 100 percent of median income), or any other class of borrowers; (ii) the method by which the proceeds will be targeted to such borrowers; and (iii) any other pertinent information relating to the issuer's low- income housing assistance policies;

• (B) An assessment of the compliance of the governmental unit or issuing authority during the twelve-month period ending with the date of the report with the statement of housing, development, and low-income housing assistance policies with respect to qualified mortgage bonds and mortgage credit certificates that were set forth in the report, if any, published in the preceding year with respect to such governmental unit, including, for example, a statement as to whether the governmental unit or issuing authority successfully implemented its policies and, if not, an analysis of the reasons for such failure; and

• (C) An assessment of the compliance of the governmental unit or issuing authority during the twelve-month period ending with the date of the report with the intent of Congress that State and local governments are expected to use their authority to issue qualified mortgage bonds and mortgage credit certificates to the greatest extent feasible (taking into account prevailing interest rates and conditions in the housing market) to assist lower income families to afford home ownership before assisting higher income families, including, for example, a description of (1) the method used by the governmental unit or issuing authority to distribute proceeds,

(2) whether and how that method enabled the governmental unit or issuing authority to assist lower income families before higher income families, and (3) any income levels that have been defined and used by the governmental unit or issuing authority in connection with distribution of the proceeds (no specific definition of lower income and higher income is imposed on governmental units or issuing authorities).

• (iii) For purposes of the assessments of compliance required by paragraph (l)(3)(i)(B) of this section to be included in the report, the "date of the report" means June 30. For purposes of the report required to be filed prior to January 1, 1986, an issuer need not perform these assessments of compliance with respect to any period prior to January 1, 1985.

• (iv) An issuer that fails to establish policies with respect to the criteria provided in paragraph (l)(3)(i) of this section will not be treated as failing to satisfy the requirements of this paragraph. Thus, for example, an issuer may state in its report that none of the proceeds of the issue will be targeted to specific areas. Similarly, an issuer that fails to successfully implement its policies will not be treated as failing to satisfy the requirements of this paragraph.

(4) Public hearing.

The public hearing required by paragraph (l)(1) of this section means a forum providing a reasonable opportunity for interested individuals to express their views, both orally and in writing, on the report that the applicable representative proposes to publish to satisfy the requirements of this paragraph (l). A public hearing held prior to January 1, 1985, will not fail to satisfy the requirements of this paragraph (l)(4) merely because the proposed policy statement was not available prior to the public hearing. In general, a governmental unit may select its own procedure for the hearing, provided that interested individuals have a reasonable opportunity to express their views. Thus, it may impose reasonable requirements on persons who wish to participate in the hearing, such as a requirement that persons desiring to speak at the hearing so request in writing at least 24 hours before the hearing or that they limit their oral remarks to 10 minutes. For purposes of this public hearing requirement, it is not necessary that the applicable elected representative who will publish the report be present at the hearing, that a report on the hearing be submitted to that official, or that State administrative procedural requirements for public hearings in general be observed. However, compliance with such State procedural requirements (except those at variance with a specific requirement set forth in this paragraph) will generally assure that the hearing satisfies the requirements of this paragraph. The hearing may be conducted by any individual appointed or employed to perform such function by the governmental unit, its agencies, or by the issuer. Thus, for example, for a report to be issued by an issuing authority that acts on behalf of a county, the hearing may be conducted by the issuing authority, the county, or an appointee or employee of either.

(5) Reasonable public notice.

(i) The reasonable public notice required by paragraph (l)(1) of this section means published notice which is reasonably designed to inform residents of the geographical area within the jurisdiction of the governmental unit that will publish the report. The notice must state the time and place for the hearing and contain the information required by paragraph (l)(5)(ii) of this section. Notice is presumed reasonable if published no fewer than 14 days before the hearing. Notice is presumed reasonably designed to inform affected residents only if published in one or more newspapers of general circulation available to residents of that locality or if announced by radio or televison broadcast to those residents.

• (ii) The notice of hearing described in this paragraph (l) (5) must state-

  • (A) The time and place for the hearing,

  • (B) Any applicable limitations regarding participation in the hearing,

  • (C) With respect to any notice of hearing published after December 31, 1984, the manner in which affected residents may obtain copies of the proposed report prior to the hearing, and

  • (D) With respect to any notice of hearing published after December 31, 1984, that the hearing will involve the issuer's policies with respect to housing, development, and low-income housing assistance which the issuer is to follow in issuing qualified mortgage bonds and mortgage credit certificates.

(6) Procedure for public hearings of multiple jurisdiction issuers.

In the case of an issuer that issues qualified mortgage bonds on behalf of two or more governmental units ("multiple jurisdiction issuer"), each governmental unit on whose behalf the issuer reasonably expects to issue qualified mortgage bonds during the succeeding calendar year must hole a public hearing following reasonable public notice prior to the publication of the report required by this paragraph. A multiple jurisdiction issuer may hold a combined hearing as long as the combined hearing is a joint undertaking that provides all residents of the participating governmental units (i.e., each governmental unit on whose behalf qualified mortgage bonds were issued by the authority and each governmental unit on whose behalf the authority reasonably expects to issue qualified mortgage bonds during the succeeding calendar year) a reasonable opportunity to be heard. The location of any combined hearing is presumed to provide a reasonable opportunity for all affected residents to be heard if it is no farther than 100 miles from the seat of government of each participating governmental unit beyond whose geographic jurisdiction the hearing is conducted.

(7) Place for filing.

The report is to be filed with the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255.

• (m) State certification requirements-(1) In general. An issue meets the requirements of this paragraph only if the issuer in good faith attempted to meet the State certification requirements of this paragraph. The requirements of this paragraph apply to obligations issued after December 31, 1984.

(2) Certification.

(i) An issue satisfied the requirements of section 103A (j) (4) and this paragraph (m)(2) only if the State official designated by law (or, if there is no State official, the Governor) certifies on or before the later of the date of issue or October 3, 1985, following a request for such certification by the issuer, that, as of the date the certification is executed, the issue meets the requirements of section 103A(g) and the regulations thereunder (relating to volume limitation). In the case of any constitutional home rule city, the certification shall be made by the chief executive officer of the city. To the extent consistent with State and local law, the Governor (or the chief executive officer of any constitutional home rule city) may delegate the responsibility to execute the certification required by this paragraph.

• (ii) The certifying official need not perform an independent investigation in order to determine whether the issue meets the requirements of section 103A(g). In determining the aggregate amount of qualified mortgage bonds previously issued by an issuer during a calendar year, the certifying official may rely on copies of the reports submitted, to date, by the issuer pursuant to section 103A(j)(3) for other issues of qualified mortgage bonds issued during that year and copies of any elections previously made pursuant to section 25(c)(2) not to issue qualified mortgage bonds, together with an affidavit executed by an officer of the issuer responsible for issuing the bonds stating that the issuer has not, to date during the calendar year, issued any other qualified mortgage bonds, the amount, if any, of the issuer's market limitation that it has, to date during the calendar year, surrendered to other issuing authorities, and that it has not, to date during the calendar year, made any other elections not to issue qualified mortgage bonds. If, based on such information, the certifying official determines that, as of the date the certification is executed, the issue will not exceed the issuer's market limitation for the year, the official may certify that the issue meets the requirements of section 103A(g).

(3) Special rule.

If 15 days elapse after the issuer files a proper request for the certification described in paragraph (m)(2) of this section and the issuer has not received from the State official designated by law (or, if there is no State official, the Governor) certification that the issue meets the requirements of section 103A(g) and requirements, the issuer may, instead, submit an affidavit executed by an officer of the issuer responsible for issuing the bonds stating that-

• (i) The issue meets the requirements of section 103(A)(g) and §6a.103A-2(g),

• (ii) At least 15 days before the execution of the affidavit the issuer filed a proper request for the certification described in paragraph (m)(2) of this section, and

• (iii) The State official designated by law (or, if there is no State official, the Governor) has not provided the certification described in paragraph (m)(2) of this section. In the case of obligations issued prior to October 4, 1985 the preceding sentence shall be applied by substituting "30 days" for "15 days". For purposes of this paragraph, a request for certification is proper if the request includes the reports and affidavits described in paragraph (m)(2)(ii) of this section.

(4) Filing.

The certification (or affidavit) required by this paragraph shall be filed with the Internal Revenue Service Center, Philadelphia, PA 19255. The certification (or affidavit) shall be submitted with the Form 8038 required to be filed by section 103A(j)(3) and paragraph (k) of this §1.103A-2. The Commissioner may grant an extension of time for filing the certification (or affidavit) if there is a reasonable cause for the failure to file such statement in a timely fashion.

(5) Effect of certification.

The fact that an issuer obtains the certification (or affidavit) described in this paragraph does not ensure that the requirements of paragraph (g) of §6a.103A-2 are met. Obligations that do not meet the requirements of paragraph (g) of §6a.103A-2 are not described in section 103 (a). RECONCILIATION ACT OF 1980 26 U.S.C. 7805. sec. 6a.103A-2(k), (l), and (m) also issued under 26 U.S.C. 103A(j) (3), (4), and (5). revised provisions read as follows:

• (k) Information reporting requirement. See §1.103A-2(k) for rules relating to section 103A(j)(3).

• (l) Policy statement. See §1.103A-2(l) for rules relating to section 103A(j)(5).

• (m) State certification. See §1.103A-2(m) for rules relating to section 103A(j)(4). ACT 26 U.S.C. 7805. table "§1.103A-2 . . . . 1545-0720". James I. Owens, Acting Commissioner of Internal Revenue. Ronald A. Pearlman, Assistant Secretary of the Treasury.

Feb 05, 1987

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary regulations relating to the time and manner of making certain elections under the Tax Reform Act of 1986. These regulations provide guidance to persons making these elections.

DATES

These regulations are effective February 5, 1987. Except as otherwise provided, the regulations apply to elections made after October 22, 1986.

FOR FURTHER INFORMATION CONTACT

Joel S. Rutstein of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Ave., NW., Washington, D.C. 20224, (Attention: CC:LR:T (LR-77-86). Telephone 202-566-3297 (not a toll free call).

SUPPLEMENTARY INFORMATION

Background

This document contains temporary regulations relating to certain elections under various sections of the Internal Revenue Code of 1986 and the Tax Reform Act of 1986 (the Act). These regulations are added to the Temporary Regulations-Elections Under Various Public Laws (26 CFR Part 5h). The temporary regulations provided by this document will remain in effect until superseded by later temporary or final regulations relating to these elections.

Explanation of Provisions

Section 5h.5(a)(1) lists certain elections that are provided by the Act and are addressed in this regulation. The general rules (and exceptions thereto) regarding the time for making the listed elections are provided in §5h.5(a)(2). The general rules (and exceptions thereto) regarding the manner of making the listed elections are provided in §5h.5(a)(3). Special rules regarding the time and manner for making certain elections listed in §5h.5(a)(1) are contained in paragraphs (b) through (i) of §5h.5. Election provisions provided by the Act, but not addressed in this regulation, will be addressed in other regulation projects. Section 5h.5(j) provides that additional information may be required from taxpayers after an election has been filed.

Special Analysis

The Commissioner of Internal Revenue has determined that this temporary regulation is not a major rule as defined in Executive Order 12291. Accordingly, a Regulatory Impact Analysis is not required. A general notice of proposed rulemaking is not required by 5 U.S.C. 553 for temporary regulations. Accordingly, the temporary regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. Chapter 6). The collection of information requirements contained in this regulation have been submitted to the Office of Management and Budget (OMB) in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB under control number 1545-0982.

Drafting Information

The principal author of these regulations is Joel S. Rutstein of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations both on matters of substance and style.

List of Subjects

26 CFR Part 5h Income taxes, Elections under various public laws, Deficit Reduction Act of 1984, Tax Reform Act of 1986. 26 CFR Part 602 Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulation

Accordingly, 26 CFR Parts 5h and 602 are amended as follows:

PART 5h-[AMENDED]

Paragraph 1. The authority for Part 5h continues to read:

Authority:

Par. 2. A new §5h.5 is added immediately after §5h.4 to read as follows:

§5h.5 Time and manner of making the elections under the Tax Reform Act of

Commissioner, the election may only be made for the taxpayer's first taxable hear

§5h.5(f)(1) described in section 165(c)(3) and incurred during the taxable

PART 602-[AMENDED]

Par. 3. The authority for Part 602 continues to read as follows:

Authority:

§602.10 [Amended]

Par. 4. Section 602.101(c) is amended by inserting in the appropriate place in the

Lawrence B. Gibbs,

Commissioner of Internal Revenue.

Approved: January 13, 1987. 26 U.S.C. 7805, section 5h.5 also issued under 26 U.S.C. 42(f)(1), 42(g)(1), 42(i)(2), 42(j)(5), 48(b)(2), 56(f)(3)(B), 83(c)(3), 141(b)(9), 142(d)(1), 142(d)(4)(B), 143(k)(9)(D)(iii), 154(d), 147(b)(4)(A), 165(l)(1), 168(b)(5), 168(f)(1), 168(g)(7), 168(h)(6)(F)(ii), 216(b)(3), 263(i), 263A(d)(3), 382(l)(5)(H), 448(d)(4), 453C(b)(2)(B), 453C(e)(4), 468B, 469(j)(9), 474, 585(c)(3)(A)(iii)(I), 585(c)(4), 616(d), 617(h), 1059(c)(4), 2632(b)(3), 2652(a)(3), 3121(w)(2), 4982(e)(4), and 7701(b). Section 5h.5 also issued under Pub. L. 99-514 sections 203(a)(1)(B), 204(e), 243(a), 243(b), 311(d)(2), 646, 801(d)(2), 806(e)(2)(c), 905(c), 1704(b), 1801(a), 1802(a), and 1804(e)(4). 1986.

(a) Miscellaneous elections-(1) Elections to which this paragraph applies.

This paragraph applies to the elections set forth below provided under the Tax Reform Act of 1986 (the Act). General rules regarding the time for making the elections are provided in paragraph (a)(2) of this section. General rules regarding the manner for making certain elections are provided in paragraph (a)(3) of this section. Special rules regarding the time and manner for making certain elections are contained in paragraphs (a)-(i) of this section. If a special rule applies to one of the elections listed below, a cross-reference to the special rule is shown in brackets at the end of the description of the "Availability of Election." Paragraph (j) of this section provides that additional information with respect to elections may be required by future regulations or revenue procedures. [Note: The following TABLE/FORM is too wide to be displayed on one screen. You must print it for a meaningful review of its contents. The table has been divided into multiple pieces with each piece containing information to help you assemble a printout of the table. The information for each piece includes: (1) a three line message preceding the tabular data showing by line # and character # the position of the upper left-hand corner of the piece and the position of the piece within the entire table; and (2) a numeric scale following the tabular data displaying the character positions.] * **** **** This is piece 1. -- It begins at character 1 of table line 1. **** * **** --------------------------------------------------------------- Section of Act Section of Code Description of Election ----------------------------------------------- ---------------- 201(a) ........ 168(b)(5) ............. Election to depreciate property using the straight line method of recovery with respect to one or more classes of property for any taxable year ........ 201(a) ........ 168(f)(1) ............. Election to exclude certain property from the accelerated cost recovery system 201(a) ........ 168(g)(7) ............. Election to use alternative depreciation system with respect to one or more classes of property for any taxable year (except for residential rental or non-residential real property where the election may be made separately with respect to each property) ........... 201(a), 1802(a) ..... 168(h)(6)(F)(ii), 168(j) (as in effect before October 22, 1986) ............... Election by a tax-exempt controlled entity to treat any gain recognized by the tax-exempt parent on any disposition of an interest in the tax-exempt controlled entity (and to treat any dividends or interest received or accured from the tax-exempt controlled entity) as unrelated business taxable income under Code section 511 in order for the tax-exempt controlled entity to not be treated as a tax-exempt entity (or as a successor to a tax-exempt entity) ............. 203(a)(1)(B) .. ---------------------- Election to apply Act section 201 (including all elections within section 201) ........ 204(e) ........ ---------------------- Election to have Act section 201 either (i) not apply to any property placed in service during 1987 or 1988 which is replacement property for property lost, damaged or destroyed in a flood which occured 11-3-86 through 11-7-85 and which was declared a natural disaster area by the President of the United States, or (ii) apply to all such replacement property placed in service during 1985 or 1986 ............. 243(a) ........ ---------------------- Election to begin the 60 month amortization period with the first month of the taxpayer's first taxable year beginning after 11-19-82 in lieu of the 11- 19-82 date or the bus operating authority acquisition date .... 243(b) ........ ---------- ------------ Election to begin the 60 month amortization period on the first month of the taxpayer's first taxable year beginning after the deregulation month in lieu of the deregulation month .. 243 (a), (b) .. ---------------------- Election by a qualified corporate taxpayer to allocate a portion of the cost basis of a qualified acquiring corporation in the stock of an acquired corporation to the basis of the authority ........... 252(a) ........ 42(f)(1) .............. Election concerning beginning of credit period for low-income housing credit .............. 252(a) ........ 42(g)(1) .............. Election concerning qualified low-income housing project to either satisfy the 20-50 or the 40-60 occupancy test ...... 252(a) ........ 42(i)(2) .............. Election to reduce eligible basis by outstanding balance of Federal loan subsidy ............. 252(a) ........ 42(j)(5) .............. Election to have certain partnerships treated as the taxpayer eligible for low-income housing credit ...... 311(d)(2) ..... ---------------------- Revocation of prior election under Code section 631(a) ...... 411(b)(1) ..... 263(i) ................ For intangible drilling and development costs paid or incurred with respect to an oil, gas, or geothermal well located outside the United States, election to include such costs in adjusted basis for purposes of computing the amount of any deduction under Code section 611 (without regard to section 613) ..... 411(b)(2) ..... 616(d) ................ For expenditures paid or incurred with respect to the development of a mine or other natural deposit (other than an oil, gas, or geothermal well) located outside the United States, election to include such expenditures paid or incurred during the taxable year for which made in adjusted basis for purposes of computing the amount of any deduction under Code section 611 (without regard to section 613) ..... 411(b)(2) ..... 617(h) ................ For expenditures paid or incurred before the development stage for the purpose of ascertaining the existence, location, extent or quality of any deposit of ore or other mineral deposit (other than an oil, gas or geothermal well) located outside the United States, election to include all such expenditures, paid or incurred during the taxable year with respect to any such deposit, in adjusted basis for purposes of computing the amount of any deduction under Code section 611 (without regard to section 613) ..... 501(a) ........ 469(j)(9) ............. Election to increase basis of property by amount of disallowed credit for purposes of determining gain or loss from a disposition of property used in a passive activity .... 614(b) ........ 1059(c)(4) ............ Election to determine whether a dividend is extraordinary by reference to the fair market value of the share of stock with respect to which the dividend was received ........ 621(a) ........ 382(l)(5)(H) .......... Election by certain new loss corporations not to apply the special rules of Code section 382(l)(5) concerning inapplicability of the section 382(a) limitation on corporate net operating loss carryforwards where the old loss corporation is involved in a Title 11-type case ........ 644(d) ........ 216(b)(3) ............. Election by a cooperative housing corporation to allocate real estate taxes or interest or both to each tenant-stockholder's dwelling unit in a manner which reasonably reflects the cost to the corporation of the tenant- stockholder's dwelling unit ....... 646 ........... ---------------------- Election by an entity to be treated as a trust under the Internal Revenue Code if such entity was created in 1906 as a common law trust and governed by the trust laws of the State of Minnesota, receives royalties from iron ore leases, and income interests in the entity are publicy traded on a national stock exchange ............ 651 ........... 4982(e)(4) ............ Election by a regulated investment company to use taxable years ending on 11-30 or 12-31 for purposes of computing capital gain net income under Code section 4982 ................ 701(a) ........ 56(f)(3)(B) ........... Election to have amount of net book income be equal to amount earnings and profits ............. 801(a) ........ 448(d)(4) ............. Election of common parent of an affiliated group that all members of such group be treated as one taxpayer if substantially all the activities of all members of the affiliated group involve performance of services in the same field .......... 801(d)(2) ..... ---------------------- Election to continue using the cash method of accounting for loans, leases and related party transactions ........ 802 .............................. 474 Election by certain small businesses to use the simplified dollar-value LIFO method .............. 803(a) ........ 263A(d)(3) ............ Election to have rules of Code section 263A (relating to capitalization and inclusion in inventory costs of certain expenses) not apply to any plant or animal produced in any farming business conducted by the electing taxpayer ... 806(e)(2)(C) .. ---------------------- Election to have net income for the short taxable year of a partnership or S corporation which results from the required change in accounting period included entirely in income for such short taxable year .. ---------------------- Election to reduce partnership or S corporation income for the short taxable year resulting from a required change in accounting period under section 806 of the Act by an unamortized adjustment amount existing as of October 22, 1986, where such adjustment was required to effectuate a previous accounting period change under Rev. Proc. 72-51, 1972-2 C.B. 832 or Rev. Proc. 83-25, 1983-1 C.B. 689 ..... 811(a) ........ 453C(b)(2)(B) ......... Election to compute adjusted bases using depreciation deduction used under Code section 312(k) . 811(a) ........ 453C(e)(4) ............ Election to have Code section 453C not apply to obligations arising from sales of timeshares and unimproved residential lots to invidividuals ....... 901(a) ........ 585(c)(3)(A)(iii)(I) .. Election to recapture more than 10% of the bad debt reserve in the first taxable year after the disqualification year ................ 901(a) ........ 585(c)(4) ............. Election to use the "cut-off method" to recapture bad debt reserves ............ 905(a) ........ 165(l)(1) ............. Election to treat amount of reasonably estimated loss on a deposit in insolvent or bankrupt qualified financial institution as a loss described in Code section 165(c)(3) and incurred in the taxable year ........ 905(c) ........ ---------------------- Election to apply Code section 451(f) (relating to treatment of interest on frozen deposits in certain financial institutions) ....... 1301(b) ....... 141(b)(9) ............. Election by issuer of tax-exempt bonds to treat a portion of an issue as a qualified 501(c)(3) bond if such portion would have qualified as a 501(c)(3) bond had it been issued separately .......... 1301(b) ....... 142(d)(1) ............. Election by issuer of tax-exempt bonds for residential rental property to satisfy either the 20-50 or the 40-60 occupancy test ................ 1301(b) ....... 142(d)(4)(B) .......... Election by issuer of tax-exempt bonds for residential rental property to treat the project as a deep rent skewed project ............. 1301(b) ....... 143(k)(9)(D)(iii) ..... Election to treat limited equity cooperative housing as residential rental property and not as owner-occupied housing ............. 1301(b) ....... 145(d) ................ Election by issuer of tax-exempt bonds to have Code section 145 not apply to the issue if the issue is an issue of exempt facility bonds or qualified redevelopment bonds, to which the volume cap applies ......... 1301(b) ....... 147(b)(4)(A) .......... Election by issuer of qualified 501(c)(3) bonds to have such bonds treated as meeting the limitation on maturity requirements of Code section 147(b)(1) if the requirements of section 147(b)(4)(B) are met ............. 1431(a) ....... 2632(b)(3) ............ Election to not allocate generation skipping transfer exemption to a direct skip transfer 1431(a) ....... 2652(a)(3) ............ Election to have qualified terminable interest property election not apply for purposes of the generation skipping transfer tax ........ 1704(b) ....... ---------------------- Election to revoke prior election under Code section 1402(e) (relating to exemption from social security taxes for certain clergy) ............. 1801(a) ....... 168(i) (as in effect before October 22, 1986) ............... Election to make finance leasing rules inapplicable to property which would otherwise be subject to them under the transitional rules of section 12(c)(1) of the Tax Reform Act of 1984 ......... 1804(e)(4) .... ---------------------- Election by a common parent of an affiliated group to apply amendments made by the Tax Reform Act of 1984 for taxable years beginning after 12-31-83 ............ 1807(a)(7) .... 468B .................. Election to treat a qualified payment made to a court-ordered fund as a payment made to a designated settlement fund ..... 1809(e)(2) .... 48(b)(2) .............. Election by lessee and lessor not to apply the rule of Code section 48(b)(2) concerning the date leased property is treated as originally placed in service ............. 1810( )(4) .... 7701(b) ............... Election to be treated as a resident alien . 1879(p)(1) .... 83(c)(3) .............. Election to treat certain stock acquired upon the exercise of nonqualified stock options as subject to a substantial risk of forfeiture by reason of Code section 83(c)(3) even though the transfer of stock pursuant to such exercise occurred before 1-1-82, the effective date of section 83(c)(3) .... 1882(c) ....... 3121(w)(2) ............ Election to revoke prior election under Code section 3121(w) (relating to exemption from social security taxes for certain churches and qualified church-controlled organizations ....... --------------------------------------------------------------- 1...+...10....+...20....+...30....+...40....+...50....+...60... ***** **** * This is piece 2. -- It begins at character 64 of table line 1. **** *** **** ------------------------ Availability of Election ------------------------ Property placed in service after 12-31-86. Election must be made for taxable year in which property is placed in service. Election shall apply to all property in the class placed in service during the taxable year for which the election is made. Property placed in service after 12-31-86. Election must be made for taxable year in which property is placed in service. Property placed in service after 12-31-86. Election must be made for taxable year in which property is placed in service. Except for residential rental or non-residential real property, election shall apply to all property in the class placed in service during the taxable year for which the election is made. Property placed in service after 9-27-85, but can apply to property placed in service before such date if the tax-exempt controlled entity so elects. [See paragraph (a)(3)(ii) of this section.] Property placed in service after 7-31-86 and before 1-1-87. (i) Property placed in service during 1987 or 1988; or (ii) property placed in service during 1985 or 1986. Bus operating authorities held on 11/19/82, or acquired after that date under a written contract that was binding on that date. Freight forwarder operating authorities held at the beginning of the 60 month period applicable to the taxpayer (i.e., the deregulation date or the first month of the first taxable year beginning after the deregulation date). For bus operating authorities: authorities held on 11/19/82, or acquired after that date under a written contract that was binding on that date. For freight forwarders: authorities held at the beginning of the 60-month period applicable to the taxpayer. Buildings placed in service after 12-31-86 and before 1-1- 90 (before 1-1-91 for buildings described in Code section 42(n)(2)(B)). [See paragraph (b) of this section.] Buildings placed in service after 12-31-86 and before 1-1-90 (before 1-1-91 for buildings described in Code section 42(n)(2)(B)). [See paragraph (b) of this section.] Buildings placed in service after 12-31-86 and before 1-1-90 (before 1-1-91 for buildings described in Code section 42(n)(2)(B)). [See paragraph (b) of this section.] Buildings placed in service after 12-31-86 and before 1-1-90 (before 1-1-91 for buildings described in Code Section 42(n)(2)(B) [See paragraph (b) of this section.] Election for taxable years beginning before 1-1-87 may be revoked for taxable years ending after 12-31-86. Costs paid or incurred after 12-31-86 in taxable years ending after such date. [See paragraph (a)(2)(iii) of this section.] Costs paid or incurred after 12-31-86 in taxable years ending after such date. [See paragraph (a)(2)(iv) of this section.] Costs paid or incurred after 12-31- 86 in taxable years ending after such date. [See paragraph (a)(2)(v) of this section.] Taxable years beginning after 12-31-86. [See paragraph (a)(3)(iii) of this section.] Dividends declared after July 18, 1986 in taxable years ending after such date. Ownership changes following either an owner shift involving a 5% shareholder occurring after 12-31-86 or an equity structure shift occuring pursuant to a plan of reorganization adopted after 12-31-86. Taxable years beginning after 12-31-86. [See paragraph (a)(3)(iv) of this section.] The election is effective beginning on first day of the first taxable year beginning after October 22, 1986 and following the year in which the election is made. Such election must be made by the board of trustees of such entity and must be accompanied by a written agreement signed by the board of trustees of the entity. Calendar years beginning after 12-31-86. [See paragraph (a)(2)(vi) of this section.] Taxable years beginning after 12-31-86. Taxable years beginning after 12-31-86. Loans, leases and related party transactions entered into before 9-26-85. Taxable years beginning after 12-31-86. [See paragraph (a)(3)(v) of this section.] Unless consent is obtained from the Commissioner, the first taxable year beginning after 12-31-86 during which the taxpayer engages in a farming business. [See paragraph (c) of this section.] Partner and shareholder taxable years beginning after 12-31-86 with or within which the short taxable year created under section 806 of the Act ends. [See paragraph (d) of this section.] Short taxable years of partnerships or S corporations beginning after 12-31-86 [See paragraph (e) of this section.] Taxable years ending after 12-31-86 with respect to dispositions made after 2-28-86. Taxable years ending after 12-31-86 with respect to dispositions made after 2-28-86. [See paragraph (a)(3)(vi) of this section.] Taxable years beginning after 12-31-86. Taxable years beginning after 12-31-86. Taxable years beginning after 12-31-82. [See paragraph (f) of this section.] Taxable years beginning after 12-31-82 and before 1-1-87. Bonds issued after 8-15-86. [See paragraph (g) of this section.] Bonds issued after 8-15-86. [See paragraph (g) of this section.] Bonds issued after 8-15-86. [See paragraph (g) of this section.] Bonds issued after 8-15-86 and before 1-1-89. [See paragraph (g) of this section.] Bonds issued after 8-15-86. [See paragraph (g) of this section.] Bonds issued after 8-15-86. [See paragraph (g) of this section.] Generation skipping transfers made, or treated as made, after October 22, 1986. Generation skipping transfers made, or treated as made, after October 22, 1986. Remuneration received in taxable years ending on or after October 22, 1986. [See paragraph (h) of this section.] Personal property leased under certain lease agreements effective on or after 1-1-84. [See paragraph (a)(3)(vii) of this section.] Groups which include a corporation which on 6-22-84 is a member of the group which files a consolidated return for such corporation's taxable year which includes 6-22-84. Generally, liabilities arising out of personal injury, death or property damage that are incurred after 7-18-84 under law in effect before the enactment of Code section 461(h). Election is made for the taxable year in which qualified payments are made to a designated settlement fund. Property originally placed in service after 4-11-84 (as determined under Code section 48(b) prior to its amendment by section 114(a)of the Tax Reform Act of 1984). [See paragraph (a)(3)(viii) of this section.] Taxable years beginning after December 31, 1984. [See paragraph (a)(3)(ix) of this section.] Transfers of stock described in section 1879(p)(1) of the Act. [See paragraph(a)(2)(viii) and(a)(3)(x) of this section.] Remuneration paid after 12-31-86 unless such electing church or church-controlled organization had withheld and paid over all employment taxes due, as if such election had never been in effect during the period from the stated effective date of the election being revoked through 12-31-86. [See paragraph (i) of this section.] ---- -------------------- 64...70....+...80....+..

(2) Time for making elections-(i) In general.

Except as otherwise provided in this section, the elections specified in paragraph (a)(1) of this section shall be made by the later of-

• (A) The due date (taking extensions into account) of the tax return for the first taxable year for which the election is to be effective, or

• (B) April 15, 1987 (in which case the election generally must be made by amended return).

• (ii) No extension of time for payment. Payments of tax due shall be made in accordance with chapter 62 of the Code.

• (iii) Time for making the election with respect to foreign intangible drilling costs. With respect to the election under Act section 411(b)(1) (Code section 263(i)(2)(A)), the election shall be made on a property-by-property basis for each oil, gas, or geothermal property (as defined in Code section 614). The election shall be made by the due date (taking extensions into account) of the income tax return for the first taxable year in which the taxpayer pays or incurs any cost with respect to the development of such property for which the election is available.

• (iv) Time for making the election with respect to foreign development expenditures. With respect to the election under Act section 411(b)(2) (Code section 616(d)(2)(A)), the election shall be made for each mine or other natural deposit not later than the time prescribed by law for filing the income tax return (taking extensions into account) for the taxable year to which such election is applicable.

• (v) Time for making the election with respect to foreign exploration expenditures. With respect to the election under Act section 411(b)(2) (Code section 617(h)(2)(A)), the election may be made at any time before the expiration of the period prescribed for filing a claim for credit or refund of the tax imposed by chapter 1 of the Code for the first taxable year for which the taxpayer desires the election to be applicable.

• (vi) Time for making certain elections by regulated investment companies. The election under Act section 651 (Code section 4982(e)(4)) shall be made on a statement attached to the form prescribed by the Internal Revenue Service which is used to report and pay the excise tax liability under such section 4982, and shall be filed on or before March 15 of the first calendar year beginning after the end of the first excise tax period for which the election is to be effective. The statement of election under section 4982(e)(4) shall be attached to the prescribed form regardless of whether the regulated investment company is liable for the excise tax imposed by section 4982 for the excise tax period in question.

• (vii) Time for making the election with respect to certain nonqualified stock options. The election under section 1879(p)(1) of the Act (Code section 83(c)(3)) shall be made-

  • (A) By April 21, 1987, in any case in which the operation of any law or rule of law on or before such date would prevent the credit or refund of any overpayment of tax resulting from such election, and

  • (B) By no later than any date after April 21, 1987 on which the operation of any law or rule of law would prevent the credit or refund of any overpayment of tax resulting from such election.

(3) Manner of making elections-(i) In general.

Except as otherwise provided in this section, the elections specified in paragraph (a)(1) of this section shall be made by attaching a statement to the tax return for the taxable year for which the election is to be effective. If because of paragraph (a)(2)(i)(B) of this section the election may be filed after the due date of the tax return for the first taxable year for which the election is to be effective, such statement must be attached to a tax return or amended return for the taxable year to which the election relates. Except as otherwise provided in the return or in the instructions accompanying the return for the taxable year, the statement shall-

• (A) Contain the name, address and taxpayer identification number of the electing taxpayer,

• (B) Identify the election,

• (C) Indicate the section of the Code (or, if the provision is not codified, the section of the Act) under which the election is made,

• (D) Specify, as applicable, the period for which the election is being made and/or the property or other items to which the election is to apply, and

• (E) Provide any information required by the relevant statutory provisions and any information necessary to show that the taxpayer is entitled to make the election.

• (ii) Special rules for making the transitional rule elections with respect to certain tax- exempt controlled entities. The irrevocable election under Act sections 201(a) and 1802(a) (Code sections 168(h)(6)(F)(ii) and 168(j), as in effect before October 22, 1986), shall be made by the tax-exempt controlled entity at the time and in the manner described in paragraphs (a)(2) and (a)(3)(i) of this section. A copy of the election statement filed by the tax-exempt controlled entity shall also be attached to the Federal tax returns (e.g., Form 990 or 5500) of each of the tax-exempt shareholders or beneficiaries of the controlled entity.

• (iii) Special rule for making the election with respect to gain or loss from a disposition of property used in a passive activity. The election under Act section 501(a) (Code section 469(j)(9)) shall be made on the form prescribed by the Internal Revenue Service for computing the taxpayer's passive activity loss and credit for the taxable year in which the property is disposed.

• (iv) Special rules for making the election with respect to cooperative housing corporations. The election under Act section 644(d) (Code section 216(b)(3)(B)(ii)) may be made by a cooperative housing corporation with respect to its real estate taxes or interest or both. The election is available for any taxable year beginning after December 31, 1986, if the cooperative housing corporation has, by January 31 of the year following the first calendar year that includes any period to which the election applies, furnished to each tenant-stockholder during that period a written statement showing the amount of the allocation (or allocations) under section 216(b)(3)(B)(i) attributable to such tenant-stockholder's dwelling unit (or units) for that period. Any cooperative housing corporation making the election shall do so in accordance with paragraph (a) (2) and (3) of this section and shall identify in the statement described in paragraph (a)(3) of this section whether the election is for real estate taxes or interest or both.

• (v) Special rules for making the election with respect to the simplified dollar-value LIFO method. The election under Act section 802 (Code section 474) may be made only if the taxpayer files with the taxpayer's income tax return for the taxable year as of the close of which the method is first to be used a statement of the taxpayer's election to use the simplified dollar-value LIFO inventory method. The statement shall be on Form 970 pursuant to the instructions to the form and to the requirements of the regulations under section 474, or in such other manner as may be acceptable to the Commissioner.

• (vi) Special rules for making election to have section 453C not apply to obligations arising from sales of timeshares and unimproved residential lots to individuals. The election under Act section 811(a) (Code section 453C(e)(4)) to have section 453C not apply to obligations arising from sales of timeshares and unimproved residential lots to individuals may be made with respect to any obligation, or with respect to a class of such obligations. In the case of an election made with respect to a class of obligations, such election shall describe the class of obligations with such specificity as to make the class readily identifiable.

• (vii) Special rules for making certain finance leasing transitional rule elections. The election relating to finance leases under Act section 1801(a)(1) (Code section 168(i) as in effect before October 22, 1986) shall be made by the lessor under a lease agreement subject to the finance lease rules of section 168(i) of the Code, as in effect before October 22, 1986, by noting this election in the books and records relating to the lease agreement within 12 months after February 5, 1987.

• (viii) Special rules for making the election relating to the date leased property is treated as originally placed in service. The election under Act section 1809(e)(2) (Code section 48(b)(2)) must be made jointly by the lessee and the lessor. The election is made jointly when both the lessee and the lessor make the election in accordance with paragraphs (a)(2) and (a)(3)(i) of this section. In addition to the other information required to be provided under paragraph (a)(3)(i) of this section, the statement described therein shall include a copy of the lease agreement and shall be signed by both the lessee and the lessor.

• (ix) Special rules for making the election to be treated as a resident alien. The election under Act section 1810(l)(4) (Code section 7701(b)) to be treated as a resident under Code setion 7701(b) shall be made by an alien individual by attaching a statement to the individual's income tax return (Form 1040), for the taxable year for which the election is to be in effect (the election year). The alien individual may not make this election until such time as he has satisfied the substantial presence test of Code section 7701(b)(1)(A)(ii) for the year following the election year. If an alien individual has not satsified the substantial presence test for the year following the election year as of the due date (without regard to extensions) of the tax return for the election year, the alien individual may request an extension of time for filing the return until after he has satisfied such test, provided that he pays with his extension application the amount of tax he expects to owe for the election year, computed as if he were a non-resident alien throughout the election year. The statement shall include the name and address of the alien individual and contain a signed declaration that the election is being made. It must specify-

  • (A) That the alien individual was not a resident in the year immediately preceding the election year;

  • (B) That the alien individual is a resident in the year immediately following the election year under the substantial presence test and the individual's number of days of presence in the United States during such year;

  • (C) The date or dates of the alien individual's 31 consecutive day period of presence and continuous presence in the United States during the election year; and

  • (D) The date or dates of absence from the United States during the election year that are deemed to be days of presence.

• (x) Special rules for making the election with respect to the treatment of the exercise of certain nonqualified stock options. The election under Act section 1879(p)(1) (Code section 83(c)(3)) is made by filing on Form 1040X a claim for credit or refund of the overpayment of tax resulting from the election. In order to satisfy the requirements of §301.6402-2(b)(1) (relating to grounds set forth in claim), the claim for credit or refund must set forth)-

  • (A) The date on which the option was granted,

  • (B) The name of the corporation which granted the option,

  • (C) The date on which the stock was transferred pursuant to the exercise of the option,

  • (D) The fiar market value of such stock on December 4, 1973,

  • (E) The fair market value on July 1, 1974 of the stock received upon the reorganization of the corporation which granted the option, and

  • (F) The date on which the taxpayer sold substantially all of the stock received in such reorganization. The taxpayer shall file a single claim for credit or refund of the entire overpayment of tax resulting from the election under Act section 1879(p)(1).

(4) Revocation-(i) Irrevocable elections.

The elections described in this section under Act sections 201(a) (Code sections 168(b)(5), 168(f)(1), 168(g)(7), and 168(h)(6)(F)(ii)), 203(a)(1)(B), 252(a) (Code sections 42(f)(1), 42(g)(1), 42(i)(2), and 42(j)(5)), 411(b)(1) (Code section 263(i)), 411(b)(2)(A) (Code section 616(d)(2)(A)), 501(a) (Code section 469(j)(9)), 801(d)(2), 905(c), 1301(b) (Code sections 141(b)(9), 142(d)(1), 142(d)(4)(B), 143(k)(9)(D)(iii), 145(d), and 147(b)(4)(A)), 1431(a) (Code section 2652(a)(3)), 1704(b), 1802(a) (Code section 168(j) as in effect before October 22, 1986), 1804(e)(4), 1879(p)(1) (Code section 83(c)(3)), and 1882(C) (Code section 3121(w)(2)) are irrevocable.

• (ii) Elections revocable with the consent of the Commissioner. The elections described in this section under Act sections 204(e), 243(a), 243(b), 243(a)(b), 411(b)(2)(B) (Code section 617(h)(2)(A)), 614(b) (Code section 1059(c)(4)), 621(a) (Code section 382(l)(5)(H)), 644(d) (Code section 216(b)(3)), 646, 651 (Code section 4982(e)(4)(B)), 701(a) (Code section 56(f)(3)(B)), 801(a) (Code section 448(d)(4)), 802 (Code section 474), 803(a) (Code section 263A(d)(3)), 806(e)(2)(C) (and the election described in H.R. Rep. No. 99-841 at II-320), 811(a) (Code sections 453C(b)(2)(B) (i) and 453C(e)(4)), 901(a) (Code sections 585(c)(3)(B)(ii) and 585(c)(4)), 905(a) (Code section 165(l)(1)), 1801(a) (Code section 168(i) as in effect before October 22, 1986), 1807(a)(7) (Code section 468B), 1809(e)(2) (Code section 48(b)(2)), and 1810(l)(4) (Code section 7701(b)) are revocable only with the consent of the Commissioner.

• (iii) Freely revocable elections. The elections described in this section under Act sections 311(d)(2) and 1431(a) (Code section 2632(b)(3)) are freely revocable.

(b) Elections with respect to the low-income housing credit.

The elections under Act section 252 (a) (Code sections 42(f)(1), 42(g)(1), 42(i)(2), and 42(j)(5)) must be made for the taxable year in which the project is placed in service and shall be made in the certification required to be filed pursuant to section 42(l)(1).

(c) Election to have the rules of section 263A (relating to capitalization and inclusion in inventory costs of certain expenses) not apply to any plant or animal produced in any farming business conducted by the electing taxpayer-(1) In general.

This paragraph applies to the election under Act section 803(a) (Code section 263A(d)(3)) to have the rules of section 263A (relating to capitalization and inclusion in inventory costs of certain expenses) not apply to any plant or animal produced in any farming business conducted by the electing taxpayer. The election is available to taxpayers engaged in the business of farming, including producers of agricultural crops, livestock, nursery stock, sod, trees bearing fruit, nuts or other crops, and ornamental trees (for purposes of section 263A, an evergreen tree that is more than 6 years old at the time it is severed from the roots shall not be treated as an ornamental tree). The election is not available to a corporation, partnership, or tax shelter that is required to use the accrual method of accounting under section 447 or section 448(a)(3), or farming syndicates (as defined in section 464(c)), or with respect to the planting, cultivation, maintenance or development of pistachio trees. In addition, the election does not apply with respect to costs incurred for the planting, cultivation, maintenance or development of any citrus or almond grove incurred during the 4-taxable-year period beginning with the taxable year in which such grove was planted. If a citrus or almond grove is planted in more than one taxable year, the portion of the grove planted in one taxable year is treated as a separate grove for this purpose.

(2) Time and manner of making the election.

Unless consent is obtained from the that begins after December 31, 1986, and during which the taxpayer engages in a farming business. The election shall be made on the Schedule E, F or other schedule required to be attached to the income tax return for the first taxable year for which the election is effective. In the case of a partnership or S corporation, the election must be made at the partner or shareholder level.

(3) Election treated as if made if certain requirements satisfied.

A taxpayer eligible to make the election under section 263A(d)(3) shall be treated as having made the election if such taxpayer reports income and expense in accordance with the rules under the election on a timely filed income tax return.

(4) Revocation.

Once the election is made, it is revocable only with the consent of the Commissioner.

(5) Special rules for treatment of expenses.

If the election is made, the plant or animal produced is treated as section 1245 property and gain is recaptured (treated as ordinary income) in the amount of deductions which, but for the election, would have been required to be capitalized with respect to the plant or animal. If the taxpayer or a related person makes the election, a non-accelerated method of depreciation (as defined in section 168(g)(2)) shall be applied to all property used predominantly in any farming business of the taxpayer or related person and placed in service in any taxable year during which the election is in effect. For purposes of this election, related party means: (i) the members of the taxpayer's family (defined for this purpose to include the spouse of the taxpayer and any of this or her children who have not reached the age of 18 as of the last day of the taxable year); (ii) any corporation (including an S corporation) 50 percent or more of the value of which is owned directly or indirectly (through the application of section 318) by the taxpayer or members of the taxpayer's family; (iii) any corporation that is a member of the same controlled group (within the meaning of section 1563) as the taxpayer; and

• (iv) any partnership if 50 percent or more of the value of the interests in such partnership is owned directly or indirectly (through the application of section 318) by the taxpayer or members of the taxpayer's family.

(d) Election with respect to the treatment of net income for the short taxable year resulting from a required change in accounting period.

This paragraph applies to the election under secton 806(e)(2)(C) of the Act. Net income for the short taxable year resulting form a required change in accounting period under the provisions of section 806 of the Act which is to be included ratably in the partners' and S corporation shareholders' income for the first four taxable years (including the short taxable year) beginning after December 31, 1986, or included entirely in income for the short taxable year at the election of the partner or shareholder, shall be taken into account in accordance with section 702 (with respect to partners) and section 1366 (with respect to S corporation shareholders).

(e) Election with respect to reducing partnership or S corporation income for the short taxable year resulting from a required change in accounting period under section 806 of the Act by an unamortized adjustment amount existing as of October 22, 1986.

-(1) In general. This paragraph applies to the election described in H.R. Rep. No. 99-841 at II-320.

(2) Partnerships or S corporations that make the election to reduce income for the short taxable year by an unamortized adjustment amount existing as of October 22, 1986.

Where a partnership or S corporation elects to reduce its income for the short taxable year required under the provisions of section 806 of the Act by the unamortized adjustment amount existing as of October 22, 1986, in accordance with paragraph (a) of this section, the income for the short taxable year (reduced by the unamortized adjustment amount) may then be subject to the election, under section 806(e)(2)(C) of the Act, by partners and S corporation shareholders to include all the net income for the short taxable year entirely in income for the partners' or shareholders' taxable year with or within which the short taxable year ends.

(3) Partnership or S corporations that do not make the election to reduce income for the short taxable year by an unamortized adjustment amount existing as of October 22, 1986.

Where a partnership or S corporation does not elect to reduce its income for the short taxable year created by the provisions of section 806 of the Act by the unamortized adjustment amount existing as of October 22, 1986, as provided in paragraph (a) of this section, the short taxable year required under the provisions of section 806 of the Act shall be considered one taxable year for purposes of amortizing the adjustment amount under the requirements of Rev. Proc. 72-51, 1972-2 C.B. 832, or Rev. Proc. 83-25, 1983-1 C.B. 689. The net income of the partnership or S corporation after reduction by the adjustment amount for the short taxable year may then be subject to the election under section 806(e)(2)(C) of the Act by partners or S corporation shareholders to include all the net income for the short taxable year entirely in income for the partners' or shareholders' taxable year with or within which the short taxable year of the partnership or S corporation ends.

(f) Election with respect to the treatment of certain losses in insolvent financial institutions-(1) In general.

This paragraph applies to the election under Act section 905(a) (Code section 165(l)(1)). If-

• (i) As of the close of the taxable year, it can reasonably be estimated that there is a loss on a deposit of a qualified individual (as defined in section 165(l)(2)) in a qualified financial institution (as defined in section 165(l)(3)), and

• (ii) Such loss is on account of the bankruptcy or insolvency of such institution, then the qualified individual may elect to treat the entire amount so estimated for that taxable year (disregarding any amount treated as a casualty loss under section 165(c)(3) in a previous taxable year) as a loss year. The election shall apply to all losses of the qualified individual on deposits in the institution with respect to which an election is made, and section 166 (relating to bad debts) shall not apply to any loss with respect to which an election is made.

(2) Time and manner of making the election.

The election may be made by claiming such loss on the tax return for any taxable year in which a reasonable estimate of such loss can be made. If the qualified individual does not claim such loss on the tax return for that taxable year, the qualified individual may not subsequently amend the tax return for that taxable year to claim such loss for that taxable year. However, for a tax return filed with respect to a taxable year beginning after December 31, 1982, but before January 1, 1986, the qualified individual may subsequently (before the expiration of the period prescribed for filing a claim for credit or refund) amend the tax return for that taxable year to claim such loss for that taxable year.

(3) Revocability of the election.

This election may be revoked only with the consent of the Commissioner.

• (g) Elections with respect to certain bonds. The elections under Act section 1301(b) (Code sections 141(b)(9), 142(d)(1), 142(d)(4)(B), 143(k)(9)(D)(iii), 145(d), and 147(b)(4)(A)) must be made in the §5h.5 (g) bond indenture or a related document (as defined in §1.103-13(b)(8)) on or before the date of issue. With respect to obligations issued on or before March 9, 1987 these elections must be made on or before March 9, 1987 and need not be made in the bond indenture or a related document, but must be made in writing and retained as part of the issuer's books and records.

• (h) Revocation of the election for exemption from social security taxes by certain clergy-(1) In general. This paragraph applies to the election under Act section 1704(b) to revoke an election under section 1402(e)(1) of the Code by a duly ordained, commissioned, or licensed minister of a church, a member of a religious order (other than a member of a religious order who has taken a vow of poverty as a member of such order), or a Christian Science practitioner. Only elections which are effective for the taxable year containing October 22, 1986 may be revoked under this paragraph.

(2) Time for revoking the election.

The election shall be revoked by filing Form 2031 before the date on which the individual becomes entitled to benefits under sections 202(a) or 223 of the Social Security Act (without regard to sections 202(j)(1) or 223(b) of such Act), and not later than the due date of the Federal income tax return (including any extension thereof) for the individual's first taxable year beginning after October 22, 1986.

(3) Manner of revoking the election.

To revoke an election under section 1402(a)(1), the individual shall file Form 2031 in accordance with the instructions accompanying that form. The revocation shall be made effective, as designated by the individual on the form, either with respect to the individual's first taxable year beginning after October 22, 1986.

(4) Special rules for payment of self-employment taxes with respect to certain taxable years ending on or after October 22, 1986-(i) Elections filed after the due date of the Federal income tax return.

In Form 2031 is filed on or after the due date of the Federal income tax return (including any extension thereof) for the individual's first taxable year ending on or after October 22, 1986, and the election made therein is effective with respect to that taxable year, Form 2031 shall be accompanied by an amended Federal income tax return for such taxable year together with payment in full of an amount equal to the total of the taxes that would have been imposed by section 1401 of the Code with respect to all of the individual's income derived in that taxable year which would have constituted net earnings from self-employment for purposes of chapter 2 of subtitle A of the Code (notwithstanding paragraph (4) or (5) of section 1402(c)) but for the exemption under section 1402(e)(1).

• (ii) Elections filed before the due date of the Federal income tax return. If Form 2031 is filed before the due date of the Federal income tax return (including any extension thereof) for the individual's first taxable year ending on or after October 22, 1986, and the election is effective with respect to that taxable year, payment in full of an amount equal to the total of the taxes that would have been imposed by section 1401 of the Code with respect to all of the individual's income derived in that taxable year which would have constituted net earnings from self-employment for purposes of chapter 2 of the subtitle A of the Code (notwithstanding paragraph (4) or (5) of section 1402(c)) but for the exemption under section 1402(e)(1) shall be made:

  • (A) In the case of Forms 2031 that are filed on or before the date on which the individual's Federal income tax return for such first taxable year is filed, with the individual's Federal income tax return for such taxable year; and

  • (B) In the case of Forms 2031 that are filed after the date on which the individual's Federal income tax return for such first taxable year is filed, with an amended Federal income tax return for that taxable year filed on or before the due date for the individual's Federal income tax return (including any extension thereof) for such taxable year.

• (iii) Interest on amounts paid after the due date of the Federal income tax return. If any amount of tax imposed by section 1401 for an individual's taxable year with respect to which an election under this paragraph (h) is effective is paid after the due date of the individual's Federal income tax return (without regard to extensions) for such taxable year, interest will be assessed on such tax from the due date of such return (without regard to extensions) to the date on which such tax is paid.

(5) Revocability of the revocation of the election.

Once having filed Form 2031, the individual may not thereafter file an application for an exemption under section 1402(e)(1).

(6) Effective date of this provision.

This provision shall apply with respect to remuneration received in the taxable years for which the individual designates the revocation to be effective, as described in paragraph (h)(3) of this section, and with respect to monthly insurance benefits payable under title II of the Social Security Act on the basis of the wages and self-employment income of any individual for months in or after the calendar year in which such individual's application for revocation is effective (and lump-sum death payments payable under such title on the basis of such wages and self-employment income in the case of deaths occurring in or after such calendar year).

• (i) Revocation of the election for exemption from social security taxes by certain churches on qualified church-controlled organizations-(1) In general. This paragraph applies to the election under Act section 1882 (Code section 3121 (w)(2)) to revoke an election under section 3121(w) by a church or qualified church-controlled organization (as defined in section 3121(w)(3)).

(2) Time and manner of revoking the election.

The revocation described in this paragraph (i) shall be made by filing a Form 941 on or before the due date for filing Form 941 (without regard to extensions) for the first quarter for which the revocation is to be effective, accompanied by payment in full of the taxes that would be due for that quarter had there been no election under section 3121(w). See paragraph(i)(4) of this section for the effective date of revocation made under this paragraph (i).

(3) Revocability of the revocation of the election.

Once an election under section 3121(w) is revoked under this paragraph (i), a new election under section 3121(w) may not be made.

(4) Effective date of this paragraph.

A revocation made under this paragraph (i) shall be effective for the quarter of the calendar year covered by the Form 941 on which the revocation is made in accordance with paragraph (i)(2) of this section and all subsequent quarters. However, no revocation shall be effective prior to January 1, 1987 unless such electing church or church-controlled organization had withheld and paid over all employment taxes due, as if such election had never been in effect, during the period from the effective date of the election being revoked through December 31, 1986.

• (j) Additional information required. Later regulations or revenue procedures issued under provisions of the Code or Act covered by this section may require the furnishing of information in addition to that which was furnished with the statement of election described in this section. In such event, the later regulations or revenue procedures will provide guidance with respect to the furnishing of such additional information. (26 U.S.C. 7805). 26 U.S.C. 7805. table "§5h.5 . . . 1545-0982". There is need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason, it is found impractical to issue this Treasury decision with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection

• (d) of that section. O. Donaldson Chapoton, Acting Assistant Secretary of the Treasury.

June 22, 1987

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document provides temporary regulations concerning the low-income housing credit under section 42 of the Internal Revenue Code of 1986, as enacted by the Tax Reform Act of 1986 (Pub. L. 99-514). These regulations provide guidance concerning the State low-income housing credit authority limitation. In addition, the text of the temporary regulations set forth in this document serves as the comment document for the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

EFFECTIVE DATE

The regulations apply to buildings placed in service after December 31, 1986, in taxable years ending after that date.

FOR FURTHER INFORMATION CONTACT

Robert Beatson of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224 (Attention: CC:LR:T LR-82-86) (202-566-3829, not a toll-free call).

SUPPLEMENTARY INFORMATION

Background

This document contains temporary regulations relating to the low-income housing credit under section 42 of the Internal Revenue Code of 1986 as enacted by section 252 of the Tax Reform Act of 1986 (Pub. L. 99-514). New §1.42-1T is added by this document to Part 1 of Title 26 of the Code of Federal Regulations. The temporary regulations provided by this document will remain in effect until superseded by final regulations on this subject.

Explanation of Provisions

Section 252 of the Tax Reform Act of 1986 enacted a new low-income housing credit equal to the applicable percentage of the qualified basis of each qualified low-income building. The temporary regulations provide guidance with respect to the State housing credit ceiling, the special set-aside for qualified nonprofit organization projects, apportionment of housing credit dollar amounts among housing credit agencies within each State, the time and manner for making housing credit allocations to qualified low-income buildings, the manner in which housing credit allocations are taken into account by owners of qualified low-income buildings, rules for low-income housing financed in whole or in part with tax-exempt bonds, termination of authority to make housing credit allocations, information reporting, and certain definitional issues.

Non-Applicability of Executive Order

12291 The Commission of Internal Revenue has determined that these temporary regulations are not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required.

Regulatory Flexibility Act

No general notice of proposed rulemaking is required by 5 U.S.C. 553(b) because these are temporary regulations, and there is a need to provide the public with immediate guidance. Accordingly, the Regulatory Flexibility Act does not apply and no Regulatory Flexibility Analysis is required for this rule.

Paperwork Reduction Act

The collection of information contained in these regulations has been submitted to the Office of Management and Budget (OMB) in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB (Control no. 1545-0988).

Drafting Information

The principal author of these regulations is Robert Beatson of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and the Treasury Department participated in developing the regulations on matters of both substance and style.

List of Subjects

26 CFR 1.0-1-1.58-8 Income taxes, Tax liability, Tax rates, Credits. 26 CFR Part 602 Reporting and recordkeeping requirements.

Amendments to the Regulations

The amendments to 26 CFR Parts 1 and 602 are as follows:

PART 1-INCOME TAX REGULATIONS

Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority:

Par. 2. A new §1.42-1T is added immediately following §1.41-8 to read as follows:

§1.42-1T Limitation on low-income housing credit allowed with respect to

§1.103-8(b)(4)(iii) for the meaning of the term "functionally related and

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

Par. 3. The authority citation for Part 602 continues to read as follows:

Authority:

§602.101 [Amended]

Par. 4. Section 602.101(c) is amended by inserting in the appropriate place in the

Lawrence B. Gibbs,

Commissioner of Internal Revenue.

Approved: June 4, 1987. 26 U.S.C. 7805. Section 1.42-1T also issued under 26 U.S.C. 42 (m). qualified low-income buildings receiving housing credit allocations from a State or local housing credit agency (temporary).

(a) In general-(1) Determination of amount of low-income housing credit.

Section 42 provides that, for purposes of section 38, a low-income housing credit is determined for a building in an amount equal to the applicable percentage of the qualified basis of the qualified low-income building. In general, the credit may be claimed annually for a 10-year credit period, beginning with the taxable year in which the building is placed in service or, at the election of the taxpayer, the succeeding taxable year. If, after the first year of the credit period, the qualified basis of a building is increased in excess of the qualified basis upon which the credit was initially determined, the allowable credit with respect to such additional qualified basis is determined using a credit percentage equal to two-thirds of the applicable percentage for the initial qualified basis. The credit for additions to qualified basis is generally allowable for the remaining years in the 15-year compliance period which begins with the first taxable year of the credit period for the building. In general, the low-income housing credit is available with respect to buildings placed in service after December 31, 1986, in taxable years ending after that date. See section 42 for the definitions of "qualified low-income building", "applicable percentage", "qualified basis", "credit period", "compliance period", and for other rules relating to determination of the amount of the low-income housing credit.

(2) Limitation on low-income housing credit allowed.

Generally, the low-income housing credit determined under section 42 is allowed and may be claimed for any taxable year if, and to the extent that, the owner of a qualified low-income building receives a housing credit allocation from a State or local housing credit agency. The aggregate amount of housing credit allocations that may be made in any calendar year by all housing credit agencies within a State is limited by a State housing credit ceiling, or volume cap, described in paragraph (b) of this section. The authority to make housing credit allocations within the State housing credit ceiling may be apportioned among the State and local housing credit agencies, under the rules prescribed in paragraph (c) of this section. Upon apportionment of the State housing credit volume cap, each State or local housing credit agency receives an aggregate housing credit dollar amount that may be used to make housing credit allocations among qualified low-income buildings located within an agency's geographic jurisdiction. The rules governing the making of housing credit allocations by any state or local housing credit agency are provided in paragraph (d) of this section. Housing credit allocations are required to be taken into account by owners of qualified low-income buildings under the rules prescribed in paragraph (e) of this section. Exceptions to the requirement that a qualified low-income building receive a housing credit allocation from a State or local housing credit agency are provided in paragraph (f) of this section. Rules regarding termination of the authority of State and local housing credit agencies to make housing credit allocations after December 31, 1989, are specified in paragraph (g) of this section. Rules concerning information reporting by State and local housing credit agencies and owners of qualified low- income buildings are provided in paragraph (h) of this section. Special statutory transitional rules are incorporated into this section of the regulations as described in paragraph (i) of this section.

(b) The State housing credit ceiling.

The aggregate amount of housing credit allocations that may be made in any calendar year by all State and local housing credit agencies within a State may not exceed the State's housing credit ceiling for such calendar year. The State housing credit ceiling for each State for any calendar year is equal to $1.25 multiplied by the State's population. A State's population for any calendar year is determined by reference to the most recent census estimate (whether final or provisional) of the resident population of the State released by the Bureau of the Census before the beginning of the calendar year for which the State's housing credit ceiling is set. Unless otherwise prescribed by applicable revenue procedure, determinations of population are based on the most recent estimates of population contained in the Bureau of the Census publication, "Current Population Reports, Series P-25: Population Estimates and Projections, Estimates of the Population of States". For purposes of this section, the District of Columbia and United States possessions are treated as States.

(c) Apportionment of State housing credit ceiling among State and local housing credit agencies-(1) In general.

A State's housing credit ceiling for any calendar year is apportioned among the State and local housing credit agencies within such State under the rules prescribed in this paragraph. A "State housing credit agency" is any State agency specifically authorized by gubernatorial act or State statute to make housing credit allocations on behalf of the State and to carry out the provisions of section 42(h). A "local housing credit agency" is any agency of a political subdivision of the State that is specifically authorized by a State enabling act to make housing credit allocations on behalf of the State or political subdivision and to carry out the provisions of section 42(h). A "State enabling act" is any gubernatorial act, State statute, or State housing credit agency regulation (if authorized by gubernatorial act or State statute). A State enabling act enacted on or before October 22, 1986, the date of enactment of the Tax Reform Act of 1986, shall be given effect for purposes of this paragraph if such State enabling act expressly carries out the provisions of section 42(h).

(2) Primary apportionment.

Except as otherwise provided in paragraphs (c) (3) and

(4) of this section, a State's housing credit ceiling is apportioned in its entirety to the State housing credit agency.

Such an apportionment is the "primary apportionment" of a State's housing credit ceiling. There shall be no primary apportionment of the State housing credit ceiling and no grants of housing credit allocations in such State until a State housing credit agency is authorized by gubernatorial act or State statute. If a State has more than one State housing credit agency, such agencies shall be treated as a single agency for purposes of the primary apportionment. In such a case, the State housing credit ceiling may be divided among the multiple State housing credit agencies pursuant to gubernatorial act or State statute.

(3) States with 1 or more constitutional home rule cities-(i) In general.

Notwithstanding paragraph (c)(2) of this section, in any State with 1 or more constitutional home rule cities, a portion of the State housing credit ceiling is apportioned to each constitutional home rule city. In such a State, except as provided in paragraph (c)(4) of this section, the remainder of the State housing credit ceiling is apportioned to the State housing credit agency under paragraph (c)(2) of this section. See paragraph (c)(3)(iii) of this section. The term "constitutional home rule city" means, with respect to any calendar year, any political subdivision of a State that, under a State constitution that was adopted in 1970 and effective on July 1, 1971, had home rule powers on the first day of the calendar year.

• (ii) Amount of apportionment to a constitutional home rule city. The amount of the State housing credit ceiling apportioned to a constitutional home rule city for any calendar year is an amount that bears the same ratio to the State housing credit ceiling for that year as the population of the constitutional home rule city bears to the population of the entire State. The population of any constitutional home rule city for any calendar year is determined by reference to the most recent census estimate (whether final or provisional) of the resident population of the constitutional home rule city released by the Bureau of the Census before the beginning of the calendar year for which the State housing credit ceiling is apportioned. However, determinations of the population of a constitutional home rule city may not be based on Bureau of the Census estimates that do not contain estimates for all of the constitutional home rule cities within the State. If no Bureau of the Census estimate is available for all such constitutional home rule cities, the most recent decennial census of population shall be relied on. Unless otherwise prescribed by applicable revenue procedure, determinations of population for constitutional home rule cities are based on estimates of population contained in the Bureau of the Census publication, "Current Population Reports, Series P-26: Local Population Estimates".

• (iii) Effect of apportionments to constitutional home rule cities on apportionments to other housing credit agencies. The aggregate amounts of the State housing credit ceiling apportioned to constitutional home rule cities under this paragraph (c)(3) reduce the State housing credit ceiling available for apportionment under paragraph (c) (2) or (4) of this section. Unless otherwise provided in a State constitutional amendment or by law changing the home rule provisions adopted in a manner provided by the State constitution, the power of the governor or State legislature to apportion the State housing credit ceiling among local housing credit agencies under paragraph (c)(4) of this section shall not be construed as allowing any reduction of the portion of the State housing credit ceiling apportioned to a constitutional home rule city under this paragraph (c)(3). However, any constitutional home rule city may agree to a reduction in its apportionment of the State housing credit ceiling under this paragraph (c)(3), in which case the amount of the State housing credit ceiling not apportioned to the constitutional home rule city shall be available for apportionment under paragraph (c) (2) or (4) of this section.

• (iv) Treatment of governmental authority within constitutional home rule city. For purposes of determining which agency within a constitutional home rule city receives the apportionment of the State housing credit ceiling under this paragraph (c)(3), the rules of this paragraph (c) shall be applied by treating the constitutional home rule city as a "State", the chief executive officer of a constitutional home rule city as a "governor", and a city council as a "State legislature". A constitutional home rule city is also treated as a "State" for purposes of the set-aside requirement for housing credit allocations to projects involving a qualified nonprofit organization. See paragraph (c)(5) of this section for rules governing set-aside requirements. In this connection, a constitutional home rule city may agree with the State housing credit agency to exchange an apportionment set aside for projects involving a qualified nonprofit organization for an apportionment that is not so restricted. In such a case, the authorizing gubernatorial act, State statute, or State housing credit agency regulation (if authorized by gubernatorial act or State statute) must ensure that the set-aside apportionment transferred to the State housing credit agency be used for the purposes described in paragraph (c)(5) of this section.

(4) Apportionment to local housing credit agencies-(i) In general.

In lieu of the primary apportionment under paragraph (c)(2) of this section, all or a portion of the State housing credit ceiling may be apportioned among housing credit agencies of governmental subdivisions. Apportionments of the State housing credit ceiling to local housing credit agencies must be made pursuant to a State enabling act as defined in paragraph (c)(1) of this section. Apportionments of the State housing credit ceiling may be made to housing credit agencies of constitutional home rule cities under this paragraph (c)(4), in addition to apportionments made under paragraph (c)(3) of this section. Apportionments of the State housing credit ceiling under this paragraph (c)(4) need not be based on the population of political subdivisions and may, but are not required to, give balanced consideration to the low-income housing needs of the entire State.

• (ii) Change in apportionments during a calendar year. The apportionment of the State housing credit ceiling among State and local housing credit agencies under this paragraph (c)(4) may be changed after the beginning of a calendar year, pursuant to a State enabling act. No change in apportionments shall retroactively reduce the housing credit allocations made by any agency during such year. Any change in the apportionment of the State housing credit ceiling under this paragraph (c)(4) that occurs during a calendar year is effective only to the extent housing credit agencies have not previously made housing credit allocations during such year from their original apportionments of the State housing credit ceiling for such year. To the extent apportionments of the State housing credit ceiling to local housing credit agencies made pursuant to this paragraph (c)(4) for any calendar year are not used by such local agencies before a certain date (e.g., November 1) to make housing credit allocations in such year, the amount of unused apportionments may revert back to the State housing credit agency for reapportionment. Such reversion must be specifically authorized by the State enabling act.

• (iii) Exchanges of apportionments. Any State or local housing credit agency that receives an apportionment of the State housing credit ceiling for any calendar year under this paragraph (c)(4) may exchange part or all of such apportionment with another State or local housing credit agency to the extent no housing credit allocations have been made in such year from the exchanged portions. Such exchanges must be made with another housing credit agency in the same State and must be consistent with the State enabling act. If an apportionment set aside for projects involving a qualified nonprofit organization is transferred or exchanged, the transferee housing credit agency shall be required to use the set-aside apportionment for the purposes described in paragraph (c)(5) of this section.

• (iv) Written records of apportionments. All apportionments, exchanges of apportionments, and reapportionments of the State housing credit ceiling which are authorized by this paragraph (c)(4) must be evidenced in the written records maintained by each State and local housing credit agency.

(5) Set-aside apportionments for projects involving a qualified nonprofit organization-(i) In general.

Ten percent of the State housing credit ceiling for a calendar year must be set aside exclusively for projects involving a qualified nonprofit organization (as defined in paragraph (c)(5)(ii) of this section). Thus, at least 10 percent of apportionments of the State housing credit ceiling under paragraphs (c) (2) and (3) of this section must be used only to make housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization. In the case of apportionments of the State housing credit ceiling under paragraph (c)(4) of this section, the State enabling act must ensure that the apportionment of at least 10 percent of the State housing credit ceiling be used exclusively to make housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization. The State enabling act shall prescribe which housing credit agencies in the State receive apportionments that must be set aside for making housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization. These set-aside apportionments may be distributed disproportionately among the State or local housing credit agencies receiving apportionments under paragraph (c)(4) of this section. The 10-percent set- aside requirement of this paragraph (c)(4) is a minimum requirement, and the State enabling act may set aside more than 10 percent of the State housing credit ceiling for apportionment to housing credit agencies for exclusive use in making housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization.

• (ii) Projects involving a qualified nonprofit organization. The term "projects involving a qualified nonprofit organization" means projects with respect to which a qualified nonprofit organization is to materially participate (within the meaning of section 469(h)) in the development and continuing operation of the project throughout the 15-year compliance period. The term "qualified nonprofit organization" means any organization that is described in section 501(c) (3) or (4), is exempt from tax under section 501(a), and includes as one of its exempt purposes the fostering of low- income housing.

(6) Expiration of unused apportionments.

Apportionments of the State housing credit ceiling under this paragraph (c) for any calendar year may be used by housing credit agencies to make housing credit allocations only in such calendar year. Any part of an apportionment of the State housing credit ceiling for any calendar year that is not used for housing credit allocations in such year expires as of the end of such year and does not carry over to any other year. However, any part of an apportionment for 1989 that is not used to make a housing credit allocation in 1989 may be carried over to 1990 and used to make a housing credit allocation to a qualified low-income building described in section 42(n)(2)(B). See paragraph (g)(2) of this section.

(d) Housing credit allocations made by State and local housing credit agencies-(1) In general.

This paragraph governs State and local housing credit agencies in making housing credit allocations to qualified low-income buildings. The amount of the apportionment of the State housing credit ceiling for any calendar year received by any State or local housing credit agency under paragraph (c) of this section constitutes the agency's aggregate housing credit dollar amount for such year. The aggregate amount of housing credit allocations made in any calendar year by a State or local housing credit agency may not exceed such agency's aggregate housing credit dollar amount for such year. A State or local housing credit agency may make housing credit allocations only to qualified low-income buildings located within the agency's geographic jurisdiction.

(2) Amount of a housing credit allocation.

In making a housing credit allocation, a State or local housing credit agency must specify a credit percentage, not to exceed the building's applicable percentage determined under section 42(b), and a qualified basis amount. The amount of the housing credit allocation for any building is the product of the specified credit percentage and the specified qualified basis amount. In specifying the credit percentage and qualified basis amount, the State or local housing credit agency shall not take account of the first-year conventions described in section 42(f) (2)(A) and (3)(B). A State or local housing credit agency may adopt rules or regulations governing conditions for specification of less than the maximum credit percentage and qualified basis amount allowable under section 42 (b) and (c), respectively. For example, an agency may specify a credit percentage and a qualified basis amount of less than the maximum credit percentage and qualified basis amount allowable under section 42 (b) and (c), respectively, when the financing and rental assistance from all sources for the project of which the building is a part is sufficient to provide the continuing operation of the building without the maximum credit amount allowable under section 42.

(3) Counting housing credit allocations against an agency's aggregate housing credit dollar amount.

The aggregate amount of housing credit allocations made in any calendar year by a State or local housing credit agency may not exceed such agency's aggregate housing credit dollar amount (i.e., the agency's apportionment of the State housing credit ceiling for such year). This limitation on the aggregate dollar amount of housing credit allocations shall be computed separately for set-aside apportionments received pursuant to paragraph (c)(5) of this section. Housing credit allocations count against an agency's aggregate housing credit dollar amount without regard to the amount of credit allowable to or claimed by an owner of a building in the taxable year in which the allocation is made or in any subsequent year. Thus, housing credit allocations (which are computed without regard to the first-year conventions as provided in paragraph (d)(2) of this section) count in full against an agency's aggregate housing credit dollar amount, even though the first-year conventions described in section 42(f) (2)(A) and (3)(B) may reduce the amount of credit claimed by a taxpayer in the first year in which a credit is allowable. See also paragraph (e)(2) of this section. Housing credit allocations count against an agency's aggregate housing credit dollar amount only in the calendar year in which made and not in subsequent taxable years in the credit period or compliance period during which a taxpayer may claim a credit based on the original housing credit allocation. Since the aggregate amount of housing credit allocations made in any calendar year by a State or local housing credit agency may not exceed such agency's aggregate housing credit dollar amount, an agency shall at all times during a calendar year maintain a record of its cumulative allocations made during such year and its remaining unused aggre gate housing credit dollar amount.

(4) Rules for when applications for housing credit allocations exceed an agency's aggregate housing credit dollar amount.

A State or local housing credit agency may adopt rules or regulations governing the awarding of housing credit allocations when an agency expects that applicants during a calendar year will seek aggregate allocations in excess of the agency's aggregate housing credit dollar amount. The State enabling act may provide uniform standards for the awarding of housing credit allocations when there is actual or anticipated excess demand from applicants in any calendar year.

(5) Reduced or additional housing credit allocations-(i) In general.

A State or local housing credit agency may not reduce or rescind a housing credit allocation made to a qualified low-income building in the manner prescribed in paragraph (d)(8) of this section. Thus, a housing credit agency may not reduce or rescind a housing credit allocation made to a qualified low-income building which is acquired by a new owner who is entitled to a carryover of the allowable credit for such building under section 42(d)(7). A housing credit agency may make additional housing credit allocations to a building in any year in the building's compliance period, whether or not there are additions to qualified basis for which an increased credit is allowable under section 42(f)(3). Each additional housing credit allocation made to a building is treated as a separate allocation and is subject to the rules and requirements of this section. However, in the case of an additional housing credit allocation made with respect to additions to qualified basis for which an increased credit is allowable under section 42(f)(3), the amount of the allocation that counts against the agency's aggregate housing credit dollar amount shall be computed as if the specified credit percentage were unreduced in the manner prescribed in section 42(f)(3)(A) and the specified qualified basis amount were unreduced by the first-year convention prescribed in section 42(f)(3)(B).

• (ii) Examples. The rules of paragraph (d)(5)(i) of this section may be illustrated by the following examples: Example (1). For 1987, the County L Housing Credit Agency has an aggregate housing credit dollar amount of $2 million. D, an individual, places in service on July 1, 1987, a new qualified low-income building. As of the close of each month in 1987 in which the building is in service, the building consists of 100 residential rental units, of which 20 units are both rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income. The total floor space of the residential rental units is 120,000 square feet, and the total floor space of the low-income units is 20,000 square feet. Tne building is not Federally subsidized within the meaning of section 42(i)(2). As of the end of 1987, the building has eligible basis under section 42(d) of $1 million. Thus, the qualified basis of the building determined without regard to the first-year convention provided in section 42(f) is $166,666.67 (i.e., $1 million eligible basis times 1/6 , the floor space fraction which is required to be used instead of the larger unit fraction). However, the amount of the low-income housing credit determined for 1987 under section 42 reflects the first-year convention provided in section 42(f)(2). Since the building has the same floor space and unit fractions as of the close of each of the six months in 1987 during which it is in service, upon applying the first-year convention in section 42(f)(2), the qualified basis of the building in 1987 is $83,333.33 (i.e., $1 million eligible basis times 1/12 , the fraction determined under section 42(f)(2)(A)). Under paragraph (d)(2) of this section, the County L Housing Credit Agency may make a housing credit allocation by specifying a credit percentage, not to exceed 9 percent, and a qualified basis amount, which may be greater or less than the qualified basis of the building in 1987 as determined under section 42(c), without regard to the first-year convention provided in section 42(f)(2). If the County L Housing Credit Agency specifies a credit percentage of 8 percent and a qualified basis amount of $100,000, the amount of the housing credit allocation is $8,000. Under paragraph (d)(3) of this section, the County L Housing Credit Agency's aggregate housing credit dollar amount for 1987 is reduced by $8,000, notwithstanding that D is entitled to claim less than $8,000 of the credit in 1987 under the rules in paragraph (e) of this section. Under paragraph (e)(2) of this section, in 1987 D is entitled to claim only $4,000 of the credit, determined by applying the first-year convention of %p6/12%p to the specified qualified basis amount contained in the housing credit allocation (i.e., .08 x $100,000 x (%p6/12%p )). Example (2). The facts are the same as in Example (1) except that on July 1, 1988, the number of occupied low-income units increases to 50 units and the floor space of the occupied low-income units increases to 48,000 square feet. These occupancy fractions remain unchanged as of the close of each month remaining in 1988. Under section 42(c), the qualified basis of the building in 1988, without regard to the first- year convention in section 42(f)(3)(B), is $400,000 (i.e., $1 million eligible basis times .4, the floor space fraction which is required to be used instead of the larger unit fraction). D's 1987 housing credit allocation from the County L Housing Credit Agency remains effective in 1988 and entitles D to a credit of $8,000 (i.e., .08, the specified credit percentage, times $100,000, the specified qualified basis amount). With respect to the additional $300,000 of qualified basis which the 1987 housing credit allocation does not cover, D must apply to the County L Housing Credit Agency for an additional housing credit allocation. Assume that the County L Housing Credit Agency has a sufficient aggregate housing credit dollar amount for 1988 to make a housing credit allocation to D in 1988 by specifying a credit percentage of 9 percent and a qualified basis amount of $300,000. The amount of the housing credit allocation that counts against the County L Housing Credit Agency's aggregate housing credit dollar amount is $27,000 (i.e., the amount counted (.09 times $300,000) is unreduced in the manner prescribed in section 42(f)(3) (A) and (B)). Since D's qualified basis in 1987 was $166,666.67, D is entitled to claim a credit in 1988 with respect to such basis of $14,000 (i.e., .08 x $100,000, the 1987 credit alllocation, +. 09 x $66,666.67, the 1988 credit allocation). In addition, D is entitled to claim a credit in 1988 and subsequent years in the 15-year compliance period with respect to the additional $233,333.33 of qualified basis cove red by the 1988 housing credit allocation. However, the allowable credit for 1988 with respect to this amount of additional qualified basis is subject to reductions prescribed in section 42(f)(3) (A) and (B). Thus, D is entitled in 1988 to a credit at a 6-percent rate applied to $116,666.67 of additional qualified basis, which is reduced to reflect the first-year convention. D's total allowable low-income housing credit in 1988 is $21,000 (i.e., $14,000 with respect to original qualified basis × $7,000 with respect to 1988 additions to qualified basis). If the County L Housing Credit Agency had specified an 8-percent credit percentage in 1988 with respect to the qualified basis not covered by the 1987 housing credit allocation to D, D's allowable credit with respect to the $233,333.33 of additions to qualified basis would not exceed, in 1988 and subsequent years, an amount determined by applying a specified credit percentage of 5.33 percent (i.e., two-thirds of 8 percent). In 1988, D's specified qualified basis amount would be adjusted for the first-year convention.

(6) No carryover of unused aggregate housing credit dollar amount.

Any portion of a State or local housing credit agency's aggregate housing credit dollar amount for any calendar year that is not used to make a housing credit allocation in such year may not be carried over to any other year, except as provided in paragraph (g) of this section. An agency may not permit owners of qualified low-income buildings to transfer housing credit allocations to other buildings. However, an agency may provide a procedure whereby owners may return to the agency, prior to the end of the calendar year in which housing credit allocations are made, unusable portions of such allocations. In such a case, an owner's housing credit allocation is deemed reduced by the amount of the allocation returned to the agency, and the agency may reallocate such amount to other qualified low-income buildings prior to the end of the year.

(7) Effect of housing credit allocations in excess of an agency's aggregate housing credit dollar amount.

In the event that a State or local housing credit agency makes housing credit allocations in excess of its aggregate housing credit dollar amount for any calendar year, the allocations shall be deemed reduced (to the extent of such excess) for buildings in the reverse order in which such allocations were made during such year.

(8) Time and manner for making housing credit allocations.

-(i) Time. Housing credit allocations are effective for the calendar year in which made in the manner prescribed in paragraph (d)(8)(ii) of this section. A State or local housing credit agency may not make a housing credit allocation to a qualified low-income building prior to the calendar year in which such building is placed in service. An agency may adopt its own procedures for receiving applications for housing credit allocations from owners of qualified low-income buildings. An agency may provide a procedure for making, in advance of a building's being placed in service, a binding commitment (e.g., by contract, inducement resolution, or other means) to make a housing credit allocation in the calendar year in which a qualified low-income building is placed in service or in a subsequent calendar year. Any advance commitment shall constitute a housing credit allocation for purposes of this section.

• (ii) Manner. Housing credit allocations are deemed made when Part I of IRS Form 8609, Low-Income Housing Credit Allocation Certification, is completed and signed by an authorized official of the housing credit agency and mailed to the owner of the qualified low-income building. A copy of all completed (as to Part I) Form 8609 allocations along with a single completed Form 8610, Annual Low-Income Housing Credit Agencies Report, must also be mailed to the Internal Revenue Service not later than the 28th day of the second calendar month after the close of the calendar year in which the housing credit was allocated to the qualified low-income building. Housing credit allocations to a qualified low-income building must be made on Form 8609 and must include-

  • (A) The address of the building;

  • (B) The name, address, and taxpayer identification number of the housing credit agency making housing credit allocation;

  • (C) The name, address, and taxpayer identification number of the owner of the qualified low-income building;

  • (D) The date of the allocation of housing credit;

  • (E) The housing credit dollar amount allocated to the building on such date;

  • (F) The specified maximum applicable credit percentage allocated to the building on such date;

  • (G) The specified maximum qualified basis amount;

  • (H) The percentage of the aggregate basis financed by tax-exempt bonds taken into account for purposes of the volume cap under section 146;

  • (I) A certification under penalties of perjury by an authorized State or local housing credit agency official that the allocation is made in compliance with the requirements of section 42(h); and

  • (J) Any additional information that may be required by Form 8609 or by an applicable revenue procedure. See paragraph (h) of this section for additional rules concerning filing of forms.

• (iii) Certification. The certifying official for the State or local housing credit agency need not perform an independent investigation of the qualified low-income building in order to certify on Part I of Form 8609 that the housing credit allocation meets the requirements of section 42(h). For example, the certifying official may rely on information contained in an application for a low-income housing credit allocation submitted by the building owner which sets forth facts necessary to determine that the building is eligible for the low-income housing credit under section 42.

• (iv) Fee. A State or local housing credit agency may charge building owners applying for housing credit allocations a reasonable fee to cover the agency's administrative expenses for processing applications.

• (v) No continuing agency responsibility. The State or local housing credit agency need not monitor or investigate the continued compliance of a qualified low-income building with the requirements of section 42 throughout the applicable compliance period.

(e) Housing credit allocation taken into account by owner of a qualified low-income building-(1) Time and manner for taking housing credit allocation into account.

An owner of a qualified low-income building may not claim a low-income housing credit determined under section 42 in any year in excess of an effective housing credit allocation received from a State or local housing credit agency. A housing credit allocation made to a qualified low-income building is effective with respect to any owner of the building beginning with the owner's taxable year in which the housing credit allocation is received. A housing credit allocation is deemed received in a taxable year, except as modified in the succeeding sentence, if that allocation si made (in the manner described in paragraph (d)(8) of this section) not later than the earlier of (i) the 60th day after the close of the taxable year, or (ii) the close of the calender year in which such taxable year ends. A housing credit allocation is deemed received in a taxable year ending in 1987, if such allocation is made (in the manner described in paragraph (d)(8) of this section) on or before December 31, 1987. A housing credit allocation is not effective for any taxable year if received in a calendar year which ends prior to when the qualified low-income building is placed in service. A housing credit allocation made to a qualified low-income building remains effective for all taxable years in the compliance period. A taxpayer is required to complete the Form 8609 on which a housing credit agency made the applicable housing credit allocation and submit a copy of such Form 8609 with its Federal income tax return for each year in the compliance period. Failure to comply with the requirement of the preceding sentence with respect to any taxable year after the first taxable year in the credit period shall be treated as a mathematical or clerical error for purposes of the provisions of section 6213 (b)(1) and (g)(2).

(2) First-year convention limitation on housing credit allocation taken into account.

For purposes of the limitation that the allowable low-income housing credit may not exceed the effective housing credit allocation received from a State or local housing credit agency, as provided in paragraph (e)(1) of this section, the amount of the effective housing credit allocation shall be adjusted by applying the first-year convention provided in section 42(f)(2)(A) and (3)(B) and the percentage credit reduction provided in section 42(f)(3)(A). Under paragraphs (d) (2) and (5) of this section, the State of local housing credit agency must specify the credit percentage and qualified basis amount, the product of which is the amount of the housing credit allocation, without taking account of the first-year convention described in section 42(f)(2)(A) and (3)(B) or the percentage credit reduction prescribed in section 42(f)(3)(A). However, for purposes of the limitation on the amount of the allowable low-income housing credit, as provided in paragraph (e)(2) of this section, in a taxable year in which the first-year convention applies to the amount of credit determined under section 42(a), the specified qualified basis amount shall be adjusted by the first-year convention fraction which is equal to the number of full months (during the first taxable year) in which the building was in service divided by 12. In addition, for purposes of the limitation on the amount of the allowable low- income housing credit, as provided in paragraph (e)(1) of this section, in a taxable year in which the reduction in credit percentage applies to additions to qualified basis, as prescribed in section 42(f)(3), the specified credit percentage shall be reduced by one-third. See examples in paragraphs (d)(5)(ii) and (e)(3)(ii) of this section.

(3) Use of excess housing credit allocation for increases in qualified basis-(i) In general.

If the housing credit allocation made to a qualified low-income building exceeds the amount of credit allowable with respect to such building in any taxable year (without regard to the first-year conventions under section 42(f)), such excess is not transferable to another qualified low-income building. However, if in a subsequent year there are increases in the qualified basis for which an increased credit is allowable under section 42(f)(3) at a reduced credit percentage, the original housing credit allocation (including the specified credit percentage and qualified basis amount) would be effective with respect to such increased credit.

• (ii) Example. The provisions of this paragraph (e)(3) may be illustrated by the following example: Example. In 1987, a newly-constructed qualified low-income building receives a housing credit allocation of $90,000 based on a specified credit percentage of 9 percent and a specified qualified basis amount of $1,000,000. The building is placed in service in 1987, but the qualified basis in such year is only $800,000, resulting in an allowable credit in 1987 (determined without regard to the first-year conventions) of $72,000. In 1988, the qualified basis is increased to $1,100,000, resulting in an additional credit allowable under section 42(f)(3) (without regard to the first-year conventions) of $18,000 (i.e., $300,000 × .06, or 2/3 of .09). The unused portion of the 1987 housing credit allocation ($18,000) is effective in 1988 and in each subsequent year in the compliance period only with respect to the specified qualified basis for the 1987 housing credit allocation ($1,000,000). Thus, the owner is allowed to claim a credit in 1988 and in each subsequent year (without regard to the first- year conventions), based on the effective housing credit allocation from 1987, of $84,000 (i.e., $72,000 + ($200,000 × .06)). The owner of the qualified low-income building must obtain a new housing credit allocation in 1988 with respect to the additional $100,000 of qualified basis in order to claim a credit on such basis in 1988 and in each subsequent year. If the applicable first-year convention under section 42(f)(3)(B) entitled the owner in 1988 to only 1/2 of the otherwise applicable credit for the additions to qualified basis, under paragraph (e)(2) of this section the owner is allowed to claim a credit in 1988, based on the effective housing credit allocation from 1987, of $78,000 (i.e., $72,000 + ($200,000 × .06 × .5)).

(4) Separate housing credit allocations for new buildings and increases in qualified basis.

Separate housing credit allocations must be received for each building with respect to which a housing credit may be claimed. Rehabilitation expenditures with respect to a qualified low-income building are treated as a separate new building under section 42(e) and must receive a separate housing credit allocation. Increases in qualified basis in a qualified low-income building are not generally treated as a new building for purposes of section 42. To the extent that a prior housing credit allocation received with respect to a qualified low-income building does not allow an increased credit with respect to an increase in the qualified basis of such building, an additional housing credit allocation must be received in order to claim a credit with respect to that portion of increase in qualified basis. See paragraph (e)(3) of this section. The amount of credit allowable with respect to an increase in qualified basis is subject to the credit percentage limitation of section 42(f)(3)(A) and the first-year convention of section 42(f)(3)(B). See paragraph (d)(5) of this section for a rule requiring that the State or local housing credit agency count a housing credit allocation made with respect to an increase in qualified basis as if the specified credit percentage were unreduced in the manner prescribed in section 42(f)(3) and the specified basis amount were unreduced by the first-year convention prescribed in section 42(f)(3)(B).

(5) Acquisition of building for which a prior housing credit allocation has been made.

If a carryover credit would be allowable to an acquirer of a qualified low-income building under section 42(d)(7), such acquirer need not obtain a new housing credit allocation with respect to such building. Under section 42(d)(7), the acquirer would be entitled to claim only such credits as would have been allowable to the prior owner of the building.

(6) Multiple housing credit allocations.

A qualified low-income building may receive multiple housing credit allocations from different housing credit agencies having overlapping jurisdictions. A qualified low-income building that receives a housing credit allocation set aside exclusively for projects involving a qualified nonprofit organization may also receive a housing credit allocation from a housing credit agency's aggregate housing credit dollar amount that is not so set aside.

(f) Exception to housing credit allocation requirement-(1) Tax-exempt bond financing-(i) In general.

No housing credit allocation is required in order to claim a credit under section 42 with respect to that portion of the eligible basis (as defined in section 42(d)) of a qualified low-income building that is financed with the proceeds of an obligation described in section 103(a) ("tax-exempt bond") which is taken into account for purposes of the volume cap under section 146. In addition, no housing credit allocation is required in order to claim a credit under section 42 with respect to the entire qualified basis (as defined in section 42(c)) of a qualified low-income building if 70 percent or more of the aggregate basis of the building and the land on which the building is located is financed with the proceeds of tax-exempt bonds which are taken into account for purposes of the volume cap under section 146. For purposes of this paragraph, "land on which the building is located" includes only land that is functionally related and subordinate to the qualified low-income building. See subordinate". For purposes of this paragraph, the basis of the land shall be determined using principles that are consistent with the rules contained in section 42(d).

• (ii) Determining use of bond proceeds. For purposes of determining the portion of proceeds of an issue of tax-exempt bonds used to finance (A) the eligible basis of a qualified low-income building, and (B) the aggregate basis of the building and the land on which the building is located, the proceeds of the issue must be allocated in the bond indenture or a related document (as defined in §1.103-13(b)(8)) in a manner consistent with the method used to allocate the net proceeds of the issue for purposes of determining whether 95 percent or more of the net proceeds of the issue are to be used for the exempt purpose of the issue. If the issuer is not consistent in making this allocation throughout the bond indenture and related documents, or if neither the bond indenture nor a related document provides an allocation, the proceeds of the issue will be allocated on a pro rata basis to all of the property financed by the issue, based on the relative cost of the property.

• (iii) Example. The provisions of this paragraph may be illustrated by the following example: Example. In 1987, County K assigns $500,000 of its volume cap for private activity bonds under section 146 to a $500,000 issue of exempt facility bonds to provide a qualified residential rental project to be owned by A, an individual. The aggregate basis of the building and the land on which the building is located is $700,000. Under the terms of the bond indenture, the net proceeds of the issue are to be used to finance $490,000 of the eligible basis of the building. More than 70 percent of the aggregate basis of the qualified low-income building and the land on which the building is located is financed with the proceeds of tax-exempt bonds to which a portion of the volume cap under section 146 was allocated. Accordingly, A may claim a credit under section 42 without regard to whether any housing credit dollar amount was allocated to that building. If, instead, the aggregate basis of the building and land were $800,000, A would be able to claim the credit under section 42 without receiving a housing credit allocation for the building only to the extent that the credit was attributable to eligible basis of the building financed with tax-exempt bonds.

• (g) Termination of authority to make housing credit allocation-(1) In general. No State or local housing credit agency shall receive an apportionment of a State housing credit ceiling for calendar years after 1989. Consequently, no housing credit allocations may be made after 1989, except as provided in paragraph (g)(2) of this section. Housing credit allocations made prior to January 1, 1990, remain effective after such date.

(2) Carryover of unused 1989 apportionment.

Any State or local housing credit agency that has an unused portion of its apportionment of the State housing credit ceiling for 1989 from which housing credit allocations have not been made in 1989 may carry over such unused portion into 1990. Such carryover portion of the 1989 apportionment shall be treated as the agency's apportionment for 1990. From this 1990 apportionment, the State or local housing credit agency may make housing credit allocations only to a qualified low-income building meeting the following requirements:

• (i) The building must be constructed, reconstructed, or rehabilitated by the taxpayer seeking the allocation;

• (ii) More than 10 percent of the reasonably anticipated cost of such construction, reconstruction, or rehabilitation must have been incurred as of January 1, 1989; and

• (iii) The building must be placed in service before January 1, 1991.

(3) Expiration of exception for tax-exempt bond financed projects.

The exception to the requirement that a housing credit allocation be received with respect to any portion of the eligible basis of a qualified low-income building, as provided in paragraph (f) of this section, shall not apply to any building placed in service after 1989, unless such building is described in paragraph (g)(2) (i), (ii), and (iii) of this section.

• (h) Filing of forms and special rules-(1) Completed form. For purposes of this section, a form shall be treated as completed if the State or local housing credit agency or the building owner has made a good faith effort to complete the form in accordance with the form and the instructions for the form.

(2) Manner of filing.

A completed Form 8586, Low-Income Housing Credit, shall be filed with the owner's Federal income tax return for each taxable year the owner of a qualified low-income building is claiming the low-income housing credit during the 10-year credit period. A completed Form 8609 (or copy thereof) shall be filed with the owner's Federal income tax return for each of the 15 taxable years in the compliance period. If a housing credit allocation is not required to be received by an owner under paragraph (f) of this section, the owner shall obtain a blank copy of Form 8609 and fill in the address of the building and the name and address of the owner in Part I. Part II of Form 8609 shall be completed by the owner of the qualified low-income building only for the first year the low-income housing credit is claimed by the building owner. Part III of Form 8609 (Statement of Qualification) shall be completed by the owner of the qualified low-income building for each year of the 15- year compliance period.

(3) Revised or renumbered forms.

If any form is revised or renumbered, any reference in this section to the form shall be treated as a reference to the revised or renumbered form.

• (i) Transitional rules. The transitional rules contained in section 252(f)(1) of the Tax Reform Act of 1986 are incorporated into this section of the regulations for purposes of determining whether a qualified low-income building is entitled to receive a housing credit allocation or is excepted from the requirement that a housing credit allocation be received. Housing credit allocations made to qualified low-income buildings described in section 252(f)(1) shall not count against the State or local housing credit agency's aggregate housing credit dollar amount. The transitional rules contained in section 252(f)(2) of the Tax Reform Act of 1986 are incorporated into this section of the regulations for purposes of determining amounts available to certain State or local housing credit agencies for the making of housing credit allocations to certain qualified low-income housing projects. Amounts available to housing credit agencies under section 252(f)(2) shall be treated as special apportionments unavailable for housing credit allocations to qualified low-income buildings not described ni section 252(f)(2). Housing credit allocations made from the special apportionments shall not count against the State or local credit agency's aggregate housing credit dollar amount. The set-aside requirements shall not apply to these special apportionments. The transitional rules contained in section 252(f)(3) of the Tax Reform Act 1986 are incorporated in this section of the regulations for purposes of determining the amount of housing credit allocations received by certain qualified low-income buildings. Housing credit allocations deemed received under section 252(f)(3) shall not count against the State or local housing credit agency's aggregate housing credit dollar amount. ACT 26 U.S.C. 7805. table "§1.42-1T . . . 1545-0988". J. Roger Mentz, Assistant Secretary of the Treasury

July 02, 1987

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary regulations relating to the allocation of interest expense among a taxpayer's expenditures. Changes to the applicable tax law were made by the Tax Reform Act of 1986 (the "Act"). The temporary regulations affect taxpayers subject to the passive loss limitation, the investment interest limitation, or the disallowance of deductions for personal interest and provide them with the guidance needed to comply with the law. The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations for the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register.

EFFECTIVE DATE

The temporary regulations are effective with respect to interest expense paid or accrued in taxable years beginning after December 31, 1986.

FOR FURTHER INFORMATION CONTACT

Michael J. Grace of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224, Attention: CC:LR:T, (202) 566-3288 (not a toll-free call).

SUPPLEMENTARY INFORMATION

Background

This document amends the Income Tax Regulations (26 CFR Part 1) to provide temporary rules relating to the allocation of interest expense for purposes of applying the limitations on passive activity losses and credits, investment interest, and personal interest. The temporary regulations reflect the amendment of the Internal Revenue Code of 1986 (the "Code") by sections 501 and 511 of the Act (100 Stat. 2233 and 2244), which added sections 469 (relating to the limitation on passive activity losses and credits) and 163(h) (relating to the disallowance of deductions for personal interest) and amended section 163(d) (relating to the limitation on investment interest). Section 469 provides that deductions from passive activities generally may not offset income other than passive income. Section 163(d)(1) limits the investment interest deduction of a noncorporate taxpayer for any taxable year to the taxpayer's net investment income for the taxable year. Section 163(h)(1) disallows deductions for personal interest paid or accrued by a noncorporate taxpayer. Qualified residence interest described in section 163(h)(3) does not constitute personal interest. Section 469(e)(1)(A)(i)(III) provides that in determining the income or loss from any passive activity there shall not be taken into account interest expense properly allocable to certain items of gross income including gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. Section 469(k)(4) provides that the Secretary of the Treasury shall prescribe such regulations as may be necessary or appropriate to carry out the provisions of section 469, including regulations which provide for the determination of the allocation of interest expense for purposes of section 469. The Joint Explanatory Statement of the Committee of Conference accompanying the Act (the "Conference Report") states that the conferees anticipate the Treasury will issue regulations providing guidance to taxpayers with respect to interest allocation. The Conference Report further provides that these regulations should be consistent with the purpose of the passive loss rules to prevent sheltering of income from personal services and portfolio investments with passive losses, and that the regulations should attempt to avoid inconsistent allocations of interest deductions under different Code provisions. Although regulations allocating interest expense are specifically authorized by section 469(k)(4), these regulations are being published under section 163 because it is believed most taxpayers seeking guidance concerning the tax treatment of interest expense will first consult the regulations under section 163. Scope of Rules These temporary regulations prescribe rules for allocating interest expense for purposes of applying the passive loss limitation and the limitations on investment interest and personal interest. Except as otherwise specifically provided, these rules do not control the allocation of interest for other purposes (e.g., the windfall profit tax). Other limitations on the deductibility of interest expense generally apply without regard to the manner in which interest expense is allocated under the temporary regulations. Thus, for example, section 265(a)(2) may disallow deductions for interest expense allocated under the temporary regulations to an expenditure in connection with a trade or business producing taxable income. Similarly, section 263A(f) may require the capitalization of interest allocated under the temporary regulations to a noncapital expenditure. (The temporary regulations provide, however, that interest expense allocated to a personal expenditure cannot be capitalized.) Interest expense may also be deferred to a later year by one of the other limitations on the deductibility of interest (by the operation, for example, of section 267(a)(2)). In that case, the interest expense is allocated to expenditures under the temporary regulations as it would have been had the deferral provision not applied, but is not taken into account for purposes of applying the passive loss, investment interest and personal interest limitations until the taxable year in which the deferral provision ceases to apply. Qualified residence interest is deductible without regard to the manner in which such interest is allocated under these rules. Allocation Rules in General Interest expense on a debt is allocated in the same manner as the debt to which the interest relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. Thus, the allocation of interest is not affected by the use of an interest in any property to secure repayment of the debt to which the interest relates. The regulations provide specific rules for determining the manner in which debt is allocated if the debt proceeds are deposited to the borrower's account. Rules are also provided for cases in which debt proceeds are not disbursed to the borrower (as in the case of seller financing) or in which the borrower receives debt proceeds in cash. Interest expense generally is subject to the limitation applicable to the expenditure to which the underlying debt is allocated. Thus, for example, if debt proceeds are allocated to an expenditure in connection with a passive activity, any otherwise allowable deduction for interest expense on the debt is subject to the passive loss limitation. Specific Rules for Allocation of Debt If debt proceeds are deposited to the borrower's account, and the account also contains unborrowed funds, the debt generally is allocated to expenditures by treating subsequent expenditures from the account as made first from the debt proceeds to the extent thereof. If the proceeds of two or more debts are deposited in the account, the proceeds are treated as expended in the order in which they were deposited. There are two exceptions to this rule. First, a taxpayer may treat any expenditure made from an account within 15 days after debt proceeds are deposited in the account as made from those proceeds to the extent thereof. Second, if an account consists solely of debt proceeds and interest income on the proceeds, the taxpayer may treat any expenditure as made first from the interest income to the extent of such income at the time of the expenditure. Special rules apply if the debt proceeds are not disbursed to the borrower. If the lender disburses the proceeds directly to a person selling property or providing services to the borrower, the disbursement is treated as an expenditure from the debt proceeds. If the debt does not involve cash disbursements (as in the case of assumptions or seller financing), the debt is treated as if the borrower had made an expenditure from the debt proceeds for the property, services, or other purpose to which the debt relates. A taxpayer may treat any cash expenditure made within 15 days after receiving debt proceeds in cash as made from the debt proceeds. In any other case, debt proceeds received in cash are treated as used to make personal expenditures. Treatment of Amounts Held in an Account Amounts held in an account are treated as property held for investment, regardless of whether the account bears interest. Thus, debt is allocated to an investment expenditure when the debt proceeds are deposited in an account. Debt allocated to such an investment expenditure is reallocated in accordance with the rules described above when the debt proceeds are expended from the account. In general, the reallocation occurs on the date of the expenditure, but the taxpayer may elect to reallocate the debt as of the first day of the month in which the expenditure occurs (or the day on which the debt proceeds are deposited in the account, if later). A taxpayer may use this first-day-of-the-month convention only if all other expenditures from the account during that month are similarly treated. Repayments and Refinancings Debt repayments are applied against the debt in a manner intended to minimize the limitations on the deductibility of interest expense. For example, if a debt is allocated to a personal expenditure and an expenditure in connection with a passive activity, a repayment will be applied first against the portion of the debt allocated to the personal expenditure. A special rule applies in the case of a repayment made from the proceeds of another debt. To the extent the proceeds of the other debt are used for the repayment, such debt is allocated to the expenditures to which the repaid debt was allocated. The normal allocation rules apply, however, to the extent proceeds of the debt are used for purposes other than the repayment. Reallocation of Debt Debt allocated to an expenditure properly chargeable to capital account with respect to an asset must be reallocated whenever the asset is sold or the nature of the use of the asset changes. For example, if a debt-financed asset used in a trade or business is converted to personal use, the debt must be reallocated to a personal expenditure. If the proceeds from the disposition of an asset exceed the amount of debt allocated to the asset, the proceeds from the disposition are treated in the same manner as an account containing both borrowed and unborrowed funds. The extent to which expenditures from this account are made from debt proceeds is determined under the normal allocation rules. A similar rule applies in the case of deferred payment sales. Debt in Connection with Passthrough Entities Interest expense of partnerships and S corporations, and of partners and S corporation shareholders, is generally allocated in the same manner as the interest expense of other taxpayers. Special rules will be provided, however, for cases in which partnerships and S corporations distribute debt proceeds to interest holders in the entity, and for cases in which taxpayers incur debt to acquire or increase their interests in partnerships or S corporations. The treatment of these transactions is not addressed in these temporary regulations because the Internal Revenue Service is still studying the interest-allocation issues such transactions raise and invites public comment. Mass Asset Situations The temporary regulations provide that debt allocated to an asset must be reallocated when the asset is sold or the nature of the use of the asset changes (for example, from use in a passive activity to use in a former passive activity). The Internal Revenue Service realizes that the application of this rule may be difficult in the case of taxpayers who continually acquire and dispose of debt-financed inventory or other assets and invites public comment on possible ways to facilitate administrability of the rule. Transitional Rules The temporary regulations apply to interest expense paid or accrued in taxable years beginning after December 31, 1986, regardless of when the underlying debt was incurred. In certain cases, however, the manner in which interest expense is allocated may be determined under a transitional rule. The first transitional rule applies to expenditures made on or before August 3, 1987. Under this transitional rule, a taxpayer may treat any expenditure made from an account within 90 days after debt proceeds are deposited in the account or any cash expenditure made within 90 days after receiving debt proceeds in cash as made from the debt proceeds to the extent thereof. As previously described, the rules applicable to expenditures made after August 3, 1987 permit taxpayers to treat an expenditure in this manner only if it is made within 15 days after the debt proceeds are deposited or received in cash. Under the second transitional rule, debt outstanding on December 31, 1986, that is properly attributable to a business or rental activity is allocated to the assets held for use or sale to customers in such business or rental activity. Debt is properly attributable to a business or rental activity for purposes of this transitional rule if the taxpayer has properly and consistently deducted interest expense (including interest expense subject to limitation under section 163(d) before its amendment by section 511 of the Act) on the debt on Schedule C, E, or F of Form 1040 in computing income or loss from the business or rental activity for taxable years beginning before January 1, 1987. Debt subject to the second transitional rule must be allocated among assets in a reasonable and consistent manner. Examples of allocations of debt that are not reasonable and consistent include (i) an allocation of debt to goodwill in excess of the basis of the goodwill, and (ii) an allocation of debt to an asset in excess of the fair market value of the asset if the amount of debt allocated to any other asset is less than the fair market value (lesser of basis or fair market value in the case of goodwill) of such other asset. A market value in the case of goodwill) of such other asset. A taxpayer shall specify the manner in which debt is allocated under this second transitional rule by attaching an allocation statement to the taxpayer's return for the first taxable year beginning after December 31, 1986. If the taxpayer does not file an allocation statement or fails to allocate the debt in a reasonable and consistent manner, the Commissioner will allocate the debt. Debt allocated to an asset under the second transitional rule may be repaid or refinanced after December 31, 1986, or there may be a disposition or change in use of the asset after that date. The effect of these events is determined under the normal repayment, refinancing and reallocation rules. Thus, for example, if an asset is sold after December 31, 1986, any debt allocated to the asset under the second transitional rule must be reallocated. Similarly, a repayment or refinancing of debt subject to the transitional rule is treated in the same manner as a repayment or refinancing of any other debt. The second transitional rule does not apply if the taxpayer elects to allocate debt outstanding on December 31, 1986, based on the use of the debt proceeds (taking into account the first transitional rule). The election not to apply the transitional rule is made by attaching an election statement to the taxpayer's return for the first taxable year beginning after December 31, 1986. In addition, the applicability of the transitional rule may be limited in the case of debt of a partnership or S corporation used to fund a distribution or loan to a partner or shareholder. Transitional issues with respect to such debt will be addressed in the special rules to be provided for passthrough entities. Alternative Allocation Methods and Possible Antiabuse Rules In developing the tracing method of interest allocation in these temporary regulations, the Internal Revenue Service seriously considered allocation based on pro rata apportionment of interest expense among a taxpayer's assets. Pro rata apportionment accords with the notion that money is fungible, regardless of whether borrowed or earned, and is used in certain Code provisions such as section 864(e). Depending on the apportionment base, recordkeeping requirements may be less burdensome than under a tracing regime. An apportionment approach may also result in lower transaction costs because taxpayers would have less incentive to arrange borrowings and expenditures based on the tax consequences. Despite these possible advantages, the Service rejected pro rata apportionment for a number of reasons. First, there is not theoretically or practically satisfactory overall apportionment base. The use of either adjusted or unadjusted basis as an apportionment base could distort the amount of debt associated with particular assets. Apportionment based on the fair market value of assets might result in more appropriate allocations, but would also require burdensome and otherwise unnecessary appraisals of asset value. Second, in order to apportion the proper amount of interest expense to consumer assets, taxpayers would be required to determine and report either the basis or fair market value of all consumer assets. Many taxpayers would consider such requirements unduly intrusive and burdensome. In addition, it would be extremely difficult to enforce such requirements. Third, any general apportionment base would have to be adjusted in various ways in order to allocate a reasonable amount of interest to noncapital expenditures. For example, to maintain the integrity of the rule that personal interest is not deductible, it might be necessary to apportion some interest to personal consumption. Similarly, labor-intensive businesses would be disadvantaged relative to capital-intensive businesses unless expenditures for noncapital items such as salaries, supplies, and research and development were capitalized for interest allocation purposes. Finally, a rule apportioning debt among all of a taxpayer's assets would distort certain economic decisions by ignoring the fact that such decisions are made by comparing the marginal cost of borrowing, the marginal return from an expenditure, and the opportunity costs of liquidating other assets in order to make the expenditure with unborrowed funds. Despite the practical and theoretical problems that a comprehensive pro rata apportionment system would present, the Service is not foreclosing the possibility that future regulations may impose some form of pro rata apportionment. The Service recognizes that some taxpayers will attempt to manipulate the tracing rules in the temporary regulations to maximize their interest deductions. For example, a sole proprietor may be able to maximize the amount of fully deductible interest expense allocated to trade or business expenditures by borrowing to pay business expenses and making personal expenditures from business receipts. Similarly, upper-income taxpayers may have sufficient liquidity to make business and investment expenditures from borrowed funds and personal expenditures from unborrowed funds. Finally, the fact that the allocation of interest expense is not affected by the use of any property to secure repayment of a debt may permit manipulation. For example, a taxpayer may use unborrowed funds to purchase an automobile for personal use, incur debt secured by that asset, and use the debt proceeds to replace the unborrowed funds. The Service therefore is considering rules to prevent abuses of the tracing method. For example, taxpayers whose gross income and total interest expense exceed specified amounts might be treated as having a minimum amount of personal interest. Alternatively, such taxpayers might be required to allocate interest expense based on pro rata apportionment. The rule that the security for a debt is irrelevant for purposes of allocating interest expense on the debt might be modified in certain cases involving debt secured by an asset and incurred within a short period of time after the purchase of the asset. The Service invites comment on these approaches and on other possible methods of preventing abuses of the rules in the temporary regulations.

Special Analyses

The Commissioner of Internal Revenue has determined that this temporary rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required. A general notice of proposed rulemaking is not required by 5 U.S.C. 553 for temporary regulations. Accordingly, the temporary regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6). The collection of information requirements contained in this regulation have been submitted to the Office of Management and Budget (OMB) in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB.

Drafting Information

The principal author of these temporary regulations is Michael J. Grace of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing regulations on matters of both substance and style.

List of Subjects

26 CFR 1.61-1-1.281-4 Income taxes, Taxable income, Deductions, Exemptions. 26 CFR Part 602 Reporting and recordkeeping requirements. Adoption of amendments to the regulations For the reasons set out in the preamble, Subchapter A, Part 1, and Subchapter H,

Part 602, of Title 26, Chapter 1 of the Code of Federal Regulations are amended as

Part 1-[Amended]

Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority:

Par. 2. The following new section is added to Part 1 in the appropriate place:

§1.163-8T Allocation of interest expense among expenditures (temporary).

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

Par. 3. The authority for Part 602 continues to read as follows:

Authority:

§602.101 [Amended]

Par. 4. Section 602.101(c) is amended by inserting in the appropriate place in the

Lawrence B. Gibbs,

Commissioner of Internal Revenue.

Approved: June 15, 1987. set forth below: Income Tax Regulations 26 U.S.C. 7805. Section 1.163-8T also issued under 26 U.S.C. 469 (k)(4).

(a) In general-(1) Application.

This section prescribes rules for allocating interest expense for purposes of applying sections 469 (the "passive loss limitation") and 163

• (d) and (h) (the "nonbusiness interest limitations").

(2) Cross-references.

This paragraph provides an overview of the manner in which interest expense is allocated for the purposes of applying the passive loss limitation and nonbusiness interest limitations and the manner in which interest expense allocated under this section is treated. See paragraph (b) of this section for definitions of certain terms, paragraph (c) for the rules for allocating debt and interest expense among expenditures, paragraphs (d) and (e) for the treatment of debt repayments and refinancings, paragraph (j) for the rules for reallocating debt upon the occurrence of certain events, paragraph (m) for the coordination of the rules in this section with other limitations on the deductibility of interest expense, and paragraph (n) of this section for effective date and transitional rules.

(3) Manner of allocation.

In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures.

(4) Treatment of interest expenses-(i) General rule.

Except as otherwise provided in paragraph (m) of this section (relating to limitations on interest expense other than the passive loss and nonbusiness interest limitations), interest expense allocated under the rules of this section is treated in the following manner:

• (A) Interest expense allocated to a trade or business expenditure (as defined in paragraph (b)(7) of this section) is taken into account under section 163 (h)(2)(A);

• (B) Interest expense allocated to a passive activity expenditure (as defined in paragraph (b)(4) of this section) or a former passive activity expenditure (as defined in paragraph (b)(2) of this section) is taken into account for purposes of section 469 in determining the income or loss from the activity to which such expenditure relates;

• (C) Interest expense allocated to an investment expenditure (as defined in paragraph (b)(3) of this section) is treated for purposes of section 163(d) as investment interest;

• (D) Interest expense allocated to a personal expenditure (as defined in paragraph (b)(5) of this section) is treated for purposes of section 163(h) as personal interest; and

• (E) Interest expense allocated to a portfolio expenditure (as defined in paragraph (b)(6) of this section) is treated for purposes of section 469(e)(2)(B)(ii) as interest expense described in section 469(e)(1)(A)(i)(III).

• (ii) Examples. The following examples illustrate the application of this paragraph (a)(4): Example (1). Taxpayer A, an individual, incurs interest expense allocated under the rules of this section to the following expenditures: $6,000 Passive activity expenditure.$4,000 Personal expenditure. The $6,000 interest expense allocated to the passive activity expenditure is taken into account for purposes of section 469 in computing A's income or loss from the activity to which such interest relates. Pursuant to section 163(h), A may not deduct the $4,000 interest expense allocated to the personal expenditure (except to the extent such interest is qualified residence interest, within the meaning of section 163(h)(3)). Example (2). (i) Corporation M, a closely held C corporation (within the meaning of section 469 (j)(1)) has $10,000 of interest expense for a taxable year. Under the rules of this section, M's interest expense is allocated to the following expenditures: $2,000 Passive activity expenditure.$3,000 Portfolio expenditure. $5,000 Other expenditures.

• (ii) Under section 163(d)(3)(D) and this paragraph (a)(4), the $2,000 interest expense allocated to the passive activity expenditure is taken into account in computing M's passive activity loss for the taxable year, but, pursuant to section 469(e)(1) and this paragraph (a)(4), the interest expense allocated to the portfolio expenditure and the other expenditures is not taken into account for such purposes.

• (iii) Since M is a closely held C corporation, its passive activity loss is allowable under section 469(e)(2)(A) as a deduction from net active income. Under section 469(e)(2)(B) and this paragraph (a)(4), the $5,000 interest expense allocated to other expenditures is taken into account in computing M's net active income, but the interest expense allocated to the passive activity expenditure and the portfolio expenditure is not taken into account for such purposes.

• (iv) Since M is a corporation, the $3,000 interest expense allocated to the portfolio expenditure is allowable without regard to section 163(d). If M were an individual, however, the interest expense allocated to the portfolio expenditure would be treated as investment interest for purposes of applying the limitation of section 163(d).

(b) Definitions.

For purposes of this section-

(1) "Former passive activity" means an activity described in section 469(f)(3), but only if an unused deduction or credit (within the meaning of section 469(f)(1) (A) or (B)) is allocable to the activity under section 469(b) for the taxable year.

(2) "Former passive activity expenditure" means an expenditure that is taken into account under section 469 in computing the income or loss from a former passive activity of the taxpayer or an expenditure (including an expenditure properly chargeable to capital account) that would be so taken into account if such expenditure were otherwise deductible.

(3) "Investment expenditure" means an expenditure (other than a passive activity expenditure) properly chargeable to capital account with respect to property held for investment (within the meaning of section 163(d)(5)(A)) or an expenditure in connection with the holding of such property.

(4) "Passive activity expenditure" means an expenditure that is taken into account under section 469 in computing income or loss from a passive activity of the taxpayer or an expenditure (including an expenditure properly chargeable to capital account) that would be so taken into account if such expenditure were otherwise deductible.

For purposes of this section, the term "passive activity expenditure" does not include any expenditure with respect to any low-income housing project in any taxable year in which any benefit is allowed with respect to such project under section 502 of the Tax Reform Act of 1986.

(5) "Personal expenditure" means an expenditure that is not a trade or business expenditure, a passive activity expenditure, or an investment expenditure.

(6) "Portfolio expenditure" means an investment expenditure properly chargeable to capital account with respect to property producing income of a type described in section 469(e)(1)(A) or an investment expenditure for an expense clearly and directly allocable to such income.

(7) "Trade or business expenditure" means an expenditure (other than a passive activity expenditure or an investment expenditure) in connection with the conduct of any trade or business other than the trade or business of performing services as an employee.

(c) Allocation of debt and interest expense-(1) Allocation in accordance with use of proceeds.

Debt is allocated to expenditures in accordance with the use of the debt proceeds and, except as provided in paragraph (m) of this section, interest expense accruing on a debt during any period is allocated to expenditures in the same manner as the debt is allocated from time to time during such period. Except as provided in paragraph (m) of this section, debt proceeds and related interest expense are allocated solely by reference to the use of such proceeds, and the allocation is not affected by the use of an interest in any property to secure the repayment of such debt or interest. The following example illustrates the principles of this paragraph (c)(1): Example. Taxpayer A, an individual, pledges corporate stock held for investment as security for a loan and uses the debt proceeds to purchase an automobile for personal use. Interest expense accruing on the debt is allocated to the personal expenditure to purchase the automobile even though the debt is secured by investment property.

(2) Allocation period-(i) Allocation of debt.

Debt is allocated to an expenditure for the period beginning on the date the proceeds of the debt are used or treated as used under the rules of this section to make the expenditure and ending on the earlier of-

• (A) The date the debt is repaid; or

• (B) The date the debt is reallocated in accordance with the rules in paragraphs (c)(4) and (j) of this section.

• (ii) Allocation of interest expense-(A) In general. Except as otherwise provided in paragraph (m) of this section, interest expense accruing on a debt for any period is allocated in the same manner as the debt is allocated from time to time, regardless of when the interest is paid.

  • (B) Effect of compounding. Accrued interest is treated as a debt until it is paid and any interest accruing on unpaid interest is allocated in the same manner as the unpaid interest is allocated. For the taxable year in which a debt is reallocated under the rules in paragraphs (c) (4) and (j) of this section, however, compound interest accruing on such debt (other than compound interest accruing on interest that accrued before the beginning of the year) may be allocated between the original expenditure and the new expenditure on a straight-line basis (i.e., by allocating an equal amount of such interest expense to each day during the taxable year). In addition, a taxpayer may treat a year as consisting of 12 30-day months for purposes of allocating interest on a straight-line basis.

  • (C) Accrual of interest expense. For purposes of this paragraph (c)(2)(ii), the amount of interest expense that accrues during any period is determined by taking into account relevant provisions of the loan agreement and any applicable law such as sections 163(e), 483, and 1271 through 1275.

• (iii) Examples. The following examples illustrate the principles of this paragraph (c)(2): Example (1). (i) On January 1, taxpayer B, a calendar year taxpayer, borrows $1,000 at an interest rate of 11 percent, compounded semiannually. B immediately uses the debt proceeds to purchase an investment security. On July 1, B sells the investment security for $1,000 and uses the sales proceeds to make a passive activity expenditure. On December 31, B pays accrued interest on the $1,000 debt for the entire year.

• (ii) Under this paragraph (c)(2) and paragraph (j) of this section, the $1,000 debt is allocated to the investment expenditure for the period from January 1 through June 30, and to the passive activity expenditure from July 1 through December 31. Interest expense accruing on the $1,000 debt is allocated in accordance with the allocation of the debt from time to time during the year even though the debt was allocated to the passive activity expenditure on the date the interest was paid. Thus, the $55 interest expense for the period from January 1 through June 30 is allocated to the investment expenditure. In addition, during the period from July 1 through December 31, the interest expense allocated to the investment expenditure is a debt, the proceeds of which are treated as used to make an investment expenditure. Accordingly, an additional $3 of interest expense for the period from July 1 through December 31 ($55×.055) is allocated to the investment expenditure. The remaining $55 of interest expense for the period from July 1 through December 31 ($1,000×.055) is allocated to the passive activity expenditure.

• (iii) Alternatively, under the rule in paragraph (c)(2)(ii)(B) of this section, B may allocate the interest expense on a straight-line basis and may also treat the year as consisting of 12 30-day months for this purpose. In that case, $56.50 of interest expense (180/360×$113) would be allocated to the investment expenditure and the remaining $56.50 of interest expense would be allocated to the passive activity expenditure. Example (2). On January 1, 1988, taxpayer C borrows $10,000 at an interest rate of 11 percent, compounded annually. All interest and principal on the debt is payable in a lump sum on December 31, 1992. C immediately uses the debt proceeds to make a passive activity expenditure. C materially participates in the activity in 1990, 1991, and 1992. Therefore, under paragraphs (c)(2) (i) and (j) of this section, the debt is allocated to a passive activity expenditure from January 1, 1988, through December 31, 1989, and to a former passive activity expenditure from January 1, 1990, through December 31, 1992. In accordance with the loan agreement (and consistent with §1.1272-1(d)(1) of the proposed regulations, 51 FR 12022, April 8, 1986), interest expense accruing during any period is determined on the basis of annual compounding. Accordingly, the interest expense on the debt is allocated as follows: - ------------------------------------------------------------------------------ Year Amount Expenditure ------------------------------------------------------------------------------- 1988 ....... $10,000 x .11 ................... $1,100 Passive activity. 1989 ....... 11,100 x .11 ..................... 1,221 Passive activity. 1990 ....... 12,321 x .11 = 1,355 ......... - -------- 1,355 x 2,321/12,321 ............... 255 Passive activity. 1,355 x 10,000/12,321 ............ 1,100 Former passive activity. --------- 1,355 1991 ....... 13,676 x .11 = 1,504 ......... --------- 1,504 x 2,576/13,676 ............... 283 Passive activity. 1,504 x 11,100/13,676 ............ 1,221 Former passive activity. --------- 1,504 1992 ....... 15,180 x .11 = 1,670 ......... --------- 1,670 x 2,859/15,180 ............... 315 Passive activity. 1,670 x 12,321/15,180 ............ 1,355 Former passive activity. --------- 1,670 ----------------------------------------------------------- --------------------

• (e) Allocation of debt; proceeds not disbursed to borrower-(i) Third-party financing. If a lender disburses debt proceeds to a person other than the borrower in consideration for the sale or use of property, for services, or for any other purpose, the debt is treated for purposes of this section as if the borrower used an amount of the debt proceeds equal to such disbursement to make an expenditure for such property, services, or other purpose.

• (ii) Debt assumptions not involving cash disbursements. If a taxpayer incurs or assumes a debt in consideration for the sale or use of property, for services, or for any other purpose, or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer, the debt is treated for purposes of this section as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to make an expenditure for such property, services, or other purpose.

(4) Allocation of debt; proceeds deposited in borrower's account-(i) Treatment of deposit.

For purposes of this section, a deposit of debt proceeds in an account is treated as an investment expenditure, and amounts held in an account (whether or not interest bearing) are treated as property held for investment. Debt allocated to an account under this paragraph (c)(4)(i) must be reallocated as required by paragraph (j) of this section whenever debt proceeds held in the account are used for another expenditure. This paragraph (c)(4) provides rules for determining when debt proceeds are expended from the account. The following example illustrates the principles of this paragraph (c)(4)(i): Example. Taxpayer C, a calendar year taxpayer, borrows $100,000 on January 1 and immediately uses the proceeds to open a noninterest-bearing checking account. No other amounts are deposited in the account during the year, and no portion of the principal amount of the debt is repaid during the year. On April 1, C uses $20,000 of the debt proceeds held in the account for a passive activity expenditure. On September 1, C uses an additional $40,000 of the debt proceeds held in the account for a personal expenditure. Under this paragraph (c)(4)(i), from January 1 through March 31 the entire $100,000 debt is allocated to an investment expenditure for the account. From April 1 through August 31, $20,000 of the debt is allocated to the passive activity expenditure, and $80,000 of the debt is allocated to the investment expenditure for the account. From September 1 through December 31, $40,000 of the debt is allocated to the personal expenditure, $20,000 is allocated to the passive activity expenditure, and $40,000 is allocated to an investment expenditure for the account.

• (ii) Expenditures from account; general ordering rule. Except as provided in paragraph (c)(4)(iii) (B) or (C) of this section, debt proceeds deposited in an account are treated as expended before-

  • (A) Any unborrowed amounts held in the account at the time such debt proceeds are deposited; and

  • (B) Any amounts (borrowed or unborrowed) that are deposited in the account after such debt proceeds are deposited. The following example illustrates the application of this paragraph (c)(4)(ii): Example. On January 10, taxpayer E opens a checking account, depositing $500 of proceeds of Debt A and $1,000 of unborrowed funds. The following chart summarizes the transactions which occur during the year with respect to the account: ------------ ------------------------------------------------------------------- Date Transaction ------- ------------------------------------------------------------------------ Jan. 10 ........ $500 proceeds of Debt A and $1,000 unborowed funds deposited. Jan. 11 ........ $500 proceeds of Debt B deposited. Feb. 17 ........ $800 personal expenditure. Feb. 26 ........ $700 passive activity expenditure. June 21 ........ $1,000 proceeds of Debt C deposited. Nov. 24 ........ $800 investment expenditure. Dec. 20 ........ $600 personal expenditure. ---------------------------------------------------------------------- --------- The $800 personal expenditure is treated as made from the $500 proceeds of Debt A and $300 of the proceeds of Debt B. The $700 passive activity expenditure is treated as made from the remaining $200 proceeds of Debt B and $500 of unborrowed funds. The $800 investment expenditure is treated as made entirely from the proceeds of Debt C. The $600 personal expenditure is treated as made from the remaining $200 proceeds of Debt C and $400 of unborrowed funds. Under paragraph (c)(4)(i) of this section, debt is allocated to an investment expenditure for periods during which debt proceeds are held in the account.

• (iii) Expenditures from account; supplemental ordering rules.-(A) Checking or similar accounts. Except as otherwise provided in this paragraph (c)(4)(iii), an expenditure from a checking or similar account is treated as made at the time the check is written on the account, provided the check is delivered or mailed to the payee within a reasonable period after the writing of the check. For this purpose, the taxpayer may treat checks written on the same day as written in any order. In the absence of evidence to the contrary, a check is presumed to be written on the date appearing on the check and to be delivered or mailed to the payee within a reasonable period thereafter. Evidence to the contrary may include the fact that a check does not clear within a reasonable period after the date appearing on the check.

  • (B) Expenditures within 15 days after deposit of borrowed funds. The taxpayer may treat any expenditure made from an account within 15 days after debt proceeds are deposited in such account as made from such proceeds to the extent thereof even if under paragraph (c)(4)(ii) of this section the debt proceeds would be treated as used to make one or more other expenditures. Any such expenditures and the debt proceeds from which such expenditures are treated as made are disregarded in applying paragraph (c)(4)(ii) of this section. The following examples illustrate the application of this paragraph (c)(4)(iii)(B): Example (1). Taxpayer D incurs a $1,000 debt on June 5 and immediately deposits the proceeds in an account ("Account A"). On June 17, D transfers $2,000 from Account A to another account ("Account B"). On June 30, D writes a $1,500 check on Account B for a passive activity expenditure. In addition, numerous deposits of borrowed and unborrowed amounts and expenditures occur with respect to both accounts throughout the month of June. Notwithstanding these other transactions, D may treat $1,000 of the deposit to Account B on June 17 as an expenditure from the debt proceeds deposited in Account A on June 5. In addition, D may similarly treat $1,000 of the passive activity expenditure on June 30 as made from debt proceeds treated as deposited in Account B on June 17. Example (2). The facts are the same as in the example in paragraph (c)(4)(ii) of this section, except that the proceeds of Debt B are deposited on February 11 rather than on January 11. Since the $700 passive activity expenditure occurs within 15 days after the proceeds of Debt B are deposited in the account, E may treat such expenditure as being made from the proceeds of Debt B to the extent thereof. If E treats the passive activity expenditure in this manner, the expenditures from the account are treated as follows: The $800 personal expenditure is treated as made from the $500 proceeds of Debt A and $300 of unborrrowed funds. The $700 passive activity expenditure is treated as made from the $500 proceeds of Debt B and $200 of unborrowed funds. The remaining expenditures are treated as in the example in paragraph (c)(4)(ii) of this section.

  • (C) Interest on segregated account. In the case of an account consisting solely of the proceeds of a debt and interest earned on such account, the taxpayer may treat any expenditure from such account as made first from amounts constituting interest (rather than debt proceeds) to the extent of the balance of such interest in the account at the time of the expenditure, determined by applying the rules in this paragraph (c)(4). To the extent any expenditure is treated as made from interest under this paragraph (c)(4)(iii)(C), the expenditure is disregarded in applying paragraph (c)(4)(ii) of this section.

• (iv) Optional method for determining date of reallocation. Solely for the purpose of determining the date on which debt allocated to an account under paragraph (c)(4)(i) of this section is reallocated, the taxpayer may treat all expenditures made during any calendar month from debt proceeds in the account as occurring on the later of the first day of such month or the date on which such debt proceeds are deposited in the account. This paragraph (c)(4)(iv) applies only if all expenditures from an account during the same calendar month are similarly treated. The following example illustrates the application of this paragraph (c)(4)(iv): Example. On January 10, taxpayer G opens a checking account, depositing $500 of proceeds of Debt A and $1,000 of unborrowed funds. The following chart summarizes the transactions which occur during the year with respect to the account (note that these facts are the same as the facts of the example in paragraph (c)(4)(ii) of this section): ------------------------------------------------------------------------------- Date Transaction --------------------------------------------------------------------------- ---- Jan. 10 ........ $500 proceeds of Debt A and $1,000 unborrowed funds deposited. Jan. 11 ........ $500 proceeds of Debt B deposited. Feb. 17 ........ $800 personal expenditure. Feb. 26 ........ $700 passive activity expenditure. June 21 ........ $1,000 proceeds of Debt C deposited. Nov. 24 ........ $800 investment expenditure. Dec. 20 ........ $600 personal expenditure. -------------------------------------------------------- ----------------------- Assume that G chooses to apply the optional rule of this paragraph (c)(4)(iv) to all expenditures. For purposes of determining the date on which debt is allocated to the $800 personal expenditure made on February 17, the $500 treated as made from the proceeds of Debt A and the $300 treated as made from the proceeds of Debt B are treated as expenditures occurring on February 1. Accordingly, Debt A is allocated to an investment expenditure for the account from January 10 through January 31 and to the personal expenditure from February 1 through December 31, and $300 of Debt B is allocated to an investment expenditure for the account from January 11 through January 31 and to the personal expenditure from February 1 through December 31. The remaining $200 of Debt B is allocated to an investment expenditure for the account from January 11 through January 31 and to the passive activity expenditure from February 1 through December 31. The $800 of Debt C used to make the investment expenditure on November 24 is allocated to an investment expenditure for the account from June 21 through October 31 and to an investment expenditure from November 1 through December 31. The remaining $200 of Debt C is allocated to an investment expenditure for the account from June 21 through November 30 and to a personal expenditure from December 1 through December 31.

• (v) Simultaneous deposits-(A) In general. If the proceeds of two or more debts are deposited in an account simultaneously, such proceeds are treated for purposes of this paragraph (c)(4) as deposited in the order in which the debts were incurred.

  • (B) Order in which debts incurred. If two or more debts are incurred simultaneously or are treated under applicable law as incurred simultaneously, the debts are treated for purposes of this paragraph (c)(4)(v) as incurred in any order the taxpayer selects.

  • (C) Borrowings on which interest accrues at different rates. If interest does not accrue at the same fixed or variable rate on the entire amount of a borrowing, each portion of the borrowing on which interest accrues at a different fixed or variable rate is treated as a separate debt for purposes of this paragraph (c)(4)(v).

• (vi) Multiple accounts. The rules in this paragraph (c)(4) apply separately to each account of a taxpayer.

(5) Allocation of debt; proceeds received in cash-(i) Expenditure within 15 days of receiving debt proceeds.

If a taxpayer receives the proceeds of a debt in cash, the taxpayer may treat any cash expenditure made within 15 days after receiving the cash as made from such debt proceeds to the extent thereof and may treat such expenditure as made on the date the taxpayer received the cash. The following example illustrates the rule in this paragraph (c)(5)(i): Example. Taxpayer F incurs a $1,000 debt on August 4 and receives the debt proceeds in cash. F deposits $1,500 cash in an account on August 15 and on August 27 writes a check on the account for a passive activity expenditure. In addition, F engages in numerous other cash transactions throughout the month of August, and numerous deposits of borrowed and unborrowed amounts and expenditures occur with respect to the account during the same period. Notwithstanding these other transactions, F may treat $1,000 of the deposit on August 15 as an expenditure made from the debt proceeds on August 4. In addition, under the rule in paragraph (c)(4)(v)(B) of this section, F may treat the passive activity expenditure on August 27 as made from the $1,000 debt proceeds treated as deposited in the account.

• (ii) Other expenditures. Except as provided in paragraphs (c)(5) (i) and (iii) of this section, any debt proceeds a taxpayer (other than a corporation) receives in cash are treated as used to make personal expenditures. For purposes of this paragraph (c)(5), debt proceeds are received in cash if, for example, a withdrawal of cash from an account is treated under the rules of this section as an expenditure of debt proceeds.

• (iii) Special rules for certain taxpayers.[Reserved.]

(6) Special rules-(i) Qualified residence debt.

[Reserved.]

• (ii) Debt used to pay interest. To the extent proceeds of a debt are used to pay interest, such debt is allocated in the same manner as the debt on which such interest accrued is allocated from time to time. The following example illustrates the application of this paragraph (c)(6)(ii): Example. On January 1, taxpayer H incurs a debt of $1,000, bearing interest at an annual rate of 10 percent, compounded annually, payable at the end of each year ("Debt A"). H immediately opens a checking account, in which H deposits the proceeds of Debt A. No other amounts are deposited in the account during the year. On April 1, H writes a check for a personal expenditure in the amount of $1,000. On December 31, H borrows $100 ("Debt B") and immediately uses the proceeds of Debt B to pay the accrued interest of $100 on Debt A. From January 1 through March 31, Debt A is allocated, under the rule in paragraph (c)(4)(i) of this section, to the investment expenditure for the account. From April 1 through December 31, Debt A is allocated to the personal expenditure. Under the rule in paragraph (c)(2)(ii) of this section, $25 of the interest on Debt A for the year is allocated to the investment expenditure, and $75 of the interest on Debt A for the year is allocated to the personal expenditure. Accordingly, for the purpose of allocating the interest on Debt B for all periods until Debt B is repaid, $25 of Debt B is allocated to the investment expenditure, and $75 of Debt B is allocated to the personal expenditure.

• (iii) Debt used to pay borrowing costs-(A) Borrowing costs with respect to different debt. To the extent the proceeds of a debt (the "ancillary debt") are used to pay borrowing costs (other than interest) with respect to another debt (the "primary debt"), the ancillary debt is allocated in the same manner as the primary debt is allocated from time to time. To the extent the primary debt is repaid, the ancillary debt will continue to be allocated in the same manner as the primary debt was allocated immediately before its repayment. The following example illustrates the rule in this paragraph (c)(6)(iii)(A): Example. Taxpayer I incurs debts of $60,000 ("Debt A") and $10,000 ("Debt B"). I immediately uses $30,000 of the proceeds of Debt A to make a trade or business expenditure, $20,000 to make a passive activity expenditure, and $10,000 to make an investment expenditure. I immediately use $3,000 of the proceeds of Debt B to pay borrowing costs (other than interest) with respect to Debt A (such as loan origination, loan commitment, abstract, and recording fees) and deposits the remaining $7,000 in an account. Under the rule in this paragraph (c)(6)(iii)(A), the $3,000 of Debt B used to pay expenses of incurring Debt A is allocated $1,500 to the trade or business expenditure ($3,000 × $30,000/$60,000), $1,000 to the passive activity expenditure ($3,000 × $20,000/$60,000), and $500 ($3,000 × $10,000/$60,000) to the investment expenditure. The manner in which the $3,000 of Debt B used to pay expenses of incurring Debt A is allocated may change if the allocation of Debt A changes, but such allocation will be unaffected by any repayment of Debt A. The remaining $7,000 of Debt B is allocated to an investment expnditure for the account until such time, if any, as this amount is used for a different expenditure.

  • (B) Borrowing costs with respect to same debt. To the extent the proceeds of a debt are used to pay borrowing costs (other than interest) with respect to such debt, such debt is allocated in the same manner as the remaining debt is allocated from time to time. The remaining debt for this purpose is the portion of the debt that is not used to pay borrowing costs (other than interst) with respect to such debt. Any repayment of the debt is treated as a repayment of the debt allocated under this paragraph (c)(6)(iii)(B) and the remaining debt is the same proportion as such amount bear to each other. The following example illustrates the application of this paragraph (c)(6)(iii)(B): Example. (i) Taxpayer J borrows $85,000. The lender disburses $80,000 of this amount to J, retaining $5,000 for borrowing costs (other than interest) with respect to the loan. J immediately uses $40,000 of the debt proceeds to make a personal expenditure, $20,000 to make a passive activity expenditure, and $20,000 to make an investment expenditure. Under the rule in this paragraph (c)(6)(iii)(B), the $5,000 used to pay borrowing costs is allocated $2,500 ($5,000 × $40,000/$80,000) to the personal expenditure, $1,250 ($5,000 × $20,000/$80,000) to the investment expenditure. The manner in which this $5,000 is allocated may change if the allocation of the remaining $80,000 of debt is changed.

• (ii) Assume that J repays $50,000 of the debt. The repayment is treated as a repayment of $2,941 ($50,000 x $5,000/$85,000) of the debt used to pay borrowing costs and a repayment of $47,059 ($50,000 x $80,000/$85,000) of the remaining debt. Under paragraph (d) of this section, J is treated as repaying the $42,500 of debt allocated to the personal expenditure ($2,500 of debt used to pay borrowing costs and $40,000 of remaining debt). In addition, assuming that under paragraph (d)(2) J chooses to treat the allocation to the passive activity expenditure as having occurred before the allocation to the investment expenditure, J is treated as repaying $7,500 of debt allocated to the passive activity expenditure ($441 of debt used to pay borrowing costs and $7,059 of remaining debt).

• (iv) Allocation of debt before actual receipt of debt proceeds. If interest properly accrues on a debt during any period before the debt proceeds are actually received or used to make an expenditure, the debt is allocated to an investment expenditure for such period.

(7) Antiabuse rules.

[Reserved.]

(d) Debt repayments-(1) General ordering rule.

If, at the time any portion of a debt is repaid, such debt is allocated to more than one expenditure, the debt is treated for purposes of this section as repaid in the following order:

• (i) Amounts allocated to personal expenditures;

• (ii) Amounts allocated to investment expenditures and passive activity expenditures (other than passive activity expenditures described in paragraph (d)(1)(iii) of this section);

• (iii) Amounts allocated to passive activity expenditures in connection with a rental real estate activity with respect to which the taxpayer actively participates (within the meaning of section 469(i));

• (iv) Amounts allocated to former passive activity expenditures; and

• (v) Amounts allocated to trade or business expenditures and to expenditures described in the last sentence of paragraph (b)(4) of this section.

(2) Supplemental ordering rules for expenditures in same class.

Amounts allocated to two or more expenditures that are described in the subdivision of paragraph (d)(1) of this section (e.g., amounts allocated to different personal expenditures) are treated as repaid in the order in which the amounts were allocated (or reallocated) to such expenditures. For purposes of this paragraph (d)(2), the taxpayer may treat allocations and reallocations that occur on the same day as occurring in any order (without regard to the order in which expenditures are treated as made under paragraph (c)(4)(iii)(A) of this section).

(3) Continuous borrowings.

In the case of borrowings pursuant to a line of credit or similar account or arrangement that allows a taxpayer to borrow funds periodically under a single loan agreement-

• (i) All borrowings on which interest accrues at the same fixed or variable rate are treated as a single debt; and

• (ii) Borrowings or portions of borrowings on which interest accrues at different fixed or variable rates are treated as different debts, and such debts are treated as repaid for purposes of this paragraph (d) in the order in which such borrowings are treated as repaid under the loan agreement.

(4) Examples.

The following examples illustrate the application of this paragraph (d): Example (1). Taxpayer B borrows $100,000 ("Debt A") on July 12, immediately deposits the proceeds in an account, and uses the debt proceeds to make the following expenditures on the following dates: August 31-$40,000 passive activity expenditure 1.October 5-$20,000 passive activity expenditure 2.December 24- $40,000 personal expenditure. On January 19 of the following year, B repays $90,000 of Debt A (leaving $10,000 of Debt A outstanding). The $40,000 of Debt A allocated to the personal expenditure, the $40,000 allocated to passive activity expenditure 1, and $10,000 of the $20,000 allocated to passive activity expenditure 2 are treated as repaid. Example (2). (i) Taxpayer A obtains a line of credit. Interest on any borrowing on the line of credit accrues at the lender's "prime lending rate" on the date of the borrowing plus two percentage points. The loan documents provide that borrowings on the line of credit are treated as repaid in the order the borrowings were made. A borrows $30,000 ("Borrowing 1") on the line of credit and immediately uses $20,000 of the debt proceeds to make a personal expenditure ("personal expenditure 1") and $10,000 to make a trade or business expenditure ("trade or business expenditure 1"). A subsequently borrows another $20,000 ("Borrowing 2") on the line of credit and immediately uses $15,000 of the debt proceeds to make a personal expenditure ("personal expenditure 2") and $5,000 to make a trade or business expenditure ("trade or business expenditure 2"). A then repays $40,000 of the borrowings.

• (ii) If the prime lending rate plus two percentage points was the same on both the date of Borrowing 1 and the date of Borrowing 2, the borrowings are treated for purposes of this paragraph (d) as a single debt, and A is treated as having repaid $35,000 of debt allocated to personal expenditure 1 and personal expenditure 2, and $5,000 of debt allocated to trade or business expenditure 1.

• (iii) If the prime lending rate plus two percentage points was different on the date of Borrowing 1 and Borrowing 2, the borrowings are treated as two debts, and, in accordance with the loan agreement, the $40,000 repaid amount is treated as a repayment of Borrowing 1 and $10,000 of Borrowing 2. Accordingly, A is treated as having repaid $20,000 of debt allocated to personal expenditure 1, $10,000 of debt allocated to trade or business expenditure 1, and $10,000 of debt allocated to personal expenditure 2.

(e) Debt refinancings-(1) In general.

To the extent proceeds of any debt (the "replacement debt") are used to repay any portion of a debt, the replacement debt is allocated to the expenditures to which the repaid debt was allocated. The amount of replacement debt allocated to any such expenditure is equal to the amount of debt allocated to such expenditure that was repaid with proceeds of the replacement debt. To the extent proceeds of the replacement debt are used for expenditures other than repayment of a debt, the replacement debt is allocated to expenditures in accordance with the rules of this section.

(2) Example.

The following example illustrates the application of this paragraph (e): Example. Taxpayer C borrows $100,000 ("Debt A") on July 12, immediately deposits the debt proceeds in an account, and uses the proceeds to make the following expenditures on the following dates (note that the facts of this example are the same as the facts of example (1) in paragraph (d)(4) of this section): August 31-$40,000 passive activity expenditure 1.October 5-$20,000 passive activity expenditure 2.December 24-$40,000 personal expenditure 1. On January 19 of the following year, C borrows $120,000 ("Debt B") and uses $90,000 of the proceeds of repay $90,000 of Debt A (leaving $10,000 of Debt A outstanding). In addition, C uses $30,000 of the proceeds of Debt B to make a personal expenditure ("personal expenditure 2"). Debt B is allocated $40,000 to personal expenditure 1, $40,000 to passive activity expenditure 1, $10,000 to passive activity expenditure 2, and $30,000 to personal expenditure 2. Under paragraph (d)(1) of this section, Debt B will be treated as repaid in the following order: (1) amounts allocated to personal expenditure 1, (2) amounts allocated to personal expenditure 2, (3) amounts allocated to passive activity expenditure 1, and

(4) amounts allocated to passive activity expenditure 2.

(f) Debt allocated to distributions by passthrough entities.

[Reserved]

(g) Repayment of passthrough entity debt.

[Reserved]

(h) Debt allocated to expenditures for interests in passthrough entities.

[Reserved]

(i) Allocation of debt to loans between passthrough entities and interest holders.

[Reserved]

(j) Reallocation of debt-(1) Debt allocated to capital expenditures-(i) Time of reallocation.

Except as provided in paragraph (j)(2) of this section, debt allocated to an expenditure properly chargeable to capital account with respect to an asset (the "first expenditure") is reallocated to another expenditure on the earlier of-

• (A) The date on which proceeds from a disposition of such asset are used for another expenditure; or

• (B) The date on which the character of the first expenditure changes (e.g., from a passive activity expenditure to an expenditure that is not a passive activity expenditure) by reason of a change in the use of the asset with respect to which the first expenditure was capitalized.

• (ii) Limitation on amount reallocated. The amount of debt reallocated under paragraph (j)(1)(i)(A) of this section may not exceed the proceeds from the disposition of the asset. The amount of debt reallocated under paragraph (j)(1)(i)(B) of this section may not exceed the fair market value of the asset on the date of the change in use. In applying this paragraph (j)(1)(ii) with respect to a debt in any case in which two or more debts are allocable to expenditures properly chargeable to capital account with respect to the same asset, only a ratable portion (determined with respect to any such debt by dividing the amount of such debt by the aggregate amount of all such debts) of the fair market value or proceeds from the disposition of such asset shall be taken into account.

• (iii) Treatment of loans made by the taxpayer. Except as provided in paragraph (j)(1)(iv) of this section, an expenditure to make a loan is treated as an expenditure properly chargeable to capital account with respect to an asset, and for purposes of paragraph (j)(1)(i)(A) of this section any repayment of the loan is treated as a disposition of the asset. Paragraph (j)(3) of this section applies to any repayment of a loan in installments.

• (iv) Treatment of accounts. Debt allocated to an account under paragraph (c)(4)(i) of this section is treated as allocated to an expenditure properly chargeable to capital account with respect to an asset, and any expenditure from the account is treated as a disposition of the asset. See paragraph (c)(4) of this section for rules under which debt proceeds allocated to an account are treated as used for another expenditure.

(2) Disposition proceeds in excess of debt.

If the proceeds from the disposition of an asset exceed the amount of debt reallocated by reason of such disposition, or two or more debts are reallocated by reason of the disposition of an asset, the proceeds of the disposition are treated as an account to which the rules in paragraph (c)(4) of this section apply.

(3) Special rule for deferred payment sales.

If any portion of the proceeds of a disposition of an asset are received subsequent to the disposition-

• (i) The portion of the proceeds to be received subsequent to the disposition is treated for periods prior to the receipt as used to make an investment expenditure; and

• (ii) Debt reallocated by reason of the disposition is allocated to such investment expenditure to the extent such debt exceeds the proceeds of the disposition previously received (other than proceeds used to repay such debt).

(4) Examples.

The following examples illustrate the application of this paragraph (j): Example (1). On January 1, 1988, taxpayer D sells an asset for $25,000. Immediately before the sale, the amount of debt allocated to expenditures properly chargeable to capital account with respect to the asset was $15,000. The proceeds of the disposition are treated as an account consisting of $15,000 of debt proceeds and $10,000 of unborrowed funds to which paragraph (c)(4) of this section applies. Thus, if D immediately makes a $10,000 personal expenditure from the proceeds and within 15 days deposits the remaining proceeds in an account, D may, pursuant to paragraph (c)(4)(iii)(B) of this section, treat the entire $15,000 deposited in the account as proceeds of a debt. Example (2). The facts are the same as in example (1) except that, instead of receiving all $25,000 of the sale proceeds on January 1, 1988, D receives 5,000 on that date, $10,000 on January 1, 1989, and $10,000 on January 1, 1990. D does not use any portion of the sale proceeds to repay the debt. Between January 1, 1988, and December 31, 1988, D is treated under paragraph (j)(3) of this section as making an investment expenditure of $20,000 to which $10,000 of debt is allocated. In addition, the remaining $5,000 of debt is reallocated on January 1, 1988, in accordance with D's use of the sales proceeds received on that date. Between January 1, 1989, and December 31, 1989, D is treated as making an investment expenditure of $10,000 to which no debt is allocated. In addition, as of January 1, 1989, $10,000 of debt is reallocated in accordance with D's use of the sales proceeds received on that date. Example 3. The facts are the same as in example (2), except that D immediately uses the $5,000 sale proceeds received on January 1, 1988, to repay $5,000 of the $15,000 debt. Between January 1, 1988, and December 31, 1988, D is treated as making an investment expenditure of $20,000 to which the remaining balance ($10,000) of the debt is reallocated. The results in 1989 are as described in example (2).

(k) Modification of rules in the case of interest expense allocated to foreign source income.

[Reserved.]

(l) Reserved.

(m) Coordination with other provisions-(1) Effect of other limitations-(i) In general.

All debt is allocated among expenditures pursuant to the rules in this section, without regard to any limitations on the deductibility of interest expense on such debt. The applicability of the passive loss and nonbusiness interest limitations to interest on such debt, however, may be affected by other limitations on the deductibility of interest expense.

• (ii) Disallowance provisions. (Interest expense that is not allowable as a deduction by reason of a disallowance provision (within the meaning of paragraph (m)(7)(ii) of this section) is not taken into account for any taxable year for purposes of applying the passive loss and nonbusiness interest limitations.

• (iii) Deferral provisions. Interest expense that is not allowable as a deduction for the taxable year in which paid or accrued by reason of a deferral provision (within the meaning of paragraph (m)(7)(iii) of this section) is allocated in the same manner as the debt giving rise to the interest expense is allocated for such taxable year. Such interest expense is taken into account for purposes of applying the passive loss and nonbusiness interest limitations for the taxable year in which such interest expense is allowable under such deferral provision.

• (iv) Capitalization provisions. Interest expense that is capitalized pursuant to a capitalization provision (within the meaning of paragraph (m)(7)(i) of this section) is not taken into account as interest for any taxable year for purposes of applying the passive loss and nonbusiness interest limitations.

(2) Effect on other limitations-(i) General rule.

Except as provided in paragraph (m)(2)(ii) of this section, any limitation on the deductibility of an item (other than the passive loss and nonbusiness interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section.

• (ii) Exception. Capitalization provisions (within the meaning of paragraph (m)(7)(i) of this section) do not apply to interest expense allocated to any personal expenditure under the rules of this section.

(3) Qualified residence interest.

Qualified residence interest (within the meaning of section 163(h)(3)) is allowable as a deduction without regard to the manner in which such interest expense is allocated under the rules of this section. In addition, qualified residence interest is not taken into account in determining the income or loss from any activity for purposes of section 469 or in determining the amount of investment interest for purposes of section 163(d). The following example illustrates the rule in this paragraph (m)(3): Example. Taxpayer E, an individual, incurs a $20,000 debt secured by a residence and immediately uses the proceeds to purchase an automobile exclusively for E's personal use. Under the rules in this section, the debt and interest expense on the debt are allocated to a personal expenditure. If, however, the interest on the debt is qualified residence interest within the meaning of section 163(h)(3), the interest is not treated as personal interest for purposes of section 163(h).

(4) Interest described in section 163(h)(2)(E).

Interest described in section 163(h)(2)(E) is allowable as a deduction without regard to the rules of this section.

(5) Interest on deemed distributee debt.

[Reserved.]

(6) Examples.

The following examples illustrate the relationship between the passive loss and nonbusiness interest limitations and other limitations on the deductibility of interest expense: Example (1). Debt is allocated pursuant to the rules in this section to an investment expenditure for the purchase of taxable investment securities. Pursuant to section 265(a)(2), the debt is treated as indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax, and, accordingly, interest on the debt is disallowed. If section 265(a)(2) subsequently ceases to apply (because, for example, the taxpayer ceases to hold any tax-exempt obligations), and the debt at such time continues to be allocated to an investment expenditure, interest on the debt that accrues after such time is subject to section 163(d). Example (2). An accrual method taxpayer incurs a debt payable to a cash method lender who is related to the taxpayer within the meaning of section 267(b). During the period in which interest on the debt is not deductible by reason of section 267(a)(2), the debt is allocated to a passive activity expenditure. Thus, interest that accrues on the debt for such period is also allocated to the passive activity expenditure. When such interest expense becomes deductible under section 267(a)(2), it will be allocated to the passive activity expenditure, regardless of how the debt is allocated at such time. Example (3). A taxpayer incurs debt that is allocated under the rules of this section to an investment expenditure. Under section 263A(f), however, interest expense on such debt is capitalized during the production period (within the meaning of section 263A(f)(4)(B)) of property used in a passive activity of the taxpayer. The capitalized interest expense is not allocated to the investment expenditure, and depreciation deductions attributable to the capitalized interest expense are subject to the passive loss limitation as long as the property is used in a passive activity. However, interest expense on the debt for periods after the production period is allocated to the investment expenditure as long as the debt remains allocated to the investment expenditure.

(7) Other limitations on interest expense-(i) Capitalization provisions.

A capitalization provision is any provision that requires or allows interest expense to be capitalized. Capitalization provisions include sections 263(g), 263A(f), and 266.

• (ii) Disallowance provisions. A disallowance provision is any provision (other than the passive loss and nonbusiness interest limitations) that disallows a deduction for interest expense for all taxable years and is not a capitalization provision. Disallowance provisions include sections 163(f)(2), 264(a)(2), 264(a)(4), 265(a)(2), 265(b)(2), 279(a), 291(e)(1)(B)(ii), 805(b)(1), and 834(c)(5).

• (iii) Deferral provisions. A deferral provision is any provision (other than the passive loss and nonbusiness interest limitations) that disallows a deduction for interest expense for any taxable year and is not a capitalization or disallowance provision. Deferral provisions include sections 267(a)(2), 465, 1277, and 1282.

(n) Effective date-(1) In general.

This section applies to interest expense paid or accrued in taxable years beginning after December 31, 1986.

(2) Transitional rule for certain expenditures.

For purposes of determining whether debt is allocated to expenditures made on or before August 3, 1987, paragraphs (c)(4)(iii)(B) and (c)(5)(i) of this section are applied by substituting "90 days" for "15 days."

(3) Transitional rule for certain debt-(i) General rule.

Except as provided in paragraph (n)(3)(ii) of this section, any debt outstanding on December 31, 1986, that is properly attributable to a business or rental activity is treated for purposes of this section as debt allocated to expenditures properly chargeable to capital account with respect to the assets held for use or for sale to customers in such business or rental activity. Debt is properly attributable to a business or rental activity for purposes of this section (regardless of whether such debt otherwise would be allocable under this section to expenditures in connection with such activity) if the taxpayer has properly and consistently deducted interest expense (including interest subject to limitation under section 163(d) as in effect prior to the Tax Reform Act of 1986) on such debt on Schedule C, E, or F of Form 1040 in computing income or loss from such business or rental activity for taxable years beginning before January 1, 1987. For purposes of this paragraph (n)(3), amended returns filed after July 2, 1987 are disregarded in determining whether a taxpayer has consistently deducted interest expense on Schedule C, E, or F of Form 1040 in computing income or loss from a business or rental activity.

• (ii) Exceptions-(A) Debt financed distributions by passthrough entities. [Reserved]

  • (B) Election out. This paragraph (n)(3) does not apply with respect to debt of a taxpayer who elects under paragraph (n)(3) (viii) of this section to allocate debt outstanding on December 31, 1986, in accordance with the provisions of this section other than this paragraph (n)(3) (i.e., in accordance with the use of the debt proceeds).

• (iii) Business or rental activity. For purposes of this paragraph (n)(3), a business or rental activity is any trade or business or rental activity of the taxpayer. For this purpose-

  • (A) A trade or business includes a business or profession the income and deductions of which (or, in the case of a partner or S corporation shareholder, the taxpayer's share thereof) are properly reported on Schedule C, E, or F of Form 1040; and

  • (B) A rental activity includes an activity of renting property the income and deductions of which (or, in the case of a partner or S corporation shareholder, the taxpayer's share thereof) are properly reported on Schedule E of Form 1040.

• (iv) Example. The following example illustrates the circumstances in which debt is properly attributable to a business or rental activity: Example. Taxpayer H incurred a debt in 1979 and properly deducted the interest expense on the debt on Schedule C of Form 1040 for each year from 1979 through 1986. Under this paragraph (n) (3), the debt is properly attributable to the business the results of which are reported on Schedule C.

• (v) Allocation requirement-(A) In general. Debt outstanding on December 31, 1986, that is properly attributable (within the meaning of paragraph (n)(3)(i) of this section) to a business or rental activity must be allocated in a reasonable and consistent manner among the assets held for use or for sale to customers in such activity on the last day of the taxable year that includes December 31, 1986. The taxpayer shall specify the manner in which such debt is allocated by filing a statement in accordance with paragraph (n)(3)(vii) of this section. If the taxpayer does not file such a statement or fails to allocate such debt in a reasonable and consistent manner, the Commissioner shall allocate the debt.

  • (B) Reasonable and consistent manner-examples of improper allocation. For purposes of this paragraph (n)(3)(v), debt is not treated as allocated in a reasonable and consistent manner if-

(1) The amount of debt allocated to goodwill exceeds the basis of the goodwill; or

(2) The amount of debt allocated to an asset exceeds the fair market value of the asset, and the amount of debt allocated to any other asset is less than the fair market value (lesser of basis or fair market value in the case of goodwill) of such other asset.

• (vi) Coordination with other provisions. The effect of any events occurring after the last day of the taxable year that includes December 31, 1986, shall be determined under the rules of this section, applied by treating the debt allocated to an asset under paragraph (n)(3)(v) of this section as if proceeds of such debt were used to make an expenditure properly chargeable to capital account with respect to such asset on the last day of the taxable year that includes December 31, 1986. Thus, debt that is allocated to an asset in accordance with this paragraph (n)(3) must be reallocated in accordance with paragraph (j) of this section upon the occurrence with respect to such asset of any event described in such paragraph (j). Similarly, such debt is treated as repaid in the order prescribed in paragraph (d) of this section. In addition, a replacement debt (within the meaning of paragraph (e) of this section) is allocated to an expenditure properly chargeable to capital account with respect to an asset to the extent the proceeds of such debt are used to repay the portion of a debt allocated to such asset under this paragraph (n)(3).

• (vii) Form for allocation of debt. A taxpayer shall allocate debt for purposes of this paragraph (n)(3) by attaching to the taxpayer's return for the first taxable year beginning after December 31, 1986, a statement that is prominently identified as a transitional allocation statement under §1.163-8T(n)(3) and includes the following information:

  • (A) A description of the business or rental activity to which the debt is properly attributable;

  • (B) The amount of debt allocated;

  • (C) The assets among which the debt is allocated;

  • (D) The manner in which the debt is allocated;

  • (E) The amount of debt allocated to each asset; and

  • (F) Such other information as the Commissioner may require.

• (viii) Form for election out. A taxpayer shall elect to allocate debt outstanding on December 31, 1986, in accordance with the provisions of this section other than this paragraph (n)(3) by attaching to the taxpayer's return (or amended return) for the first taxable year beginning after December 31, 1986, a statement to that effect, prominently identified as as election out under §1.163-8T(n)(3).

• (ix) Special rule for partnerships and S corporations. For purposes of paragraph (n)(3)(ii)(B), (v), (vii) and (viii) of this section (relating to the allocation of debt and election out), a partnership or S corporation shall be treated as the taxpayer with respect to the debt of the partnership or S corporation.

  • (X) Irrevocability. An allocation or election filed in accordance with paragraph (n)(3) (vii) or (viii) of this section may not be revoked or modified except with the consent of the Commissioner. ACT 26 U.S.C. 7805. table "§1.163-8T . . . 1545-0995". There is need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason, it is found impractical to issue this Treasury decision with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection

• (d) of that section. J. Roger Mentz, Assistant Secretary of the Treasury.

November 03, 1987

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document provides temporary regulations concerning the low-income housing credit for certain Federally-assisted buildings under section 42 of the Internal Revenue Code of 1986, as enacted by the Tax Reform Act of 1986. These regulations provide guidance concerning the low-income housing credit allowable for certain Federally-assisted buildings acquired during a 10-year period. In addition, the text of the temporary regulations set forth in this document serves as the comment document for the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

EFFECTIVE DATE

The regulations are effective for buildings placed in service by a taxpayer after December 31, 1986.

FOR FURTHER INFORMATION CONTACT

Robert Beatson of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224 (Attention: CC:LR:T LR-61-87) (202-566-3829, not a toll-free call).

SUPPLEMENTARY INFORMATION

Background

This document contains temporary regulations relating to the low-income housing credit allowable under section 42(d)(6) of the Internal Revenue Code of 1986 for certain Federally-assisted buildings described in section 42(d)(2)(B)(ii), as enacted by section 252 of the Tax Reform Act of 1986 (Pub. L. 99-514). New §1.42-2T is added by this document to Part 1 of Title 26 of the Code of Federal Regulations. The temporary regulations provided by this document will remain in effect until superseded by final regulation on this subject.

Explanation of Provisions

Section 252 of the Tax Reform Act of 1986 enacted a new low-income housing credit equal to the applicable percentage of the qualified basis of each qualified low-income building. The temporary regulations provide guidance with respect to the credit allowable for certain Federally-assisted buildings acquired during a 10-year period. The low-income housing credit is available to the acquirer of a qualified low-income building for which a special waiver is granted by the Internal Revenue Service in order to avert an assignment of the mortgage secured by the building to the Department of Housing and Urban Development or the Farmers' Home Administration, or to avert a claim against a Federal mortgage insurance fund with respect to a mortgage which is so secured.

Special Analyses

The Commissioner of Internal Revenue has determined that these temporary regulations are not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required. No general notice of proposed rulemaking is required by 5 U.S.C. 553 (b) because these are temporary regulations, and there is a need to provide the public with immediate guidance. Accordingly, the Regulatory Flexibility Act does not apply and no Regulatory Flexibility Analysis is required for this rule.

Paperwork Reduction Act

The collection of information requirements contained in these regulations have been submitted to the Office of Management and Budget (OMB) in accordance with the requirements of the Paperwork Reduction Act of 1980. These requirements have been approved by OMB (Control no. 1545-1005).

Drafting Information

The principal author of these regulations is Robert Beatson of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and the Treasury Department participated in developing the regulations on matters of both substance and style.

List of Subjects

26 CFR 1.0-1-1.58-8 Income taxes, Tax liability, Tax rates, Credits. 26 CFR Part 602 Reporting and recordkeeping requirements.

Amendments to the Regulations

The amendments to 26 CFR Parts 1 and 602 are as follows:

PART 1-INCOME TAX REGULATIONS

Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority:

Par. 2. A new §1.42-2T is added immediately following §1.42-1T to read as follows:

§1.42-2T Waiver of requirement that an existing building eligible for the

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

Par. 3. The authority citation for Part 602 continues to read as follows:

Authority:

§ 602.101 (Amended)

Par. 4. Section 602.101(c) is amended by inserting in the appropriate place in the

Lawrence B. Gibbs,

Commissioner of Internal Revenue.

Approved: October 19, 1987.

Donaldson Chapoton, 26 U.S.C. 7805. Section 1.42-2T also issued under 26 U.S.C. 42 (m). low-income housing credit has been held for 10 years prior to acquisition by the taxpayer (temporary).

(a) Low-income housing credit for existing building.

Section 42 provides that, for purposes of section 38, new and existing qualified low-income buildings are eligible for a low-income housing credit. The eligibility rules for new and existing buildings differ. Under section 42(d)(2), the acquisition cost (to the extent properly included in basis) of an existing building may be eligible for the low-income housing credit if-

(1) The taxpayer acquires the building by purchase (as defined in section 179(d)(2), as applicable under section 42(d)(2)(D)(iii)(I)),

(2) There is a period of at least 10 years between the date of the building's acquisition by the taxpayer and the later of-

• (i) The date the building was last placed in service, or

• (ii) The date of the most recent nonqualified substantial improvement of the building, and

(3) The building was not previously placed in service by the taxpayer, or by a person who was a related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the building was last previously placed in service.

(b) Waiver of 10-year holding period requirement.

Section 42(d)(6) provides that a taxpayer may apply for a waiver of the 10-year holding period requirement specified in paragraph (a)(2) of this section. The Internal Revenue Service will grant a waiver only if-

(1) The existing building satisfies all of the requirements in paragraph (c) of this section, and

(2) The taxpayer makes an application in conformity with the requirements in paragraph (d) of this section.

(c) Waiver requirements-(1) Federally-assisted building.

To satisfy the requirement of this paragraph (c)(1), a building must be a Federally-assisted building. The term "Federally-assisted building" means any building which is substantially assisted, financed, or operated under section 8 of the United States Housing Act of 1937, section 221(d)(3) or 236 of the National Housing Act of 1934, or section 515 of the Housing Act of 1949, as such acts were in effect on October 22, 1986.

(2) Federal mortgage funds at risk.

To satisfy the requirement of this paragraph (c)(2), Federal mortgage funds must be at risk with respect to a mortgage that is secured by the building or a project of which the building is a part. For purposes of this paragraph (c)(2), Federal mortgage funds are at risk if, in the event of a default by the mortgagor on the mortgage secured by the building or the project of which the building is a part-

• (i) The mortgage could be assigned to the Department of Housing and Urban Development or the Farmers' Home Administration, or

• (ii) There could arise a claim against a Federal mortgage insurance fund (or such Department or Administration).

(3) Action by the Department of Housing and Urban Development or the Farmers' Home Administration.

To satisfy the requirement of this paragraph (c)(3), specified Federal action must have been taken by either the Department of Housing and Urban Development or the Farmers' Home Administration ("the Federal agency") with respect to the building or the project of which the building is a part that demonstrates that a waiver of the 10-year holding period requirement is necessary to avert Federal mortgage funds being at risk within the meaning of paragraph (c)(2) of this section. The following specified Federal actions shall be the only means of satisfying the requirement of this paragraph (c)(3):

• (i) The federal agency intends to accept an assignment of a mortgage secured by the building or the project of which the building is a part, and such assignment requires payments by the agency or a mortgage insurance fund maintained by the agency to the prior mortgagee;

• (ii) The Federal agency or a mortgage insurance fund maintained by the agency intends to accept, as a consequence of foreclosure proceedings or otherwise, conveyance of the building or the project of which the building is a part;

• (iii) The Federal agency or a mortgage insurance fund maintained by the agency intends, as a consequence of default, to take possession of, hold title to, or otherwise assume ownership of the building or the project of which the building is a part; or

• (iv) The Federal agency has designated the building or the project of which the building is a part as a troubled building or project. A designation of a troubled building or project must satisfy the following requirements:

  • (A) Designation of troubled status must be based on a review by the Federal agency of the financial condition of the building or project and on a determination by the agency of a history of financial distress and mortgage defaults;

  • (B) Designation of troubled status must be made or received and approved by the national office of the Federal agency; and

  • (C) Federal agency regulations or procedures must provide that, in the event of transfer of the ownership of a designated troubled building or project, the building or project may be subject to review by the Federal agency. Each Federal agency may prescribe its own standards and procedures for designating a troubled building or project so long as such standards are consistent with the requirements of this paragraph (c)(3)(iv).

(4) No prior credit allowed.

The requirement of this paragraph (c)(4) is satisfied only if no prior owner was allowed a low-income housing credit under section 42 for the building.

(d) Application for Waiver-(1) Time and manner.

In order to receive a waiver of the 10-year holding period requirement specified in paragraph (a)(2) of this section, a taxpayer must file an application that complies with the requirement of this paragraph (d) and applicable procedural rules set forth in paragraph (e) of §601.201 (Statement of Procedural Rules). The application must be filed by a taxpayer who has acquired the building by purchase or who has a binding contract to purchase the building. Such binding contract may be conditioned upon the granting of a waiver under this section. The application may be filed at any time after a binding contract has been entered into, but no later than 12 months after the taxpayer's acquisition of the building. An application for a waiver of the 10-year holding period requirement must not contain a request for a ruling on any other issue arising under section 42 or other sections of the Internal Revenue Code. An application for a waiver of the 10- year holding period requirement must be mailed or delivered to the Internal Revenue Service, Associate Chief Counsel (Technical and International), Attention CC:IND:D:C, Room 6545, 1111 Constitution Avenue, NW., Washington, DC 20224.

(2) Information required.

An application for a waiver of the 10-year holding period requirement must contain the following information:

• (i) The taxpayer's name, address and taxpayer identification number;

• (ii) The name (if any) and address of the acquired building and the project (if any) of which it is a part;

• (iii) The date of acquisition or of the binding contract for acquisition of the building by the taxpayer, the amount of consideration paid or to be paid for the acquisition (including the value of any liabilities assumed by the taxpayer), and the taxpayer's certification that such acquisition is by purchase (as defined in section 179(d)(2), as applicable under section 42(d)(2)(D)(iii)(I));

• (iv) The identity of the person from whom the building is acquired, and whether such person is a Federal agency, a mortgagee holding title to the building, or the mortgagor or prior owner;

• (v) The date the building was last placed in service and the date of the most recent (if any) nonqualified substantial improvement of the building (as defined in section 42(d)(2)(D)(i));

• (vi) The taxpayer's certification that the building was not previously placed in service by the taxpayer, or by a person who was a related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the building was last placed in service;

• (vii) The source of Federal assistance received by the building (for purposes of paragraph (c)(1) of this section);

• (viii) The taxpayer's certification that, as of the earlier of the time of acquisition of the building or the time of application for the waiver, the building is a Federally- assisted building (as defined in paragraph (c)(1) of this section);

• (ix) The amount and disposition (e.g., discharge, assignment, assumption, or refinance) of any outstanding mortgage, if any, at the time of acquisition and the identities of the mortgagee and mortgagor;

• (x) The taxpayer's certification that, as of the earlier of the time of acquisition of the building or the time of application for the waiver, Federal mortgage funds are at risk within the meaning of paragraph (c)(2) of this section;

• (xi) Documentation of specified Federal agency action within the meaning of paragraph (c)(3) of this section; and

• (xii) The taxpayer's certification that no prior owner was allowed a low-income housing credit under section 42 of the building.

(3) Other rules.

(i) In the event that an acquired building will be owned by more than one taxpayer, a single application for waiver may be filed by one taxpayer on behalf of the co-owners, if the application contains the names, addresses and taxpayer identification numbers of the other owners. A general partner or a designated limited partner may file an application for waiver on behalf of a partnership.

• (ii) With respect to the requirement in paragraph (d)(2)(xi) of this section for documentation of specified Federal agency action, in the case of Federal agency designation of a troubled building or project (as described in paragraph (c)(3)(iv) of this section), a letter or other written statement is required from an appropriate official in the national office of the Federal agency verifying designation of troubled status and compliance with the requirements in paragraph (c)(3)(iv) of this section.

• (iii) With respect to the certifications required in paragraphs (d)(2) (x) and (xii) of this section, the taxpayer may make the certifications to the best of its knowledge, and no documentation from other persons need be submitted with the application.

(4) Effective date of waiver.

A waiver will be effective when granted but in no event later than 60 days after a taxpayer files a substantially complete application for waiver under this paragraph (d). If a taxpayer has filed a substantially complete application but the Internal Revenue Service requires additional information or materials, any waiver granted will be effective no later than 60 days after the initial application was filed.

(5) Attachment to return.

A waiver letter granted by the Internal Revenue Service shall be filed with the taxpayer's Federal income tax return for the first taxable year the low-income housing credit is claimed by the taxpayer.

(e) Effective date of regulations.

The provisions of §1.42-2T are effective for buildings placed in service by the taxpayer after December 31, 1986. ACT 26 U.S.C. 7805. table "§1.42-2T 1545-1005". Assistant Secretary of the Treasury.

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary regulations relating to the limitations on passive activity losses and passive activity credits. Changes to the applicable tax law were made by the Tax Reform Act of 1986. The temporary regulations affect taxpayers subject to the limitations on passive activity losses and passive activity credits and provide them with the guidance needed to comply with the law. The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations for the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register.

EFFECTIVE DATE

Except as otherwise provided in §1.469-11T, the temporary regulations are effective for taxable years beginning after December 31, 1986.

FOR FURTHER INFORMATION CONTACT

Michael J. Grace of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224, Attention: CC:LR:T, (202) 566-3288 (not a toll-free call).

SUPPLEMENTARY INFORMATION

Background

This document amends the Income Tax Regulations (26 CFR Part 1) to provide temporary rules relating to the limitations on passive activity losses and passive activity credits (the "passive loss and credit limitations"). The temporary regulations reflect the amendment of the Internal Revenue Code of 1986 (the "Code") by sections 501 and 502 of the Tax Reform Act of 1986 (Pub. L. 99-514, 100 Stat. 2233 and 2241), which added section 469. Section 469 disallows the passive activity loss and the passive activity credit for the taxable year.

Scope of the Regulations

These regulations provide general rules for applying the the passive loss and credit limitations.

Section 1.469-1T contains rules relating to the disallowance of the passive activity loss and passive activity credit, the taxpayers to whom the passive loss and credit limitations apply, the general effect of section 469 on the treatment of items of income, gain, loss, deduction, and credit from passive activities, definitions of essential terms (including "passive activity," "trade or business activity," and "rental activity"), the treatment of certain losses from oil and gas working interests, the application of the passive loss and credit limitations to C corporations (including rules relating to the application of the material participation standard, the computation of net active income, and the application of section 469 to affiliated groups of corporations filing consolidated returns), and the treatment of spouses filing joint returns. Section 1.469-2T contains rules for computing the passive activity loss, including rules for identifying passive activity gross income, passive activity deductions, and portfolio income and related deductions, and rules (including rules pursuant to section 469 (1), (2), and (3)) requiring that income from certain passive activities be treated as income that is not from a passive activity. Section 1.469-3T contains rules for computing the passive activity credit, including rules relating to the identification of credits subject to section 469 and the computation of the regular tax liability allocable to passive activities. Section 1.469-5T contains rules defining the term "material participation" for purposes of section 469 and the regulations thereunder. Section 1.469-11T explains the effective date of section 469 and the regulations thereunder and provides guidance under the transitional rule for losses and credits from preenactment interests in passive activities. Future regulations will provide rules identifying economic undertakings that are treated as separate activities for purposes of section 469 and the regulations thereunder (to be located in §1.469-4T), rules relating to the treatment of losses allowable under section 469(g) upon certain dispositions of interests in activities (to be located in §1.469-6T), rules relating to the treatment of certain "self-charged" expenses and related income (to be located in §1.469-7T), rules relating to the application of section 469 to trusts, estates, and their beneficiaries (to be located in

§1.469-8T), rules relating to the application of the $25,000 allowance under section

469 (i) for passive activity losses and credits attributable to certain rental real estate activities (to be located in §1.469-9T), rules relating to the treatment of publicly traded partnerships under section 469(k) (to be located in §1.469-10T), and rules relating to the application of the passive loss and credit limitations in the case of former passive activities and corporations that change status from year to year, i.e., corporations that cease to be "personal service corporations," corporations that cease to be "closely held corporations," and C corporations that become S corporations (to be located in §1.469-1T (k)). Significant Policy Issues I. Effect of Section 469 on Other Provisions A. Items of Income or Gain

Section §1.469-1T(d)(1) provides that the characterization of items of income or deduction as passive activity gross income or passive activity deductions does not affect the treatment of any item of income or gain under any provision of the Code other than section 469. Thus, for example, an item of capital gain from a passive activity that is treated under the regulations as an item of passive activity gross income is taken into account in determining both the passive activity loss and credit for the taxable year and the allowable capital loss for the taxable year. B. Items of Deduction Section 1.469-1T(d)(3) provides that, except as otherwise provided by regulations, a deduction that is disallowed for a taxable year under section 469 is not taken into account as a deduction that is allowed for the taxable year in computing the amount subject to any tax imposed by subtitle A of the Code. Thus, for example, if a deduction is disallowed under section 469 for purposes of computing taxable income subject to income tax, the deduction is not taken into account in computing the taxpayer's net earnings from self-employment for purposes of the tax on self-employment income imposed under chapter 2 of the Code. II. Definition of Passive Activity A. Trade or Business Activity Under section 469(c)(1), an activity which involves the conduct of a trade or business and in which the taxpayer does not materially participate is a passive activity. Section 1.469-1T(e)(2) generally defines the term "trade or business activity" to mean an activity that involves the conduct of a trade or business within the meaning of section 162. Under section 469(c)(6), the term "trade or business" may include, to the extent provided in regulations, any activity in connection with a trade or business, and any activity with respect to which expenses are allowable as a deduction with respect to which expenses are allowable as a deduction under section 212. Although the Service is studying the possibility of treating certain activities in connection with a trade or business and certain section 212 activities as trade or business activities for purposes of section 469, these regulations do not so treat any such activities. B. Rental Activity Section 469(j)(8) provides that the term "rental activity" means any activity where payments are principally for the use of tangible property. Section 1.469-1T(e)(3)(i) provides that an activity generally is a rental activity for a taxable year if the gross income attributable to the conduct of the activity for the year represents amounts paid or to be paid principally for the use of tangible property. In addition, an activity may be a rental activity if tangible property in the activity is held for rent and the expected gross income from the activity will represent payments principally for the use of such property. Section 1.469-1T(e)(3)(ii) provides six exceptions to the general rule. The first exception provides that an activity involving the use of tangible property is not a rental activity if, on the average, the period for which each customer uses the

property is seven days or less. This exception will exclude from treatment as a "rental activity" most activities involving short-term use of tangible personal property such as automobiles, videocassettes, tuxedos, and tools, and short-term use of hotel and motel rooms. The rationale for the "seven-day rule" is that a customer's use of property for seven days or less generally will require the person furnishing the property to provide services significant enough to justify the conclusion that the person is engaged in a service business rather than a rental activity. The second exception provides that an activity involving the use of tangible property is not a rental activity if (a) on the average, the period for which each customer uses the property is greater than seven days but not greater than 30 days and (b) significant personal services are provided. Thus, for example, a taxpayer operating a hotel will not be treated as engaged in a rental activity, even if guests stay for an average period that exceeds seven days, if significant personal services are provided. Section 1.469-1T(e)(3)(iv) provides that only services performed by individuals are treated as personal services. Thus, services such as telephone and cable television service are not taken into account. Section 1.469-1T(e)(3)(iv)(B) also provides that certain specified services, referred to as "excluded services" are not taken into account. The excluded services are (a) all services necessary to permit the lawful use of the property, (b) services in connection with the construction of improvements or in connection with the performance of repairs that extend the useful life of the property, and (c) in the case of improved real property, the kinds of services commonly provided in connection with long-term rentals of high-grade commercial and residential property (e.g., janitorial services). The third exception provides that an activity involving the use of tangible property is not a rental activity if extraordinary personal services are provided by or on behalf of the owner in connection with making property available for use by customers. This exception applies even if, on the average, the period for which each customer uses the property exceeds 30 days. Extraordinary personal services are provided only if the services are performed by individuals, and the customers' use of the property is incidental to their receipt of the services provided. For example, the use by patients of a hospital's boarding facilities generally is incidental to their receipt of the personal services provided by the hospital's medical and nursing staff. In some cases, it may be difficult to determine whether the use of property is incidental to the services provided. The Service invites comment on the extraordinary services rule. The fourth exception is for rentals incidental to certain nonrental activities of the taxpayer. This exception applies if (a) an insubstantial amount of rental income is derived from renting property incidental to an activity of holding such property for investment, (b) the rented property is lodging provided to the taxpayer's employees for the convenience of the taxpayer, (c) an insubstantial amount of rental income is derived from property that was recently used in a trade or business activity of the taxpayer and is temporarily rented, (d) the property is held for sale to customers in the ordinary course of a trade or business and is in fact sold during the taxable year. The fifth exception provides that an activity of making property available for use by customers is not a rental activity if the taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers. Thus, operating a facility (such as a golf course) that is used by customers who

would normally be characterized as invitees or licensees rather than lessees or tenants is not a rental activity. The sixth exception relates to property provided for use in a nonrental activity of a partnership, S corporation, or joint venture in which the taxpayer owns an interest. The provision of such property is not a rental activity if the taxpayer does not rent the property to the partnership, S corporation or joint venture, but provides the property in the taxpayer's capacity as an owner of such an interest. III. Special Rules Treating Certain Activities as Nonpassive A. Exception for Certain Oil and Gas Working Interests 1. Property unit to which exception applies. Section 469(c)(3)(A) provides that the term "passive activity" does not include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the taxpayer's liability with respect to such interest. Section 1.469-1T(e)(4)((i) applies this rule on a well-by-well basis. Thus, if a taxpayer owns a working interest in a tract of land, assigns the working interest in part of the tract to a partnership in exchange for a limited partnership interest, and drills a well on the retained portion of the tract, the working interest exception will apply to that well. If, however, the partnership drills a well on the assigned portion of the tract, the working interest exception will not apply to the taxpayer's interest in that well. 2. Entities that limit liability. Section 1.469-1T(e)(4)(v) provides that an entity limits the liability of a holder of an interest in the entity only if, under the applicable State law, the holder's potential liability for all obligations of the entity is limited (as in the case of a limited partner or a stockholder) to a determinable fixed amount. Thus, the working interest exception may apply even if the taxpayer is protected against loss by an indemnification agreement, a stop loss arrangement, insurance, any similar arrangement, or any combination of such devices. In addition, a partnership in which a taxpayer is a general partner is treated as an entity that does not limit the taxpayer's liability, and any working interest that the taxpayer holds through such a partnership is treated as an interest in an activity that is not a passive activity. Thus, deductions from the working interest (including deductions allocable to a limited partnership interest of the taxpayer) will not be subject to the passive loss limitation. Taxpayers should draw no inferences from these rules concerning the application of section 465(b)(4). If deductions and losses from a working interest are subject to limitation under section 465, then the provisions of section 465(b)(4) apply without regard to the treatment of such deductions and losses under section 469. As explained below, the regulations include rules coordinating the limitations under sections 465 and 469. 3. Effect of limited liability at the time economic performance occurs. Under §1.469- 1T(e)(4)(i), the working interest exception applies for a taxable year to an interest in an oil or gas well drilled or operated pursuant to a working interest that the taxpayer holds at any time during such year either directly or through an entity that does not limit the liability of the taxpayer with respect to such well. Section 1.469-1T(e)(4)(ii) provides that notwithstanding the working interest exception a portion of the

taxpayer's deductions from an oil or gas well will be treated as passive activity deductions (and a corresponding portion of any gross income from the well will be treated as passive activity gross income) if the taxpayer has a net loss from the well, and economic performance occurs with respect to expenses deducted for the taxable year in connection with the drilling or operation of the well at a time when the taxpayer holds the interest in the well through an entity that limits the taxpayer's liability with respect to such drilling or operation. For this purpose, the term "economic performance" has the same meaning as in section 461(h), without regard to the exceptions for recurring items or the spudding of oil and gas wells. Under this rule, the working interest exception may apply for a taxable year to a well drilled by a partnership in which the taxpayer owns a general partnership interest that is convertible at the taxpayer's option into a limited partnership interest. If, however, the interest is converted before economic performance has occurred with respect to all items of deduction taken into account by the taxpayer for the taxable year in connection with the drilling or operation of the well, the working interest exception will not apply for the taxable year to that portion of the taxpayer's net loss for the year that is attributable to deductions for expenses with respect to which economic performance occurred after the conversion. 4. Income recharacterization rule. If any loss for a taxable year from an interest in an oil or gas property is treated under the working interest exception as a loss that is not from a passive activity, then any net income from the property for any subsequent taxable year is treated as income that is not from a passive activity. This rule is explained more fully below under the heading "Income from oil or gas properties with respect to which the taxpayer benefited from the working interest exception." B. Trading Personal Property In some circumstances, the activity of trading personal property (such as securities or commodities or other property of a type that is actively traded) for one's own account has been treated as a trade or business. Even in those circumstances, however, the income or loss from the activity resembles portfolio income or loss in that it results entirely from the holding and sale of personal property. Accordingly,

§1.469-1T(e)(6) provides that an activity of trading personal property of a type that

is actively traded for the account of owners of interests in the activity is not a passive activity even if the activity is treated as a trade or business. IV. Identification of Items of Deduction and Credit That Are Disallowed Under Section 469 Section 1.469-1T(f) provides rules identifying the items of deduction and credit that are disallowed when any part of the taxpayer's passive activity loss or passive activity credit is disallowed for the taxable year. In the case of losses, the regulations generally provide that the amount of the disallowed loss is first allocated ratably among all of the taxpayer's passive activities that have net losses for the year. Any loss allocated to an activity is then generally allocated ratably among all passive activity deductions from the activity for the year. In the case of credits, the first step is omitted; the disallowed passive activity credit is allocated ratably among all of the taxpayer's credits from passive activities.

Taxpayers generally need not account separately for each item of deduction or credit disallowed under section 469. The regulations provide that separate accounting is required if and only if separate identification of an item of deduction or credit may affect the taxpayer's tax liability for any taxable year. For example, if 40 percent of the loss from a passive activity is disallowed for the taxable year, and one of the deductions from the activity is a loss from the sale of a capital asset, the taxpayer must separately identify 40 percent of that deduction as a deduction that is disallowed for the taxable year. Separate identification of the capital loss is required because the limitation on capital losses under section 1211 applies after section 469 and, thus, the disallowance of a capital loss (rather than an ordinary deduction) may affect the taxpayer's tax liability for one or more taxable years. V. Application of Section 469 to C Corporations A. Definition of "Personal Service Corporation" For purposes of section 469, §1.469-1T(g)(2)(i) defines the term "personal service corporation" by cross reference to the definition of such a corporation in §1.441- 4T(d). Those regulations generally provide that a corporation is not a personal service corporation unless it is a C corporation and its principal activity is the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. B. Effect of Net Active Income of a Closely Held Corporation Section 469(e)(2)(A) provides that the passive activity loss of a closely held corporation shall be allowable as a deduction against the net active income of such a corporation, and that a similar rule shall apply in the case of any passive activity credit of such a taxpayer. Section 1.469-1T(g)(4) provides that a closely held corporation's passive activity loss for the taxable year is decreased by the corporation's net active income for the year. Section 1.469-1T(g)(5) provides that a closely held corporation's passive activity credit for the taxable year is decreased by the corporation's net active income tax liability for the year. For purposes of this rule, a closely-held corporation's net active income tax liability is the regular tax liability that is allocable to the corporation's net active income, reduced by all credits other than credits from passive activities. Since net active income is computed by modifying taxable income, net operating loss carrybacks and carryforwards to the taxable year must be taken into account. Therefore, a net operating loss carryback which requires a closely held corporation to recompute its net active income and net active income tax liability for one or more years may also require a recomputation of the corporation's passive activity loss and passive activity credit for one or more years. C. Treatment of Affiliated Groups of Corporations Filing Consolidated Returns Section 1.469-1T(h) contains special rules for applying section 469 and the regulations thereunder to an affiliated group of corporations filing a consolidated return for the taxable year (a "consolidated group"). Under these rules, a consolidated group generally is treated as a single corporation for purposes of

section 469 and the regulations thereunder. Thus, a single passive activity loss and passive activity credit are computed for such a group. In addition, the status of each member of an affiliated group as a personal service corporation or closely held corporation is the same as the status of the entire consolidated group, determined as though the group were a single corporation. In making this determination, and in applying the participation tests set forth in §1.469-1T(g)(3), only stockholders of the group's common parent are treated as stockholders of the hypothetical single corporation. Section 1.469-1T(h)(5) contains rules for allocating a consolidated group's disallowed passive activity loss and credit among the group's members. Under these rules, the disallowed loss or credit is first allocated among the members of the group and is then allocated among the activities of the members under the general rules in

§1.469-1T(f).

Section 1.469-1T(h)(6) contains rules relating to intercompany transactions (within the meaning of §1.1502-13(a)(1)). These rules generally are intended to attribute all items of income and deduction of all members that are attributable to an intercompany transaction to the activities of the purchasing member (within the meaning of §1.1502-13(a)). The Service invites comment on all aspects of the rules in §1.469-1T(h). D. Coordination With Other Provisions The Service recognizes that further rules are needed to coordinate section 469 with certain other provisions applicable to corporations (e.g., sections 381, 382, and 1502) and invites comment on these rules. VI. Treatment of Spouses Filing a Joint Return Section 469(h)(5) provides that in determining whether a taxpayer materially participates in an activity, the participation of the taxpayer's spouse shall be taken into account. Section 469(i)(6)(D) provides a parallel rule for active participation. Section 469(1)(5) provides that the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of section 469, including regulations relating to changes in marital status and changes between joint returns and separate returns. The Service believes that treating married persons filing a joint return as separate taxpayers for purposes of section 469 would present undesirable administrative difficulties, and that it is generally preferable to treat such persons as one taxpayer. In some situations, however, this treatment would frustrate the purposes of the passive loss and credit limitations. For example, the fact that one spouse holds a working interest in an oil or gas well through an entity that does not limit the spouse's liability should not be taken into account in determining whether the working interest exception applies to any portion of the working interest that is held by the other spouse. In addition, if two individuals cease filing a joint return, it is necessary for each individual to account for the deductions and credits treated under section 469(b) as allocable to his or her passive activities.

Accordingly, §1.469-1T(j) provides that spouses filing a joint return for a taxable year generally are treated for such year as one taxpayer for purposes of section 469 and the regulations thereunder. For purposes of the working interest exception, however, married persons are treated as separate taxpayers. In addition, if any deductions or credits are disallowed under section 469, the disallowed deductions and credits attributable to each spouse's activities must be separately identified. The Service invites comment on the treatment of married persons. VII. Definition of Passive Activity Loss Section 469(d)(1) defines the term "passive activity loss" as the amount (if any) by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year. In the interest of clarity,

§1.469-2T(b) defines the passive activity loss for the taxable year as the amount, if

any, by which the passive activity deductions for the taxable year exceed the passive activity gross income for the taxable year. The rules in §1.469-2T (c) and (d) identify the items treated as passive activity gross income and passive activity deductions, respectively, for the taxable year. VIII. Identification of Items of Gross Income and Deductions From Passive Activities The regulations state that, except as otherwise provided, all items of gross income from a passive activity are included in passive activity gross income, and all deductions arising in connection with a passive activity are passive activity deductions. The regulations do not require that any particular method be employed in determining (a) whether items of income are derived from an activity, (b) whether deductions arise in connection with an activity, or (c) how shared costs should be allocated among activities. The regulations contemplate the use of reasonable methods in making these determinations, and the Service will disregard unreasonable determinations. The Service invites public comment regarding the desirability of detailed rules relating to these issues. IX. Treatment of Gain From the Disposition of an Interest in an Activity or Property Used in an Activity A. General Rule: Characterization of Gain at the Time of the Disposition Gain from a disposition of property used in an activity or of an interest in an activity held through a partnership or S corporation generally is treated as gross income from that activity. Except in the case of gain from a disposition of substantially appreciated property formerly used in a nonpassive activity and gain attributable to such property from a disposition of an interest in a partnership or S corporation, such gain is passive activity gross income if the activity is a passive activity for the taxable year of the disposition. For purposes of this rule, the gain recognized upon the disposition of a partnership interest or S corporation stock is treated as gain from the disposition of an interest in the activities in which the partnership or S corporation has an interest. Rules relating to the allocation of gain among the activities of a partnership or S corporation and the treatment of gain allocated to an activity that includes substantially appreciated

property formerly used in a nonpassive activity are discussed under the heading "Dispostions of interests in partnerships and S corporations". The Service recognizes that an approach that focuses on the character of the activity at the time of a disposition may in many circumstances appear arbitrary, and considered various other approaches. These approaches, including approaches taking into account the nature of the activity or the use of the property during the taxpayer's entire holding period, were rejected because they are found to be equally arbitrary and substantially more difficult to administer. The Service invites comment on the rules relating to the treatment of gain from dispositions of interests in activities and interests in property used in activities. B. Disposition of Property Used in More Than One Activity in the 12 Months Preceding the Disposition To ensure that the character of gain realized on the disposition of property reflects the use of the property for a reasonable period preceding the disposition, §1.469- 2T(c)(2)(ii) requires the taxpayer to allocate the amount realized on the disposition and the adjusted basis of the property among the activities in which the property was used during the 12-month period preceding the disposition. For purposes of this rule, the term "activity" includes, e.g., personal use and holding for investment. The regulations provide only that the allocation of amount realized and adjusted basis must be reasonable. Examples illustrate that an allocation among activities is considered reasonable if it is based on the period for which the property is used in each such activity during the 12-month period. These examples are not intended to foreclose the use of other reasonable allocation methods. In recognition of the recordkeeping burden that this allocation rule may impose,

§1.469-2T(c)(2)(ii) also provides a de minimis exception under which the amount

realized and adjusted basis of property that was predominantly used in one activity during the 12-month period preceding its disposition may be allocated solely to that activity if the value of the property does not exceed the lesser of (a) $10,000 and (b) 10 percent of the value of all property used in the activity at the time of the disposition. The Service invites comment on the feasibility of the allocation requirement generally, including comment on allocation rules that may be helpful to taxpayers. C. Disposition of Substantially Appreciated Property Formerly Used in a Nonpassive Activity The general rule characterizing gain by reference to the character of the activity in which property is used at the time of disposition could, if not limited, encourage taxpayers to structure dispositions in a manner that generates passive activity gross income in inappropriate situations. Accordingly, §1.469-2T(c)(2)(iii) provides that any gain from a disposition of substantially appreciated property is treated as not from a passive activity unless the property was used in a passive activity for either (a) 20 percent of the taxpayer's holding period for the property or (b) the entire 24-month period ending on the date of the disposition. For purposes of this rule,

property is substantially appreciated if its fair market value is more than 120 percent of its adjusted basis. D. Pre-1987 Installment Sales In Notice 87-8, 1987-3 I.R.B. 11, the Service announced that, under these regulations, gain recognized on the installment method would be treated as not from a passive activity if, but for the use of the installment method, the taxpayer would have taken the gain into account for a taxable year beginning before January 1, 1987. This rule is inconsistent with a proposed technical correction to section 469, and is not included in these regulations. Moreover, the Service will not enforce the rule announced in Notice 87-8 unless and until it is adopted in regulations under section 469. X. Portfolio Income Excluded From Passive Activity Gross Income A. General Rule Section 1.469-2T(c)(3) provides that passive activity gross income does not include portfolio income, which is defined as gross income that is derived from specified sources (including interest, dividends, annuities, and royalties) and is not derived in the ordinary course of a trade or business. Section 1.469-2T(c)(3)(ii) provides that, for purposes of this rule, gross income is treated as derived in the ordinary course of a trade or business only to the extent specifically provided in the regulations. That provision also specifically identifies certain types of income as derived in the ordinary course of a trade or business and provides that the Commissioner may similarly treat additional types of income as similarly derived. The Service invites comment on and ruling requests relating to the treatment of interest, dividends, annuities, and royalties as derived in the ordinary course of a trade or business. B. Characterization of Royalties From Licensing Intangible Property Section 1.469-2T(c)(3)(iii)(B) provides that royalties from licensing intangible property may be treated as derived in the ordinary course of a trade or business only if the person receiving such royalties either created the property or performed substantial services or incurred substantial costs with respect to the development or marketing of the property. Although the determinations under this rule are generally based on all of the facts and circumstances, a person will be treated as deriving royalties in the ordinary course of a trade or business if either of two quantitative tests are satisfied. The Service invites public comment on the appropriateness of this rule and the need for additional guidance. In particular, the Service seeks comment on the quantitative tests. C. Mineral Royalties The regulations do not include special rules for determining whether mineral royalties are derived in the ordinary course of a trade or business because the Service is continuing to develop criteria for making this determination. The regulations include only one example illustrating the treatment of mineral royalties. This example, which follows from §1.469-2T(c)(3)(ii)(D), indicates that royalty income derived from

royalty interests held in a trade or business activity of trading or dealing in such interests is treated as derived in the ordinary course of a trade or business. Under §1.469-2T(c)(3)(ii), the only other mineral royalties treated as income derived in the ordinary course of a trade or business are those identified by the Commissioner. Therefore, unless and until these regulations are amended, taxpayers may not treat mineral royalties (other than royalties derived from a trade or business of trading or dealing in royalty interests) as derived in the ordinary course of a trade or business without obtaining a ruling. Nonetheless, the Service believes that it may be appropriate to treat a portion of a mineral royalty payment as derived in the ordinary course of a trade or business in some cases not involving a trade or business of trading or dealing in royalty interests. Assume, for example, that royalty income is derived from an overriding royalty interest created on the transfer of a working interest by a partnership engaged in the trade or business of oil and gas development, and that the partnership is not taxed upon receipt of the royalty interest. In such a case, it may be appropriate to treat the royalty payments, by analogy to sections 483 and 1274, as deferred payments with respect to the sale of the working interest. Under this approach, the portion of each royalty payment that represents consideration paid to the partnership for the working interest would be treated as income derived in the ordinary course of a trade or business, and only the interest element in the payments would be treated as portfolio income. The Service invites public comment on whether and how such distinctions should be made, and how depletion deductions should be allocated between portfolio and nonportfolio components of royalty payments. XI. Personal Service Income Excluded From Passive Activity Gross Income A. Payments to Partners for the Performance of Services Section 469(e)(3) provides that earned income (within the meaning of section 911(d)(2)(A)) shall not be taken into account in computing the income or loss from a passive activity for any taxable year. Section 911(d)(2)(A) defines earned income in a manner that includes all payments to partners for the performance of services. Accordingly, the regulations provide, in §1.469-2T (c)(4)(i)(A) and (e)(2), that any payments to a partner that are described in section 707 (a) or (c) and represent compensation for the performance of services are excluded from passive activity gross income. The regulations do not, however, adopt the suggestion of some commentators to treat as personal service income the portion of a partner's distributive share of partnership income that represents the value of the partner's services performed on behalf of the partnership. B. Income From Retirement Plans Taxable distributions from pension, profit-sharing, and other retirement plans generally are comprised of compensation for past services and investment income. Both of these components generally are excluded from passive activity gross income. Therefore, §1.469-2T(c)(4) provides that personal service income includes all income from such distributions

XII. Income From Section 481 Adjustments If a change in accounting method results in an increase in taxable income under section 481 (a "positive section 481 adjustment"), the portion of the adjustment attributable to activities that were passive activities in the year of change is treated, under §1.469-2T(c)(5), as passive activity gross income. The portion of the adjustment attributable to an activity is determined by allocating the adjustment among the activities that would have given rise to a positive section 481 adjustment if a separate section 481 adjustment were computed with respect to each activity, in proportion to such hypothetical positive adjustments. XIII. Income From Oil or Gas Properties With Respect to Which the Taxpayer Benefited From the Working Interest Exception Section 469(c)(3)(B) provides that, if a taxpayer has a loss for a taxable year from a working interest in an oil or gas property that is treated as not from a passive activity, any net income from such property for any succeeding taxable year shall be treated as not from a passive activity. A. Pre-1987 Losses and Losses From Material Participation Activities Section 1.469-2T(c)(6)(i) provides that section 469(c)(3)(B) applies only where a loss from a working interest arises in a taxable year beginning after December 31, 1986, and is treated as not from a passive activity solely by reason of the special working interest exception in section 469(c)(3)(A). Thus, the fact that a loss for a taxable year from an oil or gas well drilled or operated pursuant to a working interest was not subject to limitation under section 469 will not cause income for any succeeding year to be treated as not from a passive activity if either (a) the loss was taken into account for a taxable year beginning prior to January 1, 1987, or (b) the loss was not subject to limitation because the taxpayer materially participated in the activity in which the loss arose. B. Definition of "Property" Neither section 469(c)(3)(B) nor the legislative history defines the term "oil or gas property." Section 1.469-2T(c)(6)(iii) provides that, for purposes of applying section 469(c)(3)(B) with respect to a working interest, the term "oil or gas property" means any oil or gas property the value of which is directly enhanced by activities the costs of which are borne by the taxpayer as a result of drilling an oil or gas well with respect to the working interest. Thus, the definition of "property" in section 614(a) and the regulations thereunder is not relevant for this purpose. The definition of the term "oil or gas property" for purposes of section 469(c)(3)(B) is illustrated by three examples. The first example indicates that if the drilling of a well on one tract reveals that a single reservoir underlies that tract and another tract in which the taxpayer owns an interest, the taxpayer's interests in both tracts are treated as part of the same oil or gas property. The second example indicates that if a well is drilled through two formations, both formations are treated as part of the same oil or gas property. The third example indicates that the mere fact that drilling activities generate information indicating the presence of oil or gas in a general geographical area is insufficient to establish that the value of oil or gas properties in such area is "directly" enhanced by the activities generating the information.

XIV. Passive Activity Deductions A. General Rule Section 1.469-2T(d)(1) provides that a deduction is a "passive activity deduction" for a taxable year if the deduction (a) arises in connection with the conduct of an activity that is a passive activity for the taxable year or (b) is carried over from the preceding taxable year under section 469(b). For purposes of this rule, a deduction is treated as arising in the taxable year in which the deduction would be allowable if taxable income for all taxable years were determined without regard to sections 469 and 1211. Thus, for example, if a partner's distributive share of a partnership deduction is disallowed under section 704(d) in 1987, but is not disallowed under section 704(d) (or any other provision other than section 469 or 1211) in 1988, the deduction is treated as arising in 1988. This rule has two significant effects. First, a deduction is not taken into account in computing the passive activity loss and credit until the first taxable year in which the deduction is not disallowed by any applicable limitation other than those contained in sections 469 and 1211. Second, the determination of whether a deduction from an activity is a passive activity deduction does not depend on the character of the activity in taxable years in which the deduction is disallowed under limitations other than section 469. Thus, in the example in the preceding paragraph, the determination of whether the partner's deduction is a passive activity deduction in 1988 depends solely on whether the activity in which it arises is a passive activity of the partner in 1988. Section 501(c)(2) of the Tax Reform Act of 1986 provides that section 469 shall not apply to any loss, deduction, or credit carried to a taxable year beginning before January 1, 1987. Consistent with the rule, §1.469-2T(d)(2)(x) provides that an item of loss or deduction that would have been allowed for a taxable year beginning before January 1, 1987, but for section 465, 704(d), or 1366(d), is not treated as passive activity deduction. B. Losses From Dispositions Section 1.469-2T(d)(5) generally treats any loss recognized upon the disposition of property used in an activity or of an interest in an activity held through a partnership or S corporation as a deduction from such activity. Rules relating to the allocation of loss among activities of a partnership or S corporation are discussed under the heading "Dispositions of interests in partnerships and S corporations." Under section 469(g)(1), the loss from a disposition may be treated in whole or in part as a loss that is not from a passive activity. Future regulations will provide rules for determining when a loss is treated under section 469(g)(1) as not from a passive activity. C. Coordination With Sections 465, 704 (d), and 1366(d) Since, for purposes of section 469, a deduction is not treated as arising in a taxable year in which it is disallowed under section 465, 704(d), or 1366(d), rules are needed to determine which deductions are disallowed for the taxable year under such sections. Section 1.469-2T(d)(6) provides such rules.

Under §1.469-2T(d)(6), if section 465, 704(d), or 1366(d) disallows all or any part of the taxpayer's loss attributable to an activity (within the meaning of section 465), or to an interest in a partnership or S corporation, as the case may be, a portion of each deduction taken into account in computing such loss is disallowed. To the extent the regulations under those provisions are not consistent with the rules in §1.469-2T(d)(6), the Service expects that such regulations will be amended. The regulations do not include any other rules coordinating section 469 with other limitations on losses and deductions. The Service invites comment on the the need for additional coordination rules. XV. Special Rules for Partners and S Corporation Shareholders A. In General The determination of whether an item of income or deduction from a partnership or S corporation is an item of passive activity gross income or a passive activity deduction, respectively, is made by reference to the taxpayer's participation in the activity that generated the item of income or deduction. Section 1.469-2T(e)(1) provides that, in the case of items of income, gain, loss, and deduction from an activity conducted through a fiscal year partnership or S corporation, the taxpayer's participation is determined for the entity's taxable year. The Service invites comment on the application of this rule. B. Certain Payments to Partners Section 1.469-2T(e)(2)(i) provides that items of gross income and deduction attributable to a transaction between a partner and a partnership shall be characterized for purposes of section 469 in a manner consistent with the treatment of such transaction under section 707(a). Section 1.469-2T(e)(2)(ii) provides that a payment to a partner for the performance of services or the use of capital, if described in section 707(c) or section 736(a)(2), is generally characterized for purposes of section 469 and the regulations thereunder as a payment of compensation for services or interest, as the case may be, and not as a distributive share of partnership income. The Service expects that a conforming amendment will be made to §1.707-1. In addition, §1.469-2T(e)(2)(iii) provides that any gain or loss taken into account by a retiring partner or a deceased partner's successor in interest as a result or a deceased partner's successor in interest as a result of a payment under section 736(b) is treated a passive activity gross income or a passive activity deduction only to the extent that the gain or loss would have been treated as passive activity gross income or a passive activity deduction if it had been recognized at the time that the liquidation of the retiring or deceased partner's interest commenced. C. Dispositions of Interests in Partnerships and S Corporations In general, for Federal income tax purposes, a disposition of an interest in a partnership or S corporation (a "passthrough entity") is treated as a disposition of such interest, rather than as a disposition of an interest in each of the entity's assets. The Service believes that the accurate measurement of passive activity gross

income and deductions would be furthered by requiring such a disposition to be treated as a disposition of an interest in the passthrough entity's assets. The regulations nonetheless have not adopted this approach as the general rule because a reasonably accurate measurement of passive activity gross income and deductions generally may be accomplished by allocating the gain or loss from the disposition of an interest in a passthrough entity among the entity's activities. Section 1.469-2T(e)(3) contains rules governing the treatment, for purposes of the passive loss and credit limitations, of a disposition of an interest in a passthrough entity by a holder of such an interest (the "holder"). A transitional rule also is provided. The general rule, contained in §1.469-2T(e)(3)(ii), requires a holder's gain or loss from a disposition of an interest in a passthrough entity (including gain or loss recognized under section 731(a)) to be allocated among the activities of the passthrough entity in proportion to the amounts of gain or loss, respectively, that would have been allocated to the holder by the passthrough entity with respect to each of the entity's activities if the entity had sold its interests in such activities on the applicable valuation date. Generally, the passthrough entity may select either the beginning of the taxable year of the passthrough entity in which the holder's disposition occurs or the date of such disposition as the applicable valuation date. The date of the holder's disposition of an interest in the passthrough entity must be used as the applicable valuation date, however, if since the beginning of the entity's taxable year the entity has sold a significant amount of the property used in any activity or the holder has contributed a significant amount of substantially appreciated or substantially depreciated property to the passthrough entity. For purposes of this rule, property is substantially appreciated if its fair market value exceeds 120 percent of its adjusted basis, and property is substantially depreciated if its adjusted basis exceeds 120 percent of its fair market value. Under §1.469-2T(e)(3)(iii), gain from a holder's disposition of an interest in a passthrough entity that is allocated to a passive activity under the general rule will nonetheless be treated as gain that is not from a passive activity if (a) gain that would be treated as gain that is not from a passive activity under §1.469- 2T(c)(2)(iii) would have been allocated to the holder if all of the property used in the activity had been sold, and (b) the amount of that gain exceeds 10 percent of the holder's gain from the disposition that is allocated to the activity under the general rule. This rule is designed to prevent taxpayers from using passthrough entities to structure dispositions of property in a manner that generates passive income in situations where such income would otherwise be treated as not from a passive activity under §1.469-2I(c)(2)(iii). Section 1.469-2T(c)(3)(iv) provides a transitional rule for dispositions of interests in a passthrough entity that occur during any taxable year of the entity beginning prior to February 19, 1988. Under this transitional rule, gain or loss from a qualifying disposition of an interest in the entity may be allocated among the activities of the entity under any reasonable method that the selects. This transitional rule does not apply to any sale of an interest in a passthrough entity that occurs after February 19, 1988, if the holder contributes certain substantially appreciated property (as defined above) to the entity after that date.

The Service continues to study the issues presented by dispositions of interests in passthrough entities and invites comment on the treatment accorded these dispositions under §1.469-2T(e)(3). XVI. Recharacterization of Certain Passive Activity Gross Income A. In General Section 469 was intended to prevent taxpayers from using losses from rental activities and passive business activities to shelter any of three types of income: (a) Personal service income, (b) active business income, and (c) Portfolio investment income. Congress recognized the difficulty of writing statutory rules that would clearly distinguish income in these classes from income properly falling in the rental or passive business income category, and anticipated the need for additional rules to address transactions structured in order to maximize the amount of income treated as rental or passive business income. Consequently, Congress enacted section 469 (1), (2), and (3), granting to the Secretary the authority to prescribe regulations that eliminate certain items of gross income, or the net income from certain activities, from the computation of the passive activity loss and credit. The Conference Report accompanying the Act states that the Secretary's regulatory authority is intended to be "exercised to protect the underlying purpose of the passive loss provision, i.e., preventing the sheltering of positive income sources through the use of tax losses derived from passive business activities." H.R. Conf. Rep. No. 99-841, 99th Cong., 2nd Sess., vol. II, at 147 (1986). In the absence of regulations, taxpayers would be encouraged to generate passive activity gross income by (a) changing their participation in, and the ownership structure of, their active businesses, and (b) replacing their portfolio investments with investments in rental or passive business activities that share many of the investment characteristics of traditional portfolio investments. Although attempts to derive capital income from rental or passive business sources are not generally abusive, they could, if undeterred, frustrate Congress' intent that the passive loss provision prevent "the sheltering of positive income sources." Thus, §1.469-2T(f) requires that income from certain activities be treated as income that is not from a passive activity. Since taxpayers could not clearly foresee the particular recharacterization rules that these regulations would adopt, the provisions in §1.469-2T(f) that recharacterize income from activities based on factors other than the taxpayer's participation in such activities do not apply to gross income taken into account for any taxable year beginning before January 1, 1988. In addition, the rule recharacterizing income from self-rented property does not apply to income that is attributable to the rental of property pursuant to a written binding contract entered into before February 19, 1988. The rules contained in §1.469-2T(f) apply only to gross income that, in the absence of such rules, would be treated as passive activity gross income. Thus, if an activity is not a passive activity, the rules in §1.469-2T(f) do not apply to gross income from the activity. Moreover, except as specifically provided by regulation, the fact that an amount of gross income from an activity is recharacterized under §1.469-2T(f) does

not cause that activity to be treated as other than a passive activity for purposes of section 469 or these regulations. B. Rules Preventing Conversion of Active Business Income Into Passive Activity Gross Income 1. Passive activities in which the taxpayer's participation is significant. The Service recognizes that, in the case of an activity that is not the full-time occupation of the taxpayer, the rules regarding material participation set forth in §1.469-5T are stringent. As a result, a taxpayer spending relatively small amounts of time in unrelated activities could, in the absence of regulations, treat the gross income from such activities as passive activity gross income even though the taxpayer's participation and services are significant factors in generating the income from the activities. In view of this concern, §1.469-2T(f)(2) provides that an amount of the taxpayer's gross income from a significant participation passive activity equal to the taxpayer's net passive income from the activity is treated as not from a passive activity. For purposes of this rule, a significant participation passive activity is an activity (other than a rental activity) in which the taxpayer participates for more than 100 hours, but does not materially participate, for the taxable year. The Service does not believe it appropriate to treat the taxpayer's net income, but not the taxpayer's net losses, from activities as nonpassive if the taxpayer's involvement in such activities is substantial. Accordingly, §1.469-5T(a)(4) provides that a taxpayer materially participates in activities that would otherwise be significant participation passive activities for purposes of §1.469-2T(f)(2) if the taxpayer's participation in all such activities exceeds 500 hours for the taxable year. 2. Activities involving the rental of property developed by the taxpayer. In general, an activity involving the rental of property is a passive activity. Under §1.469- 2T(c)(2), gain from the disposition of property used in a passive activity generally is treated as passive activity gross income. It is not appropriate, however, to treat a taxpayer's gain from the sale of a rental property as passive activity gross income if the taxpayer materially or significantly participated in the development of the property and the gain is predominantly attributable to the development of the property rather than to appreciation during the rental period. Accordingly, §1.469-2T(f)(5) provides that, in certain situations, an amount of a taxpayer's gross income from renting and selling an item of property equal to the taxpayer's net passive income from such rental and sale is treated as not from a passive activity. This rule applies if (a) any gain from the sale, exchange, or other disposition of the property is included in the taxpayer's income for the taxable year, (b) during any taxable year the taxpayer materially or significantly participated in a trade or business activity involving the performance of services for the purpose of enhancing the value of the property, and (c) a binding contract for the sale or exchange was entered into less than 24 months after the rental of the property commenced. In general, the effect of this rule is that property developed by the taxpayer must be rented for at least 24 months prior to selling the property or contracting for its sale

or the taxpayer's gain from the sale will not be treated as passive activity gross income. 3. Self-rented property. As indicated above, section 469 is intended, in part, to prevent taxpayers from sheltering active business income with losses from rental activities and passive business activities. Income from an active business consists of both income from services and income from capital invested in the business. In the absence of regulations, a taxpayer could derive passive activity gross income from an active business in which tangible property is used by renting the property to an entity conducting the activity (or by causing an entity holding the property to rent the property to the taxpayer). It would be inconsistent with the purposes of section 469 to treat rental income as passive activity gross income in such cases, and the Conference Report accompanying the Act states that it would be appropriate for the Service to exercise its regulatory authority under section 469(1)(3) in the case of "related party leases or sub-leases, with respect to property used in a business activity, that have the effect of reducing active business income and creating passive income." H.R. Conf. Rep. No. 99-841, 99th Cong., 2nd Sess., vol. II, at 147 (1986). Accordingly, §1.469-2T(f)(6) provides that an amount of the taxpayer's gross income from renting an item of property equal to the taxpayer's net passive income from such rental is treated as not from a passive activity if the property is rented for use in a trade or business activity in which the taxpayer materially participates for the taxable year. The Service recognizes that it has the authority to treat part or all of the taxpayer's rental expense in such cases as a self-charged item, and that the amount of rental income that is recharacterized under §1.469-2T(f)(6) may exceed the amount of income that it would be appropriate to recharacterize as a self-charged item. The Service invites comments on the relationship between this rule and the rules to be provided under §1.469-7T (relating to the treatment of self-charged items of income and expense). C. Rules Preventing Conversion of Portfolio Income Into Passive Activity Gross Income 1. Activities involving the rental of nondepreciable property. The Conference Report accompanying the Act states that it may be appropriate for the Service to treat "ground rents that produce income without significant expenses" as not from a passive activity. Consistently with this suggestion, §1.469-2T(f)(3) provides that an amount of the taxpayer's gross income from an activity of renting nondepreciable property equal to the taxpayer's net passive income from the activity is treated as not from a passive activity. Since nondepreciable property may be rented together with incidental depreciable property (e.g., land with minor improvements), raising a factual issue as to whether an activity in which nondepreciable property is leased consists primarily of renting such property, §1.469-2T(f)(3) provides a bright line for distinguishing activities involving the rental of nondepreciable property from other rental activities. Under the regulations, income from a rental activity is subject to this recharacterization rule if the unadjusted basis of the depreciable property rented in the activity is less than 30 percent of the unadjusted basis of all property rented in the activity. The Service invites comment regarding the appropriateness of this objective standard. 2. Equity-financed lending activities. Under §1.469-2T(c)(3)(ii)(A), interest income from loans made in the ordinary course of a trade or business of lending money is

not portfolio income. Absent a regulation expressly treating income from such an activity as nonpassive income, taxpayers could derive passive income from investments substantially similar to mutual fund investments by becoming passive investors in partnerships or S corporations that engage in a trade or business of lending equity funds contributed by the taxpayers. Permitting such income to be treated as passive income would be inconsistent with the purpose of section 469 to prevent the sheltering of portfolio income with losses from rental and passive business activities. On the other hand, income derived from borrowing money and lending the proceeds at a higher interest rate does not resemble the kind of portfolio income which Congress intended to protect from sheltering by passive losses. Accordingly, §1.469-2T(f)(4) treats as nonpassive income an amount of the taxpayer's gross income from an equity-financed lending activity equal to the lesser of (a) the taxpayer's equity-financed interest income from the activity or (b) the taxpayer's net passive income from the activity. This rule applies to the lending activities in which the average balance of debt incurred in the activity (determined at the entity level) does not exceed 80 percent of the average balance of interest-bearing assets held in the activity. In general, the taxpayer's equity-financed interest income from the activity is equal to the taxpayer's interest income from the activity multiplied by the activity's ratio of equity to interest-bearing assets. This rule is designed to treat as nonpassive income only that portion of the taxpayer's income from the activity that approximates the product of (a) the average interest rate of the activity's interest-bearing assets and (b) the taxpayer's equity contribution to the activity. 3. Passthrough entities licensing intangible property. Section §1.469-2T(c)(3)(iii)(B) provides that royalty income received by a passthrough entity from the licensing of intangible property may be treated as income derived in the ordinary course of a trade or business if the entity (a) created the property or (b) performed substantial services or incurred substantial costs with respect to the development or marketing of the property. This treatment is appropriate in the case of a taxpayer who owns an interest in such an entity at the time that the entity creates such property, performs such services, or incurs such costs. If, however, a taxpayer acquires an interest in such an entity after the entity creates such property, performs such services, or incurs such costs, the taxpayer's royalty income resembles portfolio income rather than income derived in the ordinary course of a trade or business. Accordingly,

§1.469-2T(f)(7) provides that an amount of the taxpayer's gross income from such

property equal to the taxpayer's net passive income from such property is generally treated as not from a passive activity. The Service invites comment on the rules employed in §1.469-2T(f)(7) to determine when taxpayers are subject to this rule. D. Limitation on Recharacterized Income The rules contained in §1.469-2T(f)(2) (relating to significant participation activities),

§1.469-2T(f)(3) (relating to the rental of nondepreciable property), and §1.469-

2T(f)(4) (relating to equity-financed lending activities) treat as nonpassive income an amount of the taxpayer's gross income from an activity equal to the taxpayer's net passive income from the activity. Under §1.469-2T(f)(9)(i), the taxpayer's "net passive income" from an activity for a taxable year is the excess of the taxpayer's passive activity gross income from the activity for the year (determined without regard to these recharacterization rules) over the taxpayer's passive activity deductions from the activity for the year. The rules contained in §1.469-2T(f)(5)

(relating to the rental of property developed by the taxpayer), §1.469-2T(f)(6) (relating to self-rented property), and §1.469-2T(f)(7) (relating to passthrough entities licensing intangible property) are similar, but apply on a property-by-property basis. Taxpayers should note that, under §1.469-2T(d)(1)(ii), a deduction from an activity that is disallowed under section 469 for a taxable year is treated as a passive activity deduction from the activity for the succeeding taxable year and that, under §1.469- 2T(f)(7)(ii)(B) and (9)(iv), a similar rule applies when deductions reasonably allocable to an item of property are disallowed. Thus, if a taxpayer's loss from an activity or an item of property is disallowed for a taxable year, the taxpayer's net passive income from the activity or property for the succeeding year is reduced by the amount of such disallowed loss. As a result, the regulations do not treat income from an activity or an item of property as nonpassive income while, at the same time, prohibiting the deduction of previously disallowed losses from such activity or property. Although prior-year losses from an activity or an item of property subject to the rules contained in §1.469-2T(f) generally carry forward and reduce the amount of gross income that is treated as nonpassive income under those rules, this is not the case to the extent any such loss for the prior taxable year exceeds the disallowed loss allocated to such activity or property for such year under the rules of §1.469-1T(f). In that event, the excess loss has in effect absorbed passive income, thereby resulting in the disallowance of passive losses from other activities. The Service is studying the interaction between the rules for allocating disallowed losses and rules, such as those contained in §1.469-2T(f) and those to be provided with respect to former passive activities, under which a carryover loss may be allowed to the extent of income that would otherwise be treated as nonpassive income. The Service invites suggestions for the coordination of those rules. E. Possible Recharacterization Rules to be Contained in Future Regulations The Service recognizes that the rules in these regulations are not exhaustive and that taxpayers may structure additional investments that have economic characteristics similar to those of portfolio investments so as to derive passive activity gross income from such investments. The Service intends to monitor developments in this area closely, and anticipates prescribing additional regulations to the extent necessary to prevent portfolio-type income from being treated as passive activity gross income. In general, any such additional regulations would apply prospectively only. In appropriate circumstances, however, the regulations might apply to income, derived after the date the regulations are published, from investments made prior to such date, but in such cases the rules would be issued in proposed form (rather than as temporary regulations), with a period for public comment before the regulations become final. During the preparation of these regulations, the Service considered an approach to recharacterizing certain passive activity gross income that is illustrative of the kinds of additional regulations the Service may prescribe in the future. Under this approach, gross income attributable to a preferred or guaranteed return from an investment (i.e., a return that through preferences or other arrangements is derived from sources other than the taxpayer's own invested capital) would be treated as portfolio income.

Some commentators have suggested that such a rule should address the following situation: A limited partnership is formed to acquire a rental property for $10 million. The general partner contributes $5 million to the partnership and the remaining $5 million of partnership capital is raised through a private placement of limited partnership interests to five individuals. The partnership agreement allocates 99 percent of partnership taxable income to the limited partners until the income allocated to them equals a 10 percent cumulative annual return on their invested capital, with any remaining taxable income allocated 15 percent to the limited partners and 85 percent to the general partner. Thus, the income earned on the general partner's invested capital will be applied, if necessary, to satisfy the limited partners' right to a 10 percent cumulative return. Because of the limited partners' preferential right to income, their interests, depending on circumstances such as the nature of the partnership's investment, may have the characteristics of a portfolio investment. The Service considered an approach under which a limited partner's gross income attributable to a preferred return would in certain circumstances be treated as portfolio income. The Service continues to study this approach and invites comment on the circumstances in which a "preferred" or "guaranteed" return should be treated as portfolio income. XVII. Passive Activity Credit A. Credits Subject to Section 469 A credit may be limited under section 469 if it is from a passive activity and is described in section 38 (b) (1) through (5) (relating to general business credits), section 27(b) (relating to section 936 corporations), section 28 (relating to clinical testing of certain drugs), or section 29 (relating to fuel from nonconventional sources). Section 1.469-3T(b) provides that a credit is treated as from a passive activity if (a) it arises in connection with a passive activity (i.e., an activity that is passive for the taxable year in which the credit would be allowed if section 469 and other specified limitations did not apply) or (b) in the case of a credit attributable to qualified progress expenditures (within the meaning of section 46(d)), it is reasonable to believe that the progress expenditure property (within the meaning of section 46(d)(2)) will be used in a passive activity when it is placed in service. Thus, for example, a credit attributable to qualified rehabilitation expenditures (within the meaning of section 48(g)(2)) which is allowed for the taxable year under section 46(d), is treated as a credit from a passive activity of the taxpayer if either (a) the activity in which the qualified rehabilitation expenditures are paid or incurred is a passive activity of the taxpayer for the taxable year in which such expenditures are paid or incurred, or (b) it is reasonable to believe that the rehabilitated property will be used in a passive activity of the taxpayer when it is placed in service. B. Determination of Regular Tax Liability Allocable to Passive Activities Under section 469(d)(2), the passive activity credit is the amount by which the sum of the taxpayer's credits that are subject to section 469 for the taxable year exceeds the taxpayer's regular tax liability allocable to all passive activities for such year.

Section 469(j)(3) provides that the term "regular tax liability" has the meaning given such term by section 26(b). Section 1.469-3T(d)(1) provides that the taxpayer's regular tax liability for the taxable year that is allocable to all passive activities is the regular tax liability on the excess of the taxpayer's taxable income for the year over the amount by which the taxpayer's passive activity gross income exceeds the taxpayer's passive activity deductions for the taxable year. C. Coordination With Other Limitations on Credits In general, the limitation on the passive activity credit applies before all other limitations that may apply to credits from passive activities (other than the limitation in section 41(g) (relating to research credits of certain individuals)). If a credit is subject to section 469 for a taxable year but is not disallowed by section 469, the credit becomes subject to other limitations in the same manner as credits from activities that are not passive activities. In determining the years to which a general business credit may be carried, the credit is treated for purposes of section 39 as a current year business credit in the first taxable year in which the credit is subject to section 469 but is not disallowed thereby. XVIII. Material Participation A. In General Under §1.469-5T(a), an individual is treated as materially participating in an activity for a taxable year if and only if the individual meets one of seven tests. The first four tests (contained in §1.469-5T(a) (1) through (4)) are quantitative in nature, and are based on the number of hours spent participating in the activity during the year. The fifth and sixth tests (contained in §1.469-5T(a) (5)) and (6)) are based on material participation by the taxpayer in prior years. The seventh test (contained in §1.469- 5T (a)(7)) is a facts-and-circumstances test. B. Quantitative tests Under §1.469-5T(a)(1), an individual is treated as materially participating in an activity for a taxable year if the individual participates in the activity for more than 500 hours during the year. The Service believes that the 500-hour test will have the effect of restricting deductions from the types of trade or business activities that Congress intended to treat as passive activities, since few investors in traditional tax shelters devote more than 500 hours during a taxable year to any such investment. In addition, the Service believes that income from an activity in which an individual participates for more than 500 hours during a taxable year is not properly classified as income from a passive activity. Under §1.469-5T(a)(2), an individual is treated as materially participating in an activity for a taxable year if the individual's participation in the activity for the year constitutes substantially all of the participation in the activity for the taxable year. Section 1.469-5T(a)(3) treats an individual as materially participating in an activity for a taxable year if the individual participates in the activity for more than 100 hours during the taxable year, and the individual's participation in the activity for the

year is not less than that of any other individual. These rules are included because the service recognizes that the operation of some activities may not require more than 500 hours of participation, or may not require more than 500 hours of participation by any one individual during a taxable year. Under §1.469-5T(a)(4), an individual is treated as materially participating in all of the individual's significant participation activities for a taxable year if the individual's aggregate participation is significant participation activities for the year exceeds 500 hours. For purposes of this rule, a significant participation activity is a trade or business activity in which the individual participates for more than 100 hours during the taxable year but in which the individual does not materially participate for the year (without regard to this rule). This rule is included because the Service believes that an individual who devotes more than 500 hours during a taxable year to several activities, each of which is significant activity of such individual, should be treated similarly to an individual who devotes an equivalent amount of time to a single activity. C. Tests Based on Material Participation in Prior Years Under §1.469-5T(a)(5), an individual is treated as materially participating in an activity for a taxable year if the individual materially participated in such activity for any five of the ten taxable years that immediately precede the taxable year. Under §1.469-5T(a)(6), an individual is treated as materially participating in a personal service activity for a taxable year if the taxpayer materially participated in the activity for any three taxable years that precede the taxable year. For purposes of this rule, an activity is a personal service activity if it principally involves the performance of personal services in (a) the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, or (b) any other trade or business in which capital is not a material income-producing factor. These rules are included because the Service believes that an activity in which an individual has materially participated over a long period of time or a personal service activity in which an individual has participated for a substantial period of time is likely to represent the individual's principal livelihood rather than a passive investment. In particular, the Service does not believe that withdrawal from a longstanding active business or from a personal service business that has been active for a substantial period should convert an individual's earnings from the business to passive income. Thus, the Service believes the income from such businesses generally is part of the earned income base that section 469 was intended to protect. In the case of a longstanding active business (other than a personal service business), however, the Service believes that a continuing interest in such an activity is more appropriately viewed as an investment in a passive activity if the individual has not materially participated in the activity for a significant period of time during the 10-year period immediately preceding the taxable year. D. Facts-and-Circumstances Test Section 1.469-5T(a)(7) provides that an individual may be treated as materially participating in an activity for a taxable year based on all of the facts and circumstances. The general principles to be followed in applying the facts-and-circumstances test are not addressed in these regulations, and will be included in

future regulations. Section 1.469-5T(b), however, provides that certain participation is insufficient to constitute material participation, or is not taken into account, under this test. Thus, except as provided in section 469(h)(3), the fact that an individual satisfies participation standards in other provisions of the Code and the regulations (such as the "material participation" standards in sections 1402 and 2032A) is not taken into account in determining whether the individual materially participates in an activity for purposes of section 469. In addition, an individual's participation in management of an activity is not taken into account in applying the facts-and-circumstances test to the individual if a paid manager participates in the activity or if the management services performed by such individual are exceeded by those performed by any other individual. Finally, an individual who does not participate in an activity for more than 100 hours during the taxable year cannot satisfy the facts-and-circumstances test for the year. E. Treatment of Limited Partners Section 469(h)(2) provides that, except as provided in regulations, no interest in a limited partnership shall be treated as an interest with respect to which a taxpayer materially participates. Section 1.469-5T(d) provides two exceptions to this general rule. First, the general rule does not apply to an activity for a taxable year if (a) the taxpayer participates in the activity for more than 500 hours during the taxable year, or (b) the taxpayer is treated as materially participating in the activity for the taxable year under either the longstanding material participant test or the personal-service-activity test. Second, the general rule does not apply with respect to a limited partnership interest in a partnership in which the taxpayer is also a general partner. F. Trusts and Estates Material participation rules for trusts and estates will be included in future regulations providing rules for the application of section 469 to trusts, estates, and their beneficiaries. G. Meaning of "Participation" Section 1.469-5T(f) generally provides that all work done in an activity by an individual who owns an interest in the activity (other than an interest owned through a C corporation) is taken into account as participation by the individual in the activity, without regard to the capacity in which the individual does such work. Thus, work performed by an individual as an employee of a C corporation in connection with an activity in which the individual owns an interest (other than an interest owned through a C corporation) is taken into account as participation by the individual in the activity. Section 1.469-5T(f) includes two exceptions to this general rule. First, under §1.469- 5T(f)(2)(i), work that is not customarily done by an owner is not taken into account if a principal purpose for the performance of such work is to avoid the disallowance of a passive activity loss or credit. Second, under §1.469-5T(f)(2)(ii), work done by an individual in connection with an activity in the individual's capacity as an investor in the activity is not taken into account.

In the case of a married individual, §1.469-5T(f)(3) provides that the participation of the individual's spouse is treated as participation by such individual for purposes of the passive loss and credit limitations, without regard to whether the participation of the spouse is material participation in its own right, whether the spouse owns an interest in the activity, or whether the individual and the individual's spouse file a joint return for the taxable year. H. No Recordkeeping Requirements Notwithstanding the quantitative tests set forth in the regulations, §1.469-5T(f)(4) expressly provides that taxpayers need not keep contemporaneous records of their hours of participation in each activity. The Service recognizes that, while lawyers and certain other professionals are accustomed to maintaining detailed records of how they spend their work days, most individuals do not customarily maintain such records. Accordingly, under the regulations, taxpayers will be allowed to prove the requisite number of hours by any reasonable means, including, but not limited to, appointment books, calenders, and narrative summaries. I. Material Participation for Taxable Years Beginning Before January 1, 1987 A taxpayer's participation in an activity for a taxable year beginning before January 1, 1987, may be relevant under rules such as those relating to longstanding material participants and personal service activities. Section 1.469-5T(j) provides that in any case in which it is necessary to determine whether an individual materially participated in an activity for any taxable year beginning before January 1, 1987 (other than a taxable year of a partnership, S corporation, estate, or trust ending after December 31, 1986), the individual is treated as materially participating in the activity for such year only if the individual participated in the activity for more than 500 hours during the year. The Service believes that the 500-hour test represents the only administrable rule for dealing with the determination of material participation for taxable years beginning before 1987. XIX. Effective date and transition rules. A. In General Section 469 and the regulations thereunder generally apply for taxable years beginning after December 31, 1986. However, under §1.469-11T(a)(2), specified rules in §1.469-2T(f) treating certain income as not from a passive activity apply only for taxable years beginning after December 31, 1987. These provisions are

§1.469-2T(f)(3) (relating to the rental of nondepreciable property), §1.469-2T(f)(4)

(relating to equity-financed lending activities), §1.469-2T(f)(5) (relating to the rental of property developed by the taxpayer), §1.469-2T(f)(6) (relating to self-rented property), and §1.469-2T(f)(7) (relating to passthrough entities licensing intangible property). In addition, §1.469-2T(f)(6) does not apply to income attributable to the rental of property pursuant to a written binding contract entered into before February 19, 1988. If a taxpayer is a partner, shareholder, or beneficiary of a partnership, S corporation, estate, or trust with a taxable year ending within the taxpayer's first taxable year beginning after December 31, 1986, passive items from such partnership, S corporation, estate, or trust are taken into account in computing the taxpayer's

passive activity loss or credit even if such items are attributable to taxable years of such entities beginning before January 1, 1987, or are attributable to amounts paid or incurred prior to January 1, 1987. Under §1.469-2T(e)(1), the treatment of an item of gross income, deduction, or credit from a fiscal year partnership or S corporation as passive activity gross income, as a passive activity deduction, or as a credit from a passive activity, respectively, is determined by reference to the taxpayer's participation in the activity to which such item relates for the partnership's or S corporation's taxable year in which the item arose. Future regulations relating to the treatment of beneficiaries of estates and trusts will provide guidance on this issue with respect to such taxpayers. B. Effect of Events Occurring in Years Beginning Prior to 1987 Because in certain instances the treatment under the regulations of an item of gross income, deduction, or credit for the taxable year is determined in part by reference to events in prior taxable years, §1.469-11T(a)(4) provides that events in prior taxable years generally are taken into account in making such determinations. For example, under §1.469-5T(a)(5), an individual is treated as materially participating in an activity for the taxable year if the individual materially participated in the activity for any five of the ten taxable years that immediately precede the taxable year. Under §1.469-11T(a)(4), a taxable year beginning prior to January 1, 1987, is taken into account for this purpose, but only if the individual participated in the activity for more than 500 hours during such taxable year. C. Transitional Rule for Losses From Pre-Enactment Interest 1. In general. Section 469(m) provides a transitional rule for losses and credits attributable to pre-enactment interests in passive activities. Under that rule, which applies for taxable years beginning prior to 1991, the amount of the taxpayer's passive activity loss or passive activity credit that would be disallowed in the absence of the transitional rule is reduced by an amount equal to the product of a percentage and the lesser of (a) the amount of the passive activity loss or passive activity credit that would be disallowed in the absence of the transitional rule, or (b) the amount of the passive activity loss or passive activity credit that would be disallowed in the absence of the transitional rule (determined without taking into account previously disallowed passive items or passive items that are not attributable to the taxpayer's pre-enactment interests in passive activities). The percentage is 65 percent for taxable years beginning in 1987, 40 percent for taxable years beginning in 1988, 20 percent for taxable years beginning in 1989, and 10 percent for taxable years beginning in 1990. Paragraphs (b) and (c) of §1.469-11T (b) contain rules relating to the identification of pre-enactment interests in passive activities and the computation of the amount of the passive activity loss and credit that would be disallowed if passive items that are not attributable to the taxpayer's pre-enactment interests in passive activities were not taken into account. 2. Indentification of pre-enactment interests. Under section 469(m), a taxpayer's pre-enactment interests must be identified for each taxable year during the transition period. Thus, for each such taxable year, the taxpayer must determine which of the taxpayer's interests in activities that are passive activities for the

taxable year are pre-enactment interests. Under §1.469-11T (c)(1), a pre-enactment interest is a "qualified interest" in a "pre-enactment activity." Section 1.469-11T(c)(3) provides that an activity is a "pre-enactment activity" if the activity was being conducted by any person on October 22, 1986, or if at least 50 percent (by value) of the property used in the activity during the taxable year was in existence or under construction on August 16, 1986, or was acquired or constructed at any time pursuant to a written binding contract in effect on August 16, 1986 (without regard to whether the taxpayer or any person related to the taxpayer was a party to such contract). Thus, for example, in the case of an activity of renting a building, the activity is a pre-enactment activity if the building was in existence or under construction on August 16, 1986. Section 1.469-11T(c)(2) provides that an interest in an activity is a "qualified interest" if the interest was held by the taxpayer on October 22, 1986, and at all times thereafter, or was acquired by the taxpayer pursuant to written binding contracts to which the taxpayer was a party on October 22, 1986. Section 1.469- 11T(c)(7) provides rules for determining whether a taxpayer was a party to a written binding contract on October 22, 1986. Under those rules, for example, if on October 22, 1986, a taxpayer was a party to a written binding contract to acquire a partnership interest, and the partnership was a party to a written bining contract to acquire an interest in an activity, the taxpayer is treated as a party to the partnership's contract. 3. Computation of pre-enactment loss and credit. Section 1.469-11T(b)(3) and (4) contains rules relating to the computation of the amount of the passive activity loss and credit that would be disallowed if the passive items that are not attributable to the taxpayer's pre-enactment interests in passive activities were not taken into account. The amounts determined under §1.469-11T(b)(3) (relating to the pre-enactment loss) and §1.469-11T(b)(4) (relating to the pre-enactment credit) are the amounts of the passive activity loss and the passive activity credit, respectively, that would be disallowed under §1.469-1T(a)(1) taking into account all of the provisions of section 469 and the regulations thereunder, but applying such provisions as though the taxpayer had no interests in passive activities other than the taxpayer's pre-enactment interests. Under these rules, deductions and credits disallowed in a prior year and taken into account for the taxable year under section 469(b) (including deductions and credits attributable to pre-enactment interests) also are not taken into account.

Special Analyses

The Commissioner of Internal Revenue has determined that this temporary rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required. A general notice of proposed rulemaking is not required by 5 U.S.C. 553 for temporary regulations. Accordingly, the temporary regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6).

Drafting Information

The principal author of these temporary regulations is Michael J. Grace of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue

Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations on matters of both substance and style. List of Subjects in 26 CFR 1.441-1-1.483-2 Income taxes, Accounting, Deferred compensation plans. Adoption of Amendments to the Regulations For the reasons set forth in the preamble, Title 26, Chapter I, Subchapter A, Part 1 of the Code of Federal Regulations is amended as set forth below:

PART 1-[AMENDED]

Income Tax Regulations Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority

26 U.S.C. 7805. Sections 1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T, and 1.469-11T also issued under 26 U.S.C. 469(1). Par. 2. The following new sections are added to Part 1 in the appropriate place:

§1.469-0T Table of contents (temporary).

This section lists the captions that appear in the temporary regulations under section 469.

§1.469-1T General rules (temporary).

(a) Passive activity loss and credit disallowed. (1) In general. (2) Exceptions. (b) Taxpayers to whom these rules apply. (c) Cross references. (1) Definition of passive activity. (2) Passive activity loss. (3) Passive activity credit.

(4) Effect of rules for other purposes. (5) Special rule for oil and gas working interests. (6) Treatment of disallowed losses and credits. (7) Corporations subject to section 469. (8) Consolidated groups. (9) Joint returns. (10) Material participation. (11) Effective date and transition rules. (12) Future regulations. (d) Effect of section 469 and the regulations thereunder for other purposes. (1) Treatment of items of passive activity income and gain. (2) Coordination with section 1211. (3) Treatment of passive activity losses. (e) Definition of "passive activity." (1) In general. (2) Trade or business activity. (i) In general. (ii) Certain activities not involving the conduct of a trade or business treated as trade or business activities. [Reserved] (3) Rental activity. (i) In general. (ii) Exceptions. (iii) Average period of customer use. (iv) Significant personal services. (A) In general.

(B) Excluded services. (v) Extraordinary personal services. (vi) Rental of property incidental to a nonrental activity of the taxpayer. (A) In general. (B) Property held for investment. (C) Property used in a trade or business. (D) Property held for sale to customers. (E) Lodging rented for convenience of employer. (F) Unadjusted basis. (vii) Property made available for use in a nonrental activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest. (viii) Examples. (4) Special rule for oil and gas working interests. (i) In general. (ii) Exception for deductions attributable to a period during which liability is limited. (A) In general. (B) Coordination with rules governing the identification of disallowed passive activity deductions. (C) Meaning of certain terms. (1) Allocable deductions. (2) Disqualified deductions. (3) Net loss. (4) Ratable portion. (iii) Examples. (iv) Definitions of "working interest." (v) Entities that limit liability.

(A) General rule. (B) Other limitations disregarded. (C) Examples. (vi) Cross reference to special rule for income from certain oil or gas properties. (5) Rental of dwelling unit. (6) Activity of trading personal property. (i) In general. (ii) Personal property. (iii) Example. (f) Treatment of disallowed passive activity losses and credits. (1) Scope of this paragraph. (2) Identification of disallowed passive activity deductions. (i) Allocation of disallowed passive activity loss among activites. (A) General rule. (B) Loss from an activity. (C) Significant participation passive activities. (D) Examples. (ii) Allocation within loss activities. (A) In general. (B) Excluded deductions. (iii) Separately identified deductions. (3) Identification of disallowed credits from passive activites. (i) General rule. (ii) Coordination rule. (iii) Separately identified credits.

(4) Carryover of disallowed deductions and credits. (g) Application of these rules to C corporations. (1) In general. (2) Definitions. (3) Participation of corporations. (i) Material participation. (ii) Significant participation. (iii) Participation of individual. (4) Modified computation of passive activity loss in the case of closely held corporations. (i) In general. (ii) Net active income. (iii) Examples. (5) Allowance of passive activity credit of closely held corporations to extent of net active income tax liability. (i) In general. (ii) Net active income tax liability. (h) Special rules for affiliated group filing consolidated return. (1) In general. (2) Definitions. (3) Disallowance of consolidated group's passive activity loss or credit. (4) Status and material participation of members. (i) Determination by reference to status and participation of group. (ii) Determination of status and material participation of consolidated group. (5) Modification of rules for identifying disallowed passive activity deductions and credits.

(i) Identification of disallowed deductions. (ii) Ratable portion of disallowed passive activity loss. (iii) Identification of disallowed credits. (6) Transactions between members of a consolidated group. (i) Scope. (ii) Recharacterization of gain or loss from intercompany transactions other than deferred intercompany transactions. (A) In general. (B) Recharacterization of gain or loss as portfolio items. (iii) Deferred intercompany transactions. (A) In general. (B) Deferred intercompany transactions involving property subject to depreciation, amortization, or depletion. (C) Restoration of deferred gain or loss or dispositions. (D) Certain recharacterized items treated as portfolio items. (E) Property involved in deferred intercompany transaction. (iv) Definitions. (A) Deferred intercompany transaction. (B) Directly related. (C) Intercompany transaction. (D) Purchasing member. (E) Selling member. (7) Disposition of stock of a member of an affiliated group. (8) Dispositions of property used in multiple activities. (i) [Reserved] (j) Spouses filing joint return.

(1) In general. (2) Exceptions to treatment as one taxpayer. (i) Identification of disallowed deductions and credits. (ii) Treatment of deductions disallowed under sections 704(d), 1366(d) and 465. (iii) Treatment of losses from working interests. (3) Joint return no longer filed. (4) Participation of spouses. (k) Former passive activities and changes in status of corporations. [Reserved]

§1.469-2T Passive activity loss (temporary).

(a) Scope of this section. (b) Definition of passive activity loss. (1) In general. (2) Cross references. (c) Passive activity gross income. (1) In general. (2) Treatment of gain from disposition of an interest in an activity or an interest in property used in an activity. (i) In general. (A) Treatment of gain. (B) Dispositions of partnership interests and S corporation stock. (C) Interest in property. (D) Examples. (ii) Disposition of property used in more than one activity in 12-month period preceding disposition. (iii) Dispostion of substantially appreciated property formerly used in nonpassive activity.

(A) In general. (B) Date of disposition. (C) Substantially appreciated property. (D) Coordination with paragraph (c)(2)(ii) of this section. (E) Coordination with section 163(d). (F) Example. (3) Items of portfolio income specifically excluded. (i) In general. (ii) Gross income derived in the ordinary course of a trade or business. (iii) Special rules. (A) Income from property held for investment by dealer. (B) Royalties derived in the ordinary course of the trade or business of licensing intangible property. (1) In general. (2) Substantial services or costs. (i) In general. (ii) Exception. (iii) Expenditures taken into account. (3) Passthrough entities. (4) Cross reference. (C) Mineral production payments. (iv) Examples. (4) Items of personal service income specifically excluded. (i) In general. (ii) Example.

(5) Income from section 481 adjustment. (i) In general. (ii) Positive section 481 adjustments. (iii) Ratable portion. (6) Gross income from certain oil or gas properties. (i) In general. (ii) Net income from the property. (iii) Property. (iv) Examples. (7) Other items specifically excluded. (d) Passive activity deductions. (1) In general. (2) Exceptions. (3) Interest expense. (4) Clearly and directly allocable expenses. (5) Treatment of loss from disposition. (i) In general. (ii) Disposition of Property used in more than one activity in 12-month period preceding disposition. (iii) Other applicable rules. (A) Interest in property. (B) Dispositions of partnership interests and S Corporation stock. (6) Coordination with other limitations on deduction that apply before section 469. (i) In general. (ii) Proration of deductions disallowed under basis limitations.

(A) Deductions disallowed under section 704(d). (B) Deductions disallowed under section 1366(d). (iii) Proration of deductions disallowed under at-risk limitation. (iv) Coordination of basis and at-risk limitations. (v) Separately identified items of deduction and loss. (7) Deductions from section 481 adjustment. (i) In general. (ii) Negative section 481 adjustment. (iii) Ratable portion. (8) Taxable year in which item arises. (e) Special rules for partners and S corporation shareholders. (1) In general. (2) Payments under section 707(a), 707(c), and 736(b). (i) Section 707(a). (ii) Section 707(c). (A) In general. (B) Exception. (iii) Section 736 (b). (3) Sale or exchange of interest in passthrough entity. (i) Application of this paragraph (e) (3). (ii) General rule. (A) Allocation among activities. (B) Ratable portion. (1) Dispositions on which gain is recognized. (2) Dispositions on which loss is recognized.

(C) Default rule. (D) Special rules. (1) Applicable valuation date. (i) In general. (ii) 2Exception. (2) Basis adjustments. (3) Tiered passthrough entities. (E) Meaning of certain terms. (iii) Treatment of gain allocated to certain passive activities as not from a passive activity. (iv) Dispositions occurring in taxable years beginning before February 19, 1988. (A) In general. (B) Exceptions. (v) Treatment of portfolio assets. (vi) Definitions. (vii) Examples. (f) Recharacterization of passive income in certain situations. (1) In general. (2) Special rule for significant participation. (i) In general. (ii) Significant participation passive activity. (iii) Example. (3) Rental of nondepreciable property. (4) Net interest income from passive equity-financed lending activity. (i) In general.

(ii) Equity-financed lending activity. (A) In general. (B) Certain liabilities not taken into account. (iii) Equity-financed interest income. (iv) Net interest income. (v) Interest-bearing assets. (vi) Liabilities incurred in the activity. (vii) Average outstanding balance. (viii) Example. (5) Net income from certain property rented incidental to development activity. (i) In general. (ii) Commencement of use. (iii) Services performed for the purpose of endhancing the value of property. (iv) Example. (6) Property rented to a nonpassive activity. (7) Special rules applicable to the acquisition of an interest in a passthrough entity engaged in the trade or business of licensing intangible property. (iv) In general. (ii) Royalty income from property. (iii) Exceptions. (iv) Capital expenditures. (v) Example. (8) Limitation on recharacterized income. (9) Meaning of certain terms. (10) Coordination with section 163 (d).

(11) Effective date.

§1.469-3T Passive activity credit (temporary).

(a) Computation of passive activity credit. (b) Credits subject to section 469. (1) In general. (2) Treatment of credits attributable to qualified progress expenditures. (3) Special rule for partners and S corporation shareholders. (4) Exception for pre-1987 credits. (c) Taxable year to which credit is attributable. (d) Regular tax liability allocable to passive activities. (1) In general. (2) Regular tax liability. (e) Coordination with section 39. (f) Examples.

§1.469-4T Definition of activity (temporary). [Reserved]

§1.469-5T Material participation (temporary).

(a) In general. (b) Facts and circumstances. (1) In general. [Reserved] (2) Certain participation insufficient to constitute material participation under this paragraph (b). (i) Participation satisfying standards not contained in section 469. (ii) Certain management activities. (iii) Participation less than 100 hours. (c) Significant participation activity.

(1) In general. (2) Significant participation. (d) Personal service activity. (e) Treatment of limited partners. (1) General rule. (2) Exceptions. (3) Limited Parntership interest. (i) In general. (ii) Limited Partner holding general partner interest. (f) Participation. (1) In general. (2) Exceptions. (i) Certain work not customarily done by owners. (ii) Participation as an investor. (A) In general. (B) Work done in individual's capacity as an investor. (3) Participation of spouse. (4) Methods of proof. (g) Material participation of trusts and estates. [Reserved] (h) Miscellaneous rules. (1) Participation of corporations. (2) Treatment of certain retired farmers and surviving spouses of retired or disabled farmers. (i) [Reserved] (j) Material participation for taxable years beginning before January 1, 1987.

(k) Examples.

§1.469-6T Treatment of losses upon certain dispositions (temporary). [Reserved]

§1.469-7T Treatment of self-charged items of income and expense (temporary).

[Reserved]

§1.469-8T Application of section 469 to trusts, estates, and their beneficiaries

(temporary). [Reserved]

§1.469-9T Treatment of income, deductions, and credits from certain rental real

estate activities (temporary). [Reserved]

§1.469-10T Application of section 469 to publicly traded partnerships (temporary).

[Reserved]

§1.469-11T Effective date and transition rules (temporary).

(a) Effective date. (1) In general. (2) Application of certain income recharacterization rules. (i) In general. (ii) Property rented to a nonpassive activity. (3) Qualified low-income housing projects. (4) Effect of events occurring in years prior to 1987. (5) Examples. (b) Transitional rule for pre-enactment loss and pre-enactment credit. (1) In general. (2) Applicable percentage. (3) Pre-enactment loss. (4) Pre-enactment credit. (5) Examples. (c) Definitions of pre-enactment interest. (1) General rule.

(2) Qualified interest. (i) In general. (ii) Stock in a C corporation. (3) Pre-enactment activity. (i) In general. (ii) Character before 1987 irrelevant. (4) Examples. (5) Effect of changes in a taxpayer's interest in a pre-enactment activity. (i) In general. (ii) Partnership terminations under section 708(b)(1)(B). (iii) Examples. (6) Special rule for beneficiaries of trusts or estates. (i) In general. (ii) Interests distributed to beneficiaries. (7) Written binding contract. (i) In general. (ii) Special rule for contract of partnership or S corporation. (iii) Application of rule to partnership agreements.

§1.469-1T General rules (temporary).

(a) Passive activity loss and credit disallowed-(1) In general. Except as otherwise provided in paragraph (a)(2) of this section- (i) The passive activity loss for the taxable year shall not be allowed as a deduction; and (ii) The passive activity credit for the taxable year shall not be allowed. (2) Exceptions. Paragraph (a)(1) of this section shall not apply to the passive activity loss or the passive activity credit for the taxable year to the extent provided in-

(i) Section 469(i) and the rules to be contained in §1.469-9T (relating to losses and credits attributable to certain rental real estate activities); and (ii) Section 1.469-11T (relating to losses and credits attributable to certain pre-enactment interests in activities). (b) Taxpayers to whom these rules apply. The rules of section 469 and the regulations thereunder generally apply to- (1) Individuals; (2) Trusts (other than trusts (or portions of trusts) described in section 671); (3) Estates; (4) Personal service corporations (within the meaning of paragraph (g)(2)(i) of this section); and (5) Closely held corporations (within the meaning of paragraph (g)(2)(ii) of this section). (c) Cross references-(1) Definition of "passive activity." Rules relating to the definition of the term "passive activity" are contained in paragraph (e) of this section. (2) Passive activity loss. Rules relating to the computation of the passive activity loss for the taxable year are contained in §1.469-2T. (3) Passive activity credit. Rules relating to the computation of the passive activity credit for the taxable year are contained in §1.469-3T. (4) Effect of rules for other purposes. Rules relating to the effect of section 469 and the regulations thereunder for other purposes under the Code are contained in paragraph (d) of this section. (5) Special rule for oil and gas working interests. Rules relating to the treatment of losses and credits from certain interests in oil and gas wells are contained in paragraph (e)(4) of this section (6) Treatment of disallowed losses and credits. Paragraph (f) of this section contains rules relating to- (i) The treatment of deductions from passive activities in taxable years in which the passive activity loss is disallowed in whole or in part under paragraph (a)(1)(i) of this section; and (ii) The treatment of credits from passive activities in taxable years in which the passive activity credit is disallowed in whole or in part under paragraph (a)(1)(ii) of this section.

(7) Corporation subject to section 469. Rules relating to the application of section 469 and regulations thereunder to C corporations are contained in paragraph (g) of this section. (8) Consolidated groups. Rules relating to the application of section 469 and the regulations thereunder to affiliated groups of corporations filing a consolidated return for the taxable year are contained in paragraph (h) of this section. (9) Joint returns. Rules relating to the application of section 469 and the regulations thereunder to spouses filing a joint return for the taxable year are contained in paragraph (j) of this section. (10) Material participation. Rules defining the term "material participation" are contained in §1.469-5T. (11) Effective date and transition rules. Rules relating to the effective date of section 469 and the regulations thereunder and transition rules applicable to pre-enactment interests in activities are contained in §1.469-11T. (12) Future regulations. (i) Rules relating to former passive activities and changes in corporate status will be contained in paragraph (k) of this section. (ii) Rules relating to the definition of "activity" will be contained in §1.469-4T. (iii) Rules relating to the treatment of deductions from activities that are disposed of in certain transactions will be contained in §1.469-6T. (iv) Rules relating to the treatment of self-charged items of income and expense will be contained in §1.469-7T. (v) Rules relating to the application of section 469 and the regulations thereunder to trusts, estates, and their beneficiaries will be contained in §1.469-8T. (vi) Rules relating to the treatment of income, deductions, and credits from certain rental real estate activities of individuals and certain estates will be contained in

§1.469-9T.

(vii) Rules relating to the application of section 469 to publicly traded partnerships will be contained in §1.469-10T. (d) Effect of section 469 and the regulations thereunder for other purposes-(1) Treatment of items of passive activity income and gain. Neither the provisions of section 469 (a) (1) and paragraph (a)(1) of this section nor the characterization of items of income or deduction as passive activity gross income (within the meaning of

§1.469-2T (c)) or passive activity deductions (within the meaning of §1.469-2T (d))

affects the treatment of any item of income or gain under any provision of the Internal Revenue Code other than section 469. The following example illustrates the application of this paragraph (d)(1): Example. (i) In 1991, an individual's only income and loss from passive activities are a $10,000 capital gain from passive activity × and a $12,000 ordinary loss from

passive activity Y. The taxpayer also has a $10,000 capital loss that is not derived from a passive activity. (ii) Under §1.469-2T (b), the taxpayer has a $2,000 passive activity loss for the taxable year. The only effect of section 469 and the regulations thereunder is to disallow a deduction for the taxpayer's $2,000 passive activity loss for the taxable year. Thus, the taxpayer's capital loss for the taxable year is allowed because the $10,000 capital gain from passive activity × is taken into account under section 1211 (b) in computing the taxpayer's allowable capital loss for the year. (2) Coordination with section 1211. A passive activity deduction that is not disallowed for the taxable year under section 469 and the regulations thereunder may nonetheless be disallowed for the taxable year under section 1211. The following example illustrates the application of this paragraph (d)(2): Example. In 1987, an individual derives $10,000 of ordinary income from passive activity X, no gains from the sale or exchange of captial assets or assets used in a trade or business, $12,000 of capital loss from passive activity Y, and no income, gain, deductions, or losses from any other passive activity. The capital loss from activity Y is a passive activity deduction (within the meaning of §1.469-2T(d)). Under section 469 and the regulations thereunder, the taxpayer is allowed $10,000 of the $12,000 passive activity deduction and has a $2,000 passive activity loss for the taxable year. Since the $10,000 passive activity deduction allowed under section 469 is a capital loss, such deduction is allowable for the taxable year only to the extent provided under section 1211. Therefore, the taxpayer is allowed $3,000 of the $10,000 capital loss under section 1211 and has a $7,000 capital loss carryover (within the meaning of section 1212 (b)) to the succeeding taxable year. (3) Treatment of passive activity losses. Except as otherwise provided by regulations, a deduction that is disallowed for a taxable year under section 469 and the regulations thereunder is not taken into account as a deduction that is allowed for the taxable year in computing the amount subject to any tax imposed by subtitle A of the Internal Revenue Code. The following example illustrates the application of this paragraph (d)(3): Example. An individual has a $5,000 passive activity loss for a taxable year, all of which is disallowed under paragraph (a)(1) of this section. All of the disallowed loss is allocated under paragraph (f) of this section to activities that are trades or businesses (within the meaning of section 1402(c)). Such loss is not taken into account for the taxable year in computing the taxpayer's taxable income subject to tax under section 1. In addition, under this paragraph (d)(3), such loss is not taken into account for the taxable year in computing the taxpayer's net earnings from self-employment subject to tax under section 1401. (e) Definition of "passive activity"-(1) In general. Except as otherwise provided in this paragraph (e), an activity is a passive activity of the taxpayer for a taxable year if and only if the activity- (i) Is a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer does not materially participate for such taxable year; or

(ii) Is a rental activity (within the meaning of paragraph (e) (3) of this section), without regard to whether or to what extent the taxpayer participates in such activity. (2) Trade or business activity-(i) In general. An activity is a trade or business activity for a taxable year if for such year- (A) (1) The activity involves the conduct of a trade or business (within the meaning of section 162); (2) Research or experimental expenditures paid or incurred with respect to the activity are deductible under section 174 (or would be deductible if the taxpayer adopted the method described in section 174(a)); or (3) The activity is described in paragraph (e)(2)(ii) of this section; and (B) The activity is not a rental activity or an activity involving the rental of property described in paragraph (e)(3) (vi)(B) of this section. (ii) Certain activities not involving the conduct of a trade or business treated as trade or business activities. [Reserved] (3) Rental activity-(1) In general. Except as otherwise provided in this paragraph (e)(3), an activity is a rental activity for a taxable year if- (A) During such taxable year, tangible property held in connection with the activity is used by customers or held for use by customers; and (B) The gross income attributable to the conduct of the activity during such taxable year represents (or, in the case of an activity in which property is held for use by customers, the expected gross income from the conduct of the activity will represent) amounts paid or to be paid principally for the use of such tangible property (without regard to whether the use of the property by customers is pursuant to a lease or pursuant to a service contract or other arrangement that is not denominated a lease). (ii) Exceptions. For purposes of this paragraph (e)(3), an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year- (A) The average period of customer use for such property is seven days or less; (B) The average period of customer use for such property is 30 days or less, and significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) are provided by or on behalf of the owner of the property in connection with making the property available for use by customers; (C) Extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use);

(D) The rental of such property is treated as incidental to a nonrental activity of the taxpayer under paragraph (e)(3)(vi) of this section; (E) The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers; or (F) The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity under paragraph (e)(3)(vii) of this section. (iii) Average period of customer use. For purposes of this paragraph (e)(3), the average period of customer use for property held in connection with an activity is determined for a taxable year by dividing- (A) The aggregate number of days in all periods of customer use for such property ending during the taxable year; by (B) The number of such periods of customer use. For this purpose, each period during which a customer has a continuous or recurring right to use an item of property held in connection with the activity (without regard to whether the customer uses the property for the entire period or whether such right to use the property is pursuant to a single agreement or to renewals thereof) is treated as a separate period of customer use. (iv) Significant personal services-(A) In general. For purposes of paragraph (e)(3)(ii)(B) of this section, personal services include only services performed by individuals, and do not include excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this section). In determining whether personal services provided in connection with making property available for use by customers are significant, all of the relevant facts and circumstances shall be taken into account. Relevant facts and circumstances include the frequency with which such services are provided, the type and amount of labor required to perform such services, and the value of such services relative to the amount charged for the use of the property. (B) Excluded services. For purposes of paragraph (e)(3)(iv)(A) of this section, the term "excluded services" means, with respect to any property made available for use by customers- (1) Services necessary to permit the lawful use of the property; (2) Services performed in connection with the construction of improvements to the property, or in connection with the performance of repairs that extend the property's useful life for a period substantially longer than the average period for which such property is used by customers; and (3) Services, provided in connection with the use of any improved real property, that are similar to those commonly provided in connection with long-term rentals of high-grade commercial or residential real property (e.g., cleaning and maintenance of

common areas, routine repairs, trash collection, elevator service, and security at entrances or perimeters). (v) Extraordinary personal services. For purposes of paragraph (e)(3)(ii)(C) of this section, extraordinary personal services are provided in connection with making property available for use by customers only if the services provided in connection with the use of the property are performed by individuals, and the use by customers of the property is incidental to their receipt of such services. For example, the use by patients of a hospital's boarding facilities generally is incidental to their receipt of the personal services provided by the hospital's medical and nursing staff. Similarly, the use by students of a boarding school's dormitories generally is incidental to their receipt of the personal services provided by the school's teaching staff. (vi) Rental of property incidental to a nonrental activity of the taxpayer-(A) In general. For purposes of paragraph (e)(3)(ii)(D) of this section, the rental of property shall be treated as incidental to a nonrental activity of the taxpayer only to the extent provided in this paragraph (e)(3)(vi). (B) Property held for investment. The rental of property during a taxable year shall be treated as incidental to an activity of holding such property for investment if and only if- (1) The principal purpose for holding the property during such taxable year is to realize gain from the appreciation of the property (without regard to whether it is expected that such gain will be realized from the sale or exchange of the property in its current state of development); and (2) The gross rental income from the property for such taxable year is less than two percent of the lesser of- (i) The unadjusted basis of such property; and (ii) The fair market value of such property. (C) Property used in a trade or business. The rental of property during a taxable year shall be treated as incidental to a trade or business activity (within the meaning of paragraph (e)(2) of this section) if and only if- (1) The taxpayer owns an interest in such trade or business activity during the taxable year; (2) The property was predominantly used in such trade or business activity during the taxable year or during at least two of the five taxable years that immediately precede the taxable year; and (3) The gross rental income from such property for the taxable year is less than two percent of the lesser of- (i) The unadjusted basis of such property; and (ii) The fair market value of such property.

(D) Property held for sale to customers. The rental of property during the taxable year in which the property is sold or exchanged (in a transaction in which gain or loss is recognized) shall be treated as incidental to an activity of dealing in such property if at the time of the sale or exchange the property is held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business of the taxpayer (within the meaning of section 1221(1)). (E) Lodging rented for convenience of employer. The provision of lodging to an employee or to an employee's spouse or dependents shall be treated as incidental to the activity (or activities) of the taxpayer in which the employee performs services if such lodging is furnished for the taxpayer's convenience (within the meaning of section 119). (F) Unadjusted basis. For purposes of this paragraph (e)(3)(vi), the term "unadjusted basis" means adjusted basis determined without regard to any adjustment described in section 1016 that decreases basis. (vii) Property made available for use in a nonrental activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest. If the taxpayer owns an interest in a partnership, S corporation, or joint venture conducting an activity other than a rental activity, and the taxpayer provides property for use in the activity in the taxpayer's capacity as an owner of an interest in such partnership, S corporation, or joint venture, the provision of such property is not a rental activity. Thus, if a partner contributes the use of property to a partnership, none of the partner's distributive share of partnership income is income from a rental activity unless the partnership is engaged in a rental activity. In addition, a partner's gross income attributable to a payment described in section 707(c) is not income from a rental activity under any circumstances (see §1.469-2T (e)(2)). The determination of whether property used in an activity is provided by the taxpayer in the taxpayer's capacity as an owner of an interest in a partnership, S corporation, or joint venture shall be made on the basis of all of the facts and circumstances. (viii) Examples. The following examples illustrate the application of this paragraph (e)(3): Example (1). The taxpayer is engaged in an activity of leasing photocopying equipment. The average period of customer use for the equipment exceeds 30 days. Pursuant to the lease agreements, skilled technicians employed by the taxpayer maintain the equipment and service malfunctioning equipment for no additional charge. Service calls occur frequently (three times per week on average) and require substantial labor. The value of the maintenance and repair services (measured by the cost to the taxpayer of employees performing these services) exceeds 50 percent of the amount charged for the use of the equipment. Under these facts, services performed by individuals are provided in connection with the use of the photocopying equipment, but the customers' use of the photocopying equipment is not incidental to their receipt of the services. Therefore, extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are not provided in connection with making the photocopying equipment available for use by customers, and the activity is a rental activity.

Example (2). The facts are the same as in example (1), except that the average period of customer use for the photocopying equipment exceeds seven days but does not exceed 30 days. Under these facts, significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) are provided in connection with making the photocopying equipment available for use by customers and, under paragraph (e)(3)(ii)(B) of this section, the activity is not a rental activity. Example (3). The taxpayer is engaged in an activity of transporting goods for customers. In conducting the activity, the taxpayer provides tractor-trailers to transport goods for customers pursuant to arrangements under which the tractor-trailers are selected by the taxpayer, may be replaced at the sole option of the taxpayer, and are operated and maintained by drivers and mechanics employed by the taxpayer. The average period of customer use for the tractor-trailers exceeds 30 days. Under these facts, the use of tractor-trailers by the taxpayer's customers is incidental to their receipt of personal services provided by the taxpayer. Accordingly, the services performed in the activity are extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) and, under paragraph (e)(3)(ii)(C) of this section, the activity is not a rental activity. Example (4). The taxpayer is engaged in an activity of owning and operating a residential apartment hotel. For the taxable year, the average period of customer use for apartments exceeds seven days but does not exceed 30 days. In addition to cleaning public entrances, exists, stairways, and lobbies, and collecting and removing trash, the taxpayer provides a daily maid and linen service at no additional charge. All of the services other than maid and linen service are excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this section), because such services are similar to those commonly provided in connection with long-term rentals of high-grade residential real property. The value of the maid and linen services (measured by the cost to the taxpayer of employees performing such services) is less than 10 percent of the amount charged to tenants for occupancy of apartments. Under these facts, neither significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) nor extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided in connection with making apartments available for use by customers. Accordingly, the activity is a rental activity. Example (5). The taxpayer owns 1,000 acres of unimproved land with a fair market value of $350,000 and an unadjusted basis of $210,000. The taxpayer holds the land for the principal purpose of realizing gain from appreciation. In order to defray the cost of carrying the land, the taxpayer leases the land to a rancher, who uses the land to graze cattle and pays rent of $4,000 per year. Thus, the gross rental income from the land is less than two percent of the lesser of the fair market value and the unadjusted basis of the land (.02×$210,000=$4,200). Accordingly, under paragraph (e)(3)(ii)(D) of this section, the rental of the land is not a rental activity because the rental is treated under paragraph (e)(3)(vi)(B) of this section as incidental to an activity of holding the property for investment. Example (6). (i) A calendar year taxpayer owns an interest in a farming activity which is a trade or business activity (within the meaning of paragraph (e)(2) of this section) and owns farmland which was used in the farming activity in 1985 and 1986. The fair market value of the farmland is $350,000 and its unadjusted basis is $210,000. In 1987, 1988, and 1989, the taxpayer continues to own an interest in

the farming activity but does not use the land in the activity. In 1987, the taxpayer leases the land for $4,000 to a rancher, who uses the land to graze cattle. In 1988, the taxpayer leases the land for $10,000 to a film production company, which uses the land to film scenes for a movie. In 1989, the taxpayer again leases the land for $4,000 to the rancher. (ii) For 1987 and 1989, the taxpayer owns an interest in a trade or business activity, and the farmland which the taxpayer leases to the rancher was used in such activity for two out of the five immediately preceding taxable years. In addition, the gross rental income from the land ($4,000) is less than two percent of the lesser of the fair market value and the unadjusted basis of the land (.02x$210,000=$4,200). Accordingly, the taxpayer's rental of the land is treated under paragraph (e)(3)(vi)(C) of this section as incidental to the taxpayer's farming activity, and is not a rental activity. (iii) Because the taxpayer's gross rental income from the land for 1988 ($10,000) is not less than two percent of the lesser of the fair market value and the unadjusted basis of the land, the requirement of paragraph (e)(3)(vi)(C)(3) of this section is not met. Therefore, the taxpayer's rental of the land in 1988 is not treated as incidental to the taxpayer's farming activity and is a rental activity. Example (7). (i) In 1988, the taxpayer acquires vacant land for the purpose of constructing a shopping mall. Before commencing construction, the taxpayer leases the land under a one-year lease to an automobile dealer, who uses the land to park cars held in its inventory. The taxpayer commences construction of the shopping mall in 1989. (ii) The taxpayer acquired the land for the principal purpose of constructing the shopping mall, not for the principal purpose or realizing gain from the appreciation of the property. Therefore, the rental of the property in 1988 is not treated under paragraph (e)(3)(vi)(B) of this section as incidental to an activity of holding the property for investment. (iii) The land has not been used in any taxable year in any trade or business of the taxpayer. Therefore, the rental of the property in 1988 is not treated under paragraph (e)(3)(vi)(C) of this section as incidental to a trade or business activity. (iv) Since the rental of the land in 1988 is not treated under paragraph (e)(3)(vi) of this section as incidental to a nonrental activity of the taxpayer, the rental of the land in 1988 is a rental activity. See §1.469-2T(f)(3) for a special rule relating to the treatment of gross income from the rental of nondepreciable property. Example (8). The taxpayer makes farmland available to a tenant farmer pursuant to an arrangement designated a "crop-share lease." Under the arrangement, the tenant is required to use the tenant's best efforts to farm the land and produce marketable crops. The taxpayer is obligated to pay 50 percent of the costs incurred in the activity (without regard to whether any crops are successfully produced or marketed), and is entitled to 50 percent of the crops produced (or 50 percent of the proceeds from marketing the crops). For purposes of paragraph (e)(3)(vii) of this section, the taxpayer is treated as providing the farmland for use in a farming activity conducted by a joint venture in the taxpayer's capacity as an owner of an interest in the joint venture. Accordingly, under paragraph (e)(3)(ii)(F) of this

section, the taxpayer is not engaged in a rental activity, without regard to whether the taxpayer performs any services in the farming activity. Example (9). The taxpayer owns a taxicab which the taxpayer operates during the day and leases to another driver for use at night under a one-year lease. Under the terms of the lease, the other driver is charged a fixed rental for use of the taxicab. Assume that, under the rules to be contained in §1.469-4T, the taxpayer is engaged in two separate activities, an activity of operating the taxicab and an activity of making the taxicab available for use by the other driver. Under these facts, the period for which the other driver uses the taxicab exceeds 30 days, and the taxpayer does not provide extraordinary personal services in connection with making the taxicab available to the other driver. Accordingly, the lease of the taxicab is a rental activity. Example (10). The taxpayer operates a golf course. Some customers of the golf course pay green fees upon each use of the golf course, while other customers purchase weekly, monthly, or annual passes. The golf course is open to all customers from sunrise to sunset every day of the year except certain holidays and days on which the taxpayer determines that the course is to wet for play. The taxpayer thus makes the golf course available during prescribed hours for nonexclusive use by various customers. Accordingly, under paragraph (e)(3)(ii)(E) of this section, the taxpayer is not engaged in a rental activity, without regard to the average period of customer use for the golf course. (4) Special rule for oil and gas working interests-(i) In general. Except as otherwise provided in paragraph (e)(4)(ii) of this section, an interest in an oil or gas well drilled or operated pursuant to a working interest (within the meaning of paragraph (e)(4)(iv) of this section) of a taxpayer is not an interest in a passive activity for the taxpayer's taxable year (without regard to whether the taxpayer materially participates in such activity) if at any time during such taxable year the taxpayer holds such working interest either- (A) Directly; or (B) Through an entity that does not limit the liability of the taxpayer with respect to the drilling or operation of such well pursuant to such working interest. (ii) Exception for deductions attributable to a period during which liability is limited- (A) In general. If paragraph (e)(4)(i) of this section applies for a taxable year to the taxpayer's interest in an oil or gas well that would, but for the application of paragraph (e)(4)(i) of this section, by an interest in a passive activity for the taxable year, and the taxpayer has a net loss (within the meaning of paragraph (e)(4)(ii)(C)(3) of this section) from the well for the taxable year- (1) The taxpayer's disqualified deductions (within the meaning of paragraph (e)(4)(ii)(C)(2) of this section) from such oil or gas well for such year shall be treated as passive activity deductions for such year (within the meaning of §1.469- 2T(d)); and (2) A ratable portion (within the meaning of paragraph (e)(4)(ii)(C)(4) of this section) of the taxpayer's gross income from such oil or gas well for such year shall

be treated as passive activity gross income for such year (within the meaning of

§1.469-2T(c)).

(B) Coordination with rules governing the identification of disallowed passive activity deductions. If gross income and deductions from an activity for a taxable year are treated as passive activity gross income and passive activity deductions under paragraph (e)(4)(ii)(A) of this section, such activity shall be treated as a passive activity for such year for purposes of applying paragraph (f) (2) and (4) of this section. (C) Meaning of certain terms. For purposes of this paragraph (e)(4)(ii), the following terms shall have the meanings set forth below: (1) Allocable deductions. The deductions allocable to a taxable year are any deductions that arise in such year (within the meaning of §1.469-2T (d)(8)) and any deductions that are treated as deductions for such year under paragraph (f)(4) of this section. (2) Disqualified deductions. The taxpayer's "disqualified deductions" from an oil or gas well for a taxable year are the taxpayer's deductions- (i) That are attributable to such well and allocable to the taxable year; and (ii) With respect to which economic performance (within the meaning of section 461(h), without regard to section 461 (h)(3) or (i)(2)) occurs at a time during which the taxpayer's only interest in the working interest is held through an entity that limits the taxpayer's liability with respect to the drilling or operation of such well. (3) Net loss. The "net loss" of a taxpayer from an oil or gas well for a taxable year equals the amount by which the taxpayer's deductions that are attributable to such oil or gas well and allocable to such year exceeds the gross income of the taxpayer from such well for such year. (4) Ratable portion. The "ratable portion" of the taxpayer's gross income from an oil or gas well for a taxable year equals the total amount of such gross income multiplied by the fraction obtained by dividing- (i) The disqualified deductions from such oil or gas well for the taxable year; by (ii) The total amount of the deductions that are attributable to such oil or gas well and allocable to the taxable year. (iii) Examples. The following examples illustrate the application of paragraphs (e)(4) (i) and (ii) of this section: Example (1). (i) A, a calendar year individual, acquires on January 1, 1987, a general partnership interest in P, a calendar year partnership that holds a working interest in an oil or gas property. Pursuant to the partnership agreement, A is entitled to convert the general partnership interest into a limited partnership interest at any time. On December 1, 1987, pursuant to a contract with D, an independent drilling contractor, P commences drilling a single well pursuant to the working

interest. Under the drilling contract, P pays D for the drilling only as the work is performed. All drilling costs are deducted by P in the year in which they are paid. At the end of 1987, A converts the general partnership interest into a limited partnership interest, effective immediately. The drilling of the well is completed on February 28, 1988. A's interest in the well would but for this paragraph (e)(4) be an interest in a passive activity. (ii) Throughout 1987, A holds the working interest through an entity that does not limit A's liability with respect to the drilling of the well pursuant to the working interest. In 1988, however, A holds the working interest through an entity that limits A's liability with respect to the drilling and operation of the well throughout such year. Accordingly, under paragraph (e)(4)(i) of this section, A's interest in P's well is not an interest in a passive activity for 1987 but is an interest in a passive activity for 1988. Moreover, since economic performance occurs in 1987 with respect to all items of deduction for drilling costs that are allocable to 1987, A has no disqualified deductions for 1987. Example (2). The facts are the same as in example (1), except that all costs of drilling under the contract with D (including costs of drilling performed after 1987) are paid before the end of 1987 and A has a net loss for 1987. In addition, A has $15,000 of total deductions that are attributable to the well and allocable to 1987, but economic performance (as that term is used in paragraph (e)(4)(ii)(C)(2)(ii) of this section) does not occur with respect to $5,000 of those deductions until 1988. Under paragraph (e)(4)(ii) of this section, the $5,000 of deductions with respect to which economic performance occurs in 1988 are disqualified deductions and are treated as passive activity deductions for 1987. In addition, one-third ($5,000/$15,000) of A's gross income from the well for 1987 is treated as passive activity gross income. (iv) Definition of "working interest." For purposes of section 469 and the regulations thereunder, the term "working interest" means an operating mineral interest (within the meaning of section 614(d) and the regulations thereunder). (v) Entities that limit liability-(A) General rule. For purposes of paragraph (e)(4)(i)(B) of this section, an entity limits the liability of the taxpayer with respect to the drilling or operation of a well pursuant to a working interest held through such entity if the taxpayer's interest in the entity is in the form of- (1) A limited partnership interest in a partnership in which the taxpayer is not a general partner; (2) Stock in a corporation; or (3) An interest in any entity (other than a limited partnership or corporation) that, under applicable State law, limits the potential liability of a holder of such an interest for all obligations of the entity to a determinable fixed amount (for example, the sum of the taxpayer's capital contributions). (B) Other limitations disregarded. For purposes of this paragraph (e)(4), protection against loss through any of the following is not taken into account in determining whether a taxpayer holds a working interest through an entity that limits the taxpayer's liability:

(1) An indemnification agreement; (2) A stop loss arrangement; (3) Insurance; (4) Any similar arrangement; or (5) Any combination of the foregoing. (C) Examples. The following examples illustrate the application of this paragraph (e)(4)(v): Example (1). A owns a 20 percent interest as a general partner in the capital and profits of P, a partnership which owns oil or gas working interests. The other partners of P agree to indemnify A against liability in excess of A's capital contribution for any of P's costs and expenses with respect to P's working interests. As a general partner, however, A is jointly and severally liable for all of P's liabilities and, under paragraph (e)(4)(v)(B)(1) of this section, the indemnification agreement is not taken into account in determining whether A holds the working interests through an entity that limits A's liability. Accordingly, the partnership does not limit A's liability with respect to the drilling or operation of wells pursuant to the working interests. Example (2). B owns a 10 percent interest in X, an entity (other than a limited partnership or corporation) created under applicable State law to hold working interests in oil or gas properties. Under applicable State law, B is liable without limitation for 10 percent of X's costs and expenses with respect to X's working interests but is not liable for the remaining 90 percent of such costs and expenses. Since B's liability for the obligations of X is not limited to a determinable fixed amount (within the meaning of paragraph (e)(4)(v)(A)(3) of this section), the entity does not limit B's liability with respect to the drilling or operation of wells pursuant to the working interests. Example (3). C is both a general partner and a limited partner in a partnership that owns a working interest in oil or gas property. Because C owns an interest as a general partner in each well drilled pursuant to the working interest, C's entire interest in each well drilled pursuant to the working interest is treated under paragraph(e)(4)(i) of this section as an interest in an activity that is not a passive activity (without regard to whether C materially participates in such activity). (vi) Cross reference to special rule for income from certain oil or gas properties. A special rule relating to the treatment of income from certain interests in oil or gas properties is contained in §1.469-2T(c)(6). (5) Rental of dwelling unit. An activity involving the rental of a dwelling unit that is used as a residence by the taxpayer during the taxable year (within the meaning of section 280A(c)(5)) is not a passive activity of the taxpayer for such year. (6) Activity of trading personal property-(i) In general. An activity of trading personal property for the account of owners of interests in the activity is not a passive activity

(without regard to whether such activity is a trade or business activity (within the meaning of paragraph (e)(2) of this section)). (ii) Personal property. For purposes of this paragraph (e)(6), the term "personal property" means personal property (within the meaning of section 1092(d), without regard to paragraph (3) thereof). (iii) Example. The following example illustrates the application of this paragraph (e)(6): Example. A partnership is a trader of stocks, bonds, and other securities (within the meaning of section 1236(c)). The capital employed by the partnership in the trading activity consists of amounts contributed by the partners in exchange for their partnership interests, and funds borrowed by the partnership. The partnership derives gross income from the activity in the form of interest, dividends, and capital gains. Under these facts, the partnership is treated as conducting an activity of trading personal property for the account of its partners. Accordingly, under this paragraph (e)(6), the activity is not a passive activity. (f) Treatment of disallowed passive activity losses and credits-(1) Scope of this paragraph. The rules in this paragraph (f)- (i) Identify the passive activity deductions that are disallowed for any taxable year in which all or a portion of the taxpayer's passive activity loss is disallowed under paragraph (a)(1)(i) of this section; (ii) Identify the credits from passive activities that are disallowed for any taxable year in which all or a portion of the taxpayer's passive activity credit is disallowed under paragraph (a)(1)(i) of this section; and (iii) Provide for the carryover of disallowed deductions and credits. (2) Identification of disallowed passive activity deductions-(i) Allocation of disallowed passive activity loss among activities-(A) General rule. If all or any portion of the taxpayer's passive activity loss is disallowed for the taxable year under paragraph (a)(1)(i) of this section, a ratable portion of the loss (if any) from each passive activity of the taxpayer is disallowed. For purposes of the preceding sentence, the ratable portion of a loss from an activity is computed by multiplying the passive activity loss that is disallowed for the taxable year by the fraction obtained by dividing- (1) The loss from the activity for the taxable year; by (2) The sum of the losses for the taxable year from all activities having losses for such year. (B) Loss from an activity. For purposes of this paragraph (f)(2)(i), the term "loss from an activity" means- (1) The amount by which the passive activity deductions from the activity for the taxable year (within the meaning of §1.469-2T(d)) exceed the passive activity gross

income from the activity for the taxable year (within the meaning of §1.469-2T(c)); reduced by (2) Any part of such amount that is allowed under section 469(i) and the rules to be contained in §1.469-9T (relating to the $25,000 allowance for certain rental real estate activities). (C) Significant participation passive activities. If the taxpayer's passive activity gross income from significant participation passive activities (within the meaning of

§1.469-2T(f) (2)(ii)) for the taxable year (determined without regard to §1.469-

2T(f)(2) through (4)) exceeds the taxpayer's passive activity deductions from such activities for the taxable year, such activities shall be treated, solely for purposes of applying this paragraph (f)(2)(i) for the taxable year, as a single activity that does not have a loss for such taxable year. (D) Examples. The following examples illustrate the application of this paragraph (f)(2)(i): Example (1). An individual holds interests in three passive activities, A, B, and C. The gross income and deductions from these activities for the taxable year are as follows: ------------------------------------------------------------------------------ A B C Total ------------------------------------------------------------------------------ Gross income .................. $7,000 $4,000 $12,000 $23,000 Deductions .................. (16,000) (20,000) (8,000) (44,000) --------------------------------------------------- Net income (loss) ........... ($9,000) ($16,000) $4,000 ($21,000) ---------------------- -------------------------------------------------------- The taxpayer's $21,000 passive activity loss for the taxable year is disallowed under paragraph (a)(1)(i) of this section. Therefore, a ratable portion of the losses from activities A and B is disallowed. The disallowed portion of each loss is determined as follows: A: $21,000 x $9,000/$25,000 ............. $7,560 B: $21,000 x $16,000/$25,000 ........... $13,440 ---------- Total .................................. $21,000 Example (2). An individual holds interests in four passive activities, A, B, C, and D. The results of operations of these activities for the taxable year are as follows: ------ ------------------------------------------------------------------------- A B C D Total ----- -------------------------------------------------------------------------- Gross income ......... 15,000 5,000 10,000 10,000 40,000 Deductions .......... (5,000) (10,000) (20,000) (8,000) (43,000) Net income (loss) .... 10,000 (5,000) (10,000) 2,000 (3,000) ------------------------------------------------------------------------------- Activities A and B are significant participation passive activities (within the meaning of §1.469-2T(f)(2)(ii)). The gross income from these activities for the taxable year ($20,000) exceeds the passive activity deductions from those activities for the taxable year ($15,000) by $5,000 and, under §1.469-2T(f)(2), $5,000 of gross income from those activities is treated as not from a passive activity. Therefore, solely for purposes of applying this paragraph (f)(2)(i) for the taxable year, activities A and B are treated as a single activity that does not have a loss for the taxable year. Under §1.469-2T(b), the taxpayer's passive activity loss for the taxable year is $8,000 ($43,000 of passive activity deductions minus $35,000 of passive activity gross income). The results of treating activities A and B as a single activity that does not have a loss for the taxable year is that none of the $8,000 passive activity loss is

allocated under this paragraph (f)(2)(i) to activity B for the taxable year, even though the taxpayer incurred a loss in that activity for the taxable year. (ii) Allocation within loss activities-(A) In general. If all or any portion of a taxpayer's loss from an activity is disallowed under paragraph (f)(2)(i) of this section for the taxable year, a ratable portion of each passive activity deduction (other than an excluded deduction (within the meaning of paragraph (f)(2)(ii)(B) of this section)) of the taxpayer from such activity is disallowed. For purposes of the preceding sentence, the ratable portion of a passive activity deduction of a taxpayer is the amount of the disallowed portion of the taxpayer's loss from the activity (within the meaning of paragraph (f)(2)(i)(B) of this section) for the taxable year multiplied by the fraction obtained by dividing- (1) The amount of such deduction; by (2) The sum of all passive activity deductions (other than excluded deductions (within the meaning of paragraph (f)(2)(ii)(B) of this section)) of the taxpayer from such activity from the taxable year. (B) Excluded deductions. The term "excluded deduction" means any passive activity deduction of a taxpayer that is taken into account in computing the taxpayer's net income from an item of property for a taxable year in which an amount of the taxpayer's gross income from such item of property is treated as not from a passive activity under §1.469-2T(c)(6) or §1.469-2T(f) (5), (6), or (7). (iii) Separately identified deductions. In identifying the deductions from an activity that are disallowed under this paragraph (f)(2), the taxpayer need not account separately for a deduction unless such deduction may, if separately taken into account, result in an income tax liability for any taxable year different from that which would result were such deduction not taken into account separately. For related rules applicable to partnerships and S corporations, see §1.702-1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Deductions that must be accounted for separately include (but are not limited to) deductions that- (A) Arise in a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in taxable years in which the taxpayer actively participates (within the meaning of section 469(i) and the rules to be contained in

§1.469-9T) in such activity;

(B) Arise in a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in taxable years in which the taxpayer does not actively participate (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in such activity; or (C) Are taken into account under section 1211 (relating to the limitation on capital losses) or section 1231 (relating to property used in a trade or business and involuntary conversions). (3) Identification of disallowed credits from passive activities-(i) General rule. If all or any portion of the taxpayer's passive activity credit is disallowed for the taxable year under paragraph (a)(1)(ii) of this section, a ratable portion of each credit from each

passive activity of the taxpayer is disallowed. For purposes of the preceding sentence, the ratable portion of a credit of a taxpayer is computed by multiplying the portion of the taxpayer's passive activity credit that is disallowed for the taxable year by the fraction obtained by dividing- (A) The amount of the credit; by (B) The sum of all of the taxpayer's credits from passive activities for the taxable year. (ii) Coordination rule. For purposes of paragraph (f)(3)(i) of this section, the credits from a passive activity do not include any credit or portion of a credit that- (A) Is allowed for the taxable year under section 469(i) and the rules to be contained in §1.469-9T (relating to the $25,000 allowance for certain rental real estate activities); or (B) Increases the basis of property during the taxable year under section 469(j)(9) and the rules to be contained in §1.469-6T (relating to the election to increase the basis of certain property by disallowed credits). (iii) Separately identified credits. In identifying the credits from an activity that are disallowed under this paragraph (f)(3), the taxpayer need not account separately for any credit unless such credit may, if separately taken into account, result in an income tax liability for any taxable year different from that which would result were such credit not taken into account separately. For related rules applicable to partnerships and S corporations, see §1.702-1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Credits that must be accounted for separately include (but are not limited to)- (A) Credits (other than the low-income housing and rehabilitation investment credits) from a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) that arise in a taxable year in which the taxpayer actively participates (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in such activity; (B) Credits (other than the low-income housing and rehabilitation investment credits) from a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) that arise in a taxable year in which the taxpayer does not actively participate (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in such activity; (C) Low-income housing and rehabilitation investment credits from a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in

§1.469-9T); and

(D) Any credit that is subject to the limitations of sections 26(a), 28(d)(2), 29(b)(5), or 38(c) in a manner that differs from the manner in which any other credit is subject to such limitations.

(4) Carryover of disallowed deductions and credits. Any deduction or credit from an activity of the taxpayer that is disallowed for a taxable year under paragraph (f)(2) or (3) of this section, respectively, shall be treated for purposes of section 469 and the regulations thereunder as a deduction or credit, as the case may be, from such activity for the taxpayer's immediately succeeding taxable year. The following example illustrates the application of this pragraph (f)(4): Example. The facts are the same as in example (1) in paragraph (f)(2)(i)(D) of this section. The $7,560 of loss from activity A and the $13,440 of loss from activity B that are disallowed for the taxable year under paragraph (f)(2) of this section are allocated among the passive activity deductions from those activities for such year under paragraph (f)(2)(ii) of this section and are treated under this paragraph (f)(4) as deductions from activities A and B, respectively, for the succeeding taxable year. (g) Application of these rules to C corporations-(1) In general. Except as otherwise provided in the rules to be contained in paragraph (k) of this section, section 469 and the regulations thereunder do not apply to any corporation that is not a personal service corporation or a closely held corporation for the taxable year. See paragraphs (g) (4) and (5) of this section for special rules for computing the passive activity loss and passive activity credit, respectively, of a closely held corporation. (2) Definitions. For purposes of section 469 and the regulations thereunder- (i) The term "personal service corporation" means a C corporation that is a personal service corporation for the taxable year (within the meaning of §1.441-4T(d)); and (ii) The term "closely held corporation" means a C corporation that meets the stock ownership requirements of section 542(a)(2) (taking into account the modifications in section 465(a)(3)) for the taxable year and is not a personal service corporation for such year. (3) Participation of corporations-(i) Material participation. For purposes of section 469 and the regulations thereunder, a corporation described in paragraph (g)(2) of this section shall be treated as materially participating in an activity for a taxable year if and only if- (A) One or more individuals, each of whom is treated under paragraph (g)(3)(iii) of this section as materially participating in such activity for the taxable year, directly or indirectly hold (in the aggregate) more than 50 percent (by value) of the outstanding stock of such corporation; or (B) In the case of a closely held corporation (within the meaning of paragraph (g)(2)(ii) of this section), the requirements of section 465(c)(7)(C) (without regard to clause (iv) thereof and taking into account section 465(c)(7)(D)) are met with respect to such activity. (ii) Significant participation. For purposes of §1.469-2T(f)(2), an activity of a corporation described in paragraph (g)(2) of this section shall be treated as a significant participation passive activity for a taxable year if and only if-

(A) The corporation is not treated as materially participating in such activity for the taxable year; and (B) One or more individuals, each of whom is treated under paragraph (g)(3)(iii) of this section as significantly participating in such activity, directly or indirectly hold (in the aggregate) more than 50 percent (by value) of the outstanding stock of such corporation. (iii) Participation of individual. Whether an individual is treated for purposes of this paragraph (g)(3) as materially participating or significantly participating in an activity of a corporation shall be determined under the rules of §1.469-5T, except that in applying such rules- (A) All activities of the corporation shall be treated as activities in which the individual holds an interest in determining whether the individual participates (within the meaning of §1.469-5T(f)) in an activity of the corporation; and (B) The individual's participation in all activities other than activities of the corporation shall be disregarded in determining whether the individual's participation in an activity of the corporation is treated as material participation under §1.469- 5T(a)(4) (relating to material participation in significant participation activities). (4) Modified computation of passive activity loss in the case of closely held corporations.-(i) In general. A closely held corporation's passive activity loss for the taxable year is the amount, if any, by which the corporation's passive activity deductions for the taxable year (within the meaning of §1.469-2T(d)) exceed the sum of- (A) The corporation's passive activity gross income for the taxable year (within the meaning of §1.469-2T(c)); and (B) The corporation's net active income for the taxable year. (ii) Net active income. For purposes of this paragraph (g)(4), a corporation's net active income for the taxable year is such corporation's taxable income for the taxable year, determined without regard to the following items for the year: (A) Passive activity gross income; (B) Passive activity deductions; (C) Portfolio income (within the meaning of §1.469-2T(c)(3)(i)), including any gross income that is treated as portfolio income under any other provision of the regulations (see, e.g., §1.469-2T(c)(2)(iii)(E) (relating to gain from the disposition of substantially appreciated property formerly held for investment) and §1.469- 2T(f)(10) (relating to certain recharacterized passive activity gross income); (D) Gross income that is treated under §1.469-2T(c)(6) (relating to gross income from certain oil or gas properties) as not from a passive activity;

(E) Gross income and deductions from any trade or business activity (within the meaning of paragraph (e)(2) of this section) that is described in paragraph (e)(6) of this section (relating to certain activities of trading personal property) but only if the corporation did not materially participate in such activity for the taxable year; (F) Deductions described in §1.469-2T(d)(2)(i), (ii), and (iv) (relating to certain deductions attributable to portfolio income); and (G) Interest expense allocated under §1.163-8T to a portfolio expenditure (within the meaning of §1.163-8T(b)(6)). (iii) Examples. The following examples illustrate the application of this paragraph (g)(4): Example (1). (i) For 1987, X, a closely held corporation, is engaged in two activities, a trade or business activity in which X materially participates for 1987 and a rental activity. X also holds portfolio investments. For 1987, X has the following gross income and deductions: Gross income: Rents ................................................................. $60,000 Gross income from business ............................................ 100,000 Portfolio income ....................................................... 35,000 ------------- Total ................................................................ $195,000 ------------- Deductions: Rental deductions .................................................. ($100,000) Business deductions (80,000) Interest expense allocable to portfolio expenditures under sec. 1.163-8T ........................................................... (10,000) Deductions (other than interest expense) clearly and directly allocable to portfolio income ....................................... (5,000) ------------- Total .............................................................. ($195,000) ------------- (ii) The corporation's net active income for 1987 is $20,000, computed as follows: Gross income ........................................... $195,000 Amounts not taken into account in computing net active income: Rents (see paragraph (g)(4)(ii)(A) of this section) ....................... $60,000 Portfolio income (see paragraph (g)(4)(ii)(C) of this section) ......... $35,000 ------------ $95,000 ($95,000) --------------------------- Gross income taken into account in computing net active income .......................... $100,000 $100,000 ------------- Deductions ........................................... ($195,000) Amounts not taken into account in computing net active income: Rental deductions (see paragraph (g)(4)(ii)(B) of this section) ...... ($100,000) Interest expense allocated to portfolio expenditures (see paragraph (g)(4)(ii)(G) of this section) ............................. ($10,000) Other deductions clearly and directly allocable to portfolio income (see paragraph (g)(4)(ii)(F) of this section) ........ ($5,000) ($115,000) $115,000 ------------- Deductions taken into account in computing net active income ......................... ($80,000) ($80,000) ------------- Net active income ..................................................... $20,000 ------------ (iii) Under paragraph(g)(4)(i) of this section, X's passive activity loss for 1987 is $20,000, the amount by which the passive activity deductions for the taxable year ($100,000) exceed the sum of (a) the passive activity gross income for the taxable year ($60,000) and (b) the net active income for the taxable year ($20,000). Under paragraph (f)(4) of this section, the $20,000 of deductions from X's rental activity that are disallowed for 1987 are treated as deductions from the rental activity for 1988. If computed without regard to the net active income for the taxable year, X's

passive activity loss would be $40,000 ($100,000 of rental deductions minus $60,000 of rental income). Thus, the effect of the rule in paragraph (g)(4)(i) of this section is to reduce the corporation's passive activity loss for the taxable year by the amount of the corporation's net active income for such year. (iv) Under these facts, X's taxable income for 1987 is $20,000, computed as follows: Gross income ..................................... $195,000 Deductions: Total deductions ................ ($195,000) Passive activity loss .............. $20,000 ------------- Allowable deductions ............ ($175,000) ($175,000) ------------- Taxable income .................................... $20,000 ------------- Example (2). (i) The facts are the same as in example (1), except that, in 1988, X has a loss from the trade or business activity, and a net operating loss ("NOL") of $15,000 that is carried back under section 172(b) to 1987. Since NOL carrybacks are taken into account in computing net active income, X's net active income for 1987 must be recomputed as follows: Net active income before NOL carryback ............. $20,000 NOL carryback .................................... ($15,000) ------------ Net active income ................................... $5,000 ------------ (ii) Under these facts, X's disallowed passive activity loss for 1987 is $35,000, the amount by which the passive activity deductions for the taxable year ($100,000) exceed the sum of (a) the passive activity gross income for the taxable year ($60,000) and (b) the net active income for the taxable year ($5,000). (iii) Under paragraph (f)(4) of this section, the $35,000 of deductions from X's rental activity that are disallowed for 1987 are treated as deductions from the rental activity for 1988. X's taxable income for 1987 is $20,000, computed as follows: Gross income ..................................... $195,000 Deductions: Total deductions ................. ($210,000 Passive activity loss .............. $35,000 Allowable deductions ............ ($175,000) ($175,000) ------------- Taxable income ............... ------------- $20,000 ------------- Thus, taking the NOL carryback into account in computing net active income for 1987 does not affect X's taxable income for 1987, but increases the deductions treated under paragraph (f)(4) as deductions from X's rental activity for 1988 and decreases X's NOL carryover to years other than 1987. (5) Allowance of passive activity credit of closely held corporations to extent of net active income tax liability-(i) In general. Solely for purposes of determining the amount disallowed under paragraph (a)(1)(ii) of this section, a closely held corporation's passive activity credit for the taxable year shall be reduced by such corporation's net active income tax liability for such year. (ii) Net active income tax liability. For purposes of paragraph (g)(5)(i) of this section, a corporation's net active income tax liability for a taxable year is the amount (if any) by which- (A) The corporation's regular tax liability (within the meaning of section 26(b)) for the taxable year, determined by reducing the corporation's taxable income for such year by an amount equal to the excess (if any) of the corporation's passive activity gross income for such year over the corporation's passive activity deductions for such year; exceeds

(B) The sum of- (1) The corporation's regular tax liability for the taxable year, determined by reducing the corporation's taxable income for such year by an amount equal to the excess (if any) of the sum of the corporation's net active income (within the meaning of paragraph (g)(4)(ii) of this section) and passive activity gross income for such year over the corporation's passive activity deductions for such year; and (2) The corporation's credits (other than credits from passive activities) that are allowable for the taxable year (without regard to the limitations contained in sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469). (h) Special rules for affiliated group filing consolidated return-(1) In general. For purposes of computing the consolidated taxable income and tax liability of an affiliated group of corporations filing a consolidated return for the taxable year, and the separate taxable income (within the meaning of §1.1502-12) of each member of such group, section 469 and the regulations thereunder shall be applied in the manner provided in this paragraph (h). (2) Definitions. For purposes of this paragraph (h)- (i) The terms "group," "member," "subsidiary," and "consolidated return year" shall have the meanings set forth in §1.1502-1; (ii) The term "consolidated group" means a group filing a consolidated return for the taxable year; and (iii) The term "consolidated taxable income" shall have the meaning set forth in

§1.1502-11.

(3) Disallowance of consolidated group's passive activity loss or credit. A consolidated group's passive activity loss or passive activity credit for the taxable year shall be disallowed to the extent provided in paragraph (a) of this section. For purposes of the preceding sentence, a consolidated group's passive activity loss and passive activity credit shall be determined by taking into account the following items of each member of such group: (i) Passive activity gross income; (ii) Passive activity deductions; (iii) Net active income (in the case of a consolidated group treated as a closely held corporation under paragraph (h)(4)(ii) of this section); and (iv) Credits from passive activities. (4) Status and material participation of members-(i) Determination by reference to status and participation of group. For purposes of section 469 and the regulations thereunder-

(A) Each member of a consolidated group shall be treated as a closely held corporation or personal service corporation, respectively, for the taxable year, if and only if the consolidated group is treated (under the rules of paragraph (h)(4)(ii) of this section) as a closely held corporation or personal service corporation for such year; and (B) The determination of whether a trade or business activity (within the meaning of paragraph (e)(2) of this section) conducted by one or more members of a consolidated group is a passive activity of such members shall be made by reference to the consolidated group's participation in such activity. (ii) Determination of status and material participation of consolidated group. For purposes of determining under paragraph (g)(2) of this section whether a consolidated group is treated as a closely held corporation or a personal service corporation, and determining under paragraph (g)(3) of this section whether the consolidated group materially participates in any activity conducted by one or more members of such group- (A) The members of such consolidated group shall be treated as one corporation; (B) Only the outstanding stock of the common parent shall be treated as outstanding stock of such corporation; (C) An employee of any member of such group shall be treated as an employee of such corporation; and (D) An activity is treated as the principal activity of such corporation if and only if it is the principal activity (within the meaning of §1.44-4T(f)) of the consolidated group. (5) Modification of rules for identifying disallowed passive activity deductions and credits-(i) Identification of disallowed deductions. In applying paragraphs (f) (2) and (4) of this section to a consolidated group for purposes of identifying the passive activity deductions of such consolidated group and of each member of such consolidated group that are disallowed for the taxable year and treated as deductions from activities for the succeeding taxable year, the following rules shall apply: (A) A ratable portion (within the meaning of paragraph (h)(5)(ii) of this section) of the passive activity loss of the consolidated group that is disallowed for the taxable year shall be allocated to each member of the group; (B) Pararaph (f)(2) of this section shall then be applied to each member of the group as if- (1) Such member were a separate taxpayer; and (2) The amount allocated to such member under paragraph (h)(5)(i)(A) of this section were the amount of such member's passive activity loss that is disallowed for the taxable year; and

(C) Paragraph (f)(4) of this section shall be applied to each member of the group as if it were a separate taxpayer. (ii) Ratable portion of disallowed passive activity loss. For purposes of paragraph (h)(5)(i)(A) of this section, a member's ratable portion of the disallowed passive activity loss of the consolidated group is the amount of such disallowed loss multiplied by the fraction obtained by dividing- (A) The amount of the passive activity loss of such member of the consolidated group that would be disallowed for the taxable year if the items of gross income and deduction of such member were the only items of the group for such year; by (B) The sum of the amounts described in paragraph (h)(5)(ii)(A) of this section for all members of the group. (iii) Identification of disallowed credits. In applying paragraph (f)(3) of this section to a consolidated group for purposes of identifying the credits from passive activities of members of such consolidated group that are disallowed for the taxable year, the consolidated group shall be treated as one taxpayer. Thus, a ratable portion of each of the group's credits from passive activities is disallowed. (6) Transactions between members of a consolidated group-(i) Scope. This paragraph (h)(6) provides rules regarding the treatment, for purposes of section 469 and the regulations thereunder, of items of income and deduction attributable to intercompany transactions. See paragraph (h)(6)(iv) of this section for the definition of "intercompany transaction" and certain other terms used in this paragraph (h)(6). (ii) Recharacterization of gain or loss from intercompany transactions other than deferred intercompany transactions-(A) In general. If the selling member in an intercompany transaction (other than a deferred intercompany transaction) recognizes an item of gain or loss described in §1.1502-13(b) that is directly related to an item of deduction of the purchasing member, and both the gain or loss and the directly related item of deduction are taken into account in computing consolidated taxable income for the same taxable year, the items of income or deduction that are taken into account by the selling member in computing such gain or loss shall be taken into account in computing consolidated taxable income for such taxable year as items of income or deduction of the selling member from the activity to which the directly related deduction of the purchasing member is attributable. (B) Recharacterization of gain or loss as portfolio items. Any item of income or deduction of a selling member that is recharacterized under this paragraph (h)(6)(ii) shall be treated as an item of income or deduction described in §1.469-2T(c)(3)(i) (relating to portfolio income) or §1.469-2T(d)(2)(i) (relating to expenses clearly and directly allocable to portfolio income), as the case may be, if and only if the directly related item of deduction is a deduction described in §1.469-2T (d)(2)(i) or a deduction for interest expense that is allocated under §1.163-8T to a portfolio expenditure (within the meaning of §1.163-8T (b)(6)). (iii) Deferred intercompany transactions-(A) In general. For purposes of section 469 and the regulations thereunder, the treatment of deferred gain or loss on a deferred intercompany transaction between members of a group shall be determined in accordance with this paragraph (h)(6)(iii).

(B) Deferred intercompany transactions involving property subject to depreciation, amortization, or depletion. If, for any consolidated return year, the selling member in a deferred intercompany transaction is required to take into account deferred gain or loss under §1.1502-13(d) as a result of depreciation, amortization, or depletion of a member of the group, then for purposes of section 469 and the regulations thereunder such deferred gain or loss shall be taken into account for such year as gain or loss of the selling member from the activity (or activities) to which such depreciation, amortization, or depletion deductions are attributable. (C) Restoration of deferred gain or loss on dispositions. If, for any consolidated return year, the selling member in a deferred intercompany transaction (other than a deferred intercomapny transaction described in §1.1502-13(e)(1)) is required to take deferred gain or loss into account under §1.1502-13(e)(2) or (f), then for purposes of section 469 and the regulations thereunder- (1) Such deferred gain or loss shall be treated as gain or loss of the selling member from a disposition of the property involved in such deferred intercompany transaction at the time of (i) the event that requires such gain or loss to be taken into account or (ii) in the case of a transaction described in §1.1502-13(e)(2), the disposition of such property outside the consolidated group; and (2) Such deferred gain or loss shall, except as otherwise provided in §1.1502-2T (c)(2) or (d)(5), be taken into account for such year as gain or loss of the selling member from the activity (or activities) of the affiliated group in which the property involved in such deferred intercompany transaction is used immediately preceding the time specified in paragraph (h)(6)(iii)(C)(1) of this section. See paragraph (h)(8) of this section, relating to dispositions by a member of substantially appreciated property formerly used in a nonpassive activity. (D) Certain recharacterized items treated as portfolio items. Any deferred gain or loss or a selling member that is recharacterized under this paragraph (h)(6)(iii) shall be treated as an item of income or deduction described in §1.469-2T(c)(3)(i) (relating to portfolio income) or §1.469-2T(d)(2)(i) (relating to expenses clearly and directly allocable to portfolio income), as the case may be, if and only if the property involved in the transaction is property that produces portfolio income (within the meaning of §1.469-2T(c)(3)((i)). (E) Property involved in deferred intercompany transaction. For purposes of this paragraph (h)(6)(iii), the property involved in a deferred intercompany transaction is the property sold or exchanged in such transaction or the property with respect to which expenditures incurred in such transaction are capitalized. (iv) Definitions. For purposes of this paragraph (h)(6), the terms set forth below shall have the following meanings: (A) Deferred intercompany transaction. The term "deferred intercompany transaction" shall have the meaning set forth in §1.1502-13(a)(2). (B) Directly related. An item of gross income and an item of deduction are "directly related" if and to the extent that the same amount paid or accrued generates both

the income and the deduction, without regard to whether the income and the deduction are taken into account by the taxpayer in the same taxable year. (C) Intercompany transaction. The term "intercompany transaction" shall have the meaning set forth in §1.1502-13(a)(1). (D) Purchasing member. The term "purchasing member" shall have the meaning set forth in §1.1502-13(a). (E) Selling member. The term "selling member" shall have the meaning set forth in §1.502-13(a). (7) Disposition of stock of a member of an affiliated group. Any gain recognized by a member on the disposition of stock of a subsidiary (including income resulting from the recognition of an excess loss account under §1.1502-19 (a)) shall be treated as portfolio income (within the meaning of §1.469-2T (c)(3)(i)). (8) Dispositions of property used in multiple activities. The determination of whether

§1.469-2T(c)(2)(ii) or (iii) or (d)(5)(ii) applies to a disposition (including a deemed

disposition described in paragraph (h)(6)(iii)(C)(1) of this section) of property by a member of a consolidated group shall be made by treating such member as having held the property for the entire period that the group has owned such property and as having used the property in all of the activities in which the group has used such property (i) [Reserved] (j) Spouses filing joint return-(1) In general. Except as otherwise provided in the regulations under section 469, spouses filing a joint return for a taxable year shall be treated for such year as one taxpayer for purposes of section 469 and the regulations thereunder Thus, for example, spouses filing a joint return are treated as one taxpayer for purposes of- (i) Section 1.469-2T (relating generally to the computation of such taxpayer's passive activity loss); and (ii) Paragraph (f) of this section (relating to the allocation of such taxpayer's disallowed passive activity loss and passive activity credit among activities and the identification of disallowed passive activity deductions and credits from passive activities). (2) Exceptions to treatment as one taxpayer-(i) Identification of disallowed deductions and credits. For purposes of paragraphs (f)(2)(iii) and (3) (iii) of this section, spouses filing a joint return for the taxable year must account separately for the deductions and credits attributable to the interests of each spouse in any activity. (ii) Treatment of deductions disallowed under sections 704(d), 1366(d), and 465. Notwithstanding any other provision of this section or §1.469-2T, this paragraph (j) shall not affect the application of section 704(d), section 1366(d), or section 465 to taxpayers filing a joint return for the taxable year.

(iii) Treatment of losses from working interests. Paragraph (e)(4) of this section (relating to losses and credits from certain interests in oil and gas wells) shall be applied by treating a husband and wife (whether or not filing a joint return) as separate taxpayers. (3) Joint return no longer filed. If an individual- (A) Does not file a joint return for the taxable years; and (B) Filed a joint return for the immediately preceding taxable year; then the passive activity deductions and credits allocable to such individual's activities for the taxable year under paragraph (f)(4) of this section shall be determined by taking into account the items of deduction and credit attributable to such individual's interests in passive activities for the immediately preceding taxable year. See paragraph (j)(2)(i) of this section. (4) Participation of spouses. Rules treating an individual's participation in an activity as participation of such individual's spouse in such activity (without regard to whether the spouses file a joint return) are contained in §1.469-5T(f)(3). (k) Former passive activities and changes in status of corporations. [Reserved]

§1.469-2T Passive activity loss (temporary).

(a) Scope of this section. This section contains rules for determining the amount of the taxpayer's passive activity loss for the taxable year for purposes of section 469 and the regulations thereunder. The rules contained in this section- (1) Provide general guidance for identifying items of income and deduction that are taken into account in determining the amount of the passive activity loss for the taxable year; (2) Specify particular items of income and deduction that are not taken into account in determining the amount of the passive activity loss for the taxable year; and (3) Specify the manner in which provisions of the Internal Revenue Code and the regulations, other than section 469 and the regulations thereunder, are applied for purposes of determining the extent to which items of deduction are taken into account for a taxable year in computing the amount of the passive activity loss for such year. (b) Definition of passive activity loss-(1) In general. In the case of a taxpayer other than a closely held corporation (within the meaning of §1.469-1T(g)(2)(ii)), the passive activity loss for the taxable year is the amount, if any, by which the passive activity deductions for the taxable year exceed the passive activity gross income for the taxable year. (2) Cross references. See paragraph (c) of this section for the definition of "passive activity gross income," paragraph (d) of this section for the definition of "passive

activity deduction," and §1.469-1T(g)(4) for the computation of the passive activity loss of a closely held corporation. (c) Passive activity gross income-(1) In general. Except as otherwise provided in the regulations under section 469, passive activity gross income for a taxable year includes an item of gross income if and only if such income is from a passive activity. (2) Treatment of gain from disposition of an interest in an activity or an interest in property used in an activity-(i) In general-(A) Treatment of gain. Except as otherwise provided in the regulations under section 469, any gain recognized upon the sale, exchange or other disposition (a "disposition") of an interest in property used in an activity at the time of the disposition or of an interest in an activity held through a partnership or S corporation is treated in the following manner: (1) The gain is treated as gross income from such activity for the taxable year or years in which it is recognized; (2) If the activity is a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as passive activity gross income for the taxable year or years in which it is recognized; and (3) If the activity is not a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as not from a passive activity. (B) Dispositions of partnership interests and S corporation stock. A partnership interest or S corporation stock is not property used in an activity for purposes of this paragraph (c)(2). See paragraph (e)(3) of this section for rules treating the gain recognized upon the disposition of a partnership interest or S corporation stock as gain from the disposition of interests in the activities in which the partnership or S corporation has an interest. (C) Interest in property. For purposes of applying this paragraph (c)(2) to a disposition of property- (1) Any material portion of the property that was used, at any time before the disposition, in any activity at a time when the remainder of the property was not used in such activity shall be treated as a separate interest in property; and (2) The amount realized from the disposition and the adjusted basis of the property must be allocated among the separate interests in a reasonable manner. (D) Examples. The following examples illustrate the application of this paragraph (c)(2)(i): Example (1). A owns an interest in a trade or business activity in which A has never materially partcipated. In 1987, A sells equipment that was used exclusively in the activity and realizes a gain on the sale. Under paragraph (c)(2)(i)(A)(2) of this section, the gain is passive activity gross income. Example (2). B owns an interest in a trade or business activity in which B materially participates for 1987. In 1987, B sells a building used in the activity in an installment

sale and realizes a gain on the sale. B does not materially participate in the activity for 1988 or any subsequent year. Under paragraph (c)(2)(i)(A)(3) of this section, none of B's gain from the sale (including gain taken into account after 1987) is passive activity gross income. Example (3). C enters into a contract to acquire property used by the seller in a rental activity. Before acquiring the property pursuant to the contract, C sells all rights under the contract and realizes a gain on the sale. Since C's rights under the contract are not property used in a rental activity, the gain is not income from a rental activity. The result would be the same if C owned an option to acquire the property and sold the option. Example (4). D sells a ten-floor office building. D owned the building for three years preceding the sale and at all times during that period used seven floors of the building in a trade or business activity and three floors in a rental activity. The fair market value per square foot is substantially the same throughout the building, and D did not maintain a separate adjusted basis for any part of the building. Under paragraph (c)(2)(i)(C)(1) of this section, the seven floors used in the trade or business activity and the three floors used in the rental activity are treated as separate interests in property. Under paragraph (c)(2)(i)(C)(2) of this section, the amount realized and the adjusted basis of the building must be allocated between the separate interests in a reasonable manner. Under these facts, an allocation based on the square footage of the parts of the building used in each activity would be reasonable. Example (5). The facts are the same as in example (4), except that two of the seven floors used in the trade or business activity were used in the rental activity until five months before the sale. Under paragraph (c)(2)(i)(C)(1) of this section, the five floors used exclusively in the trade or business activity and the two floors used first in the rental activity and then in the trade or business activity are treated as separate interests in property. See paragraph (c)(2)(ii) of this section for rules for allocating amount realized and adjusted basis upon a disposition of an interest in property used in more than one activity during the 12-month period ending on the date of the disposition. (ii) Disposition of property used in more than one activity in 12-month period preceding disposition. In the case of a disposition of an interest in property that is used in more than one activity during the 12-month period ending on the date of the disposition, the amount realized from the disposition and the adjusted basis of such interest must be allocated among such activities on a basis that reasonably reflects the use of such interest in property during such 12-month period. For purposes of this paragraph (c)(2)(ii), an allocation of the amount realized and adjusted basis solely to the activity in which an iterest in property is predominantly used during the 12-month period ending on the date of the disposition reasonably reflects the use of such interest in property if the fair market value of such interest does not exceed the lesser of- (A) $10,000; and (B) 10 percent of the sum of the fair market value of such interest and the fair market value of all other property used in such activity immediately before the disposition.

The following examples illustrate the application of this paragraph (c)(2)(ii): Example (1). The facts are the same as in example (5) of paragraph (c)(2)(i)(D) of this section. Under paragraph (c)(2)(i)(C)(2) of this section, D allocates the amount realized and adjusted basis of the building 30 percent to the three floors used exclusively in the rental activity, 50 percent to the five floors used exclusively in the trade or business activity, and 20 percent to the two floors used first in the rental activity and then in the trade or business activity. Under this paragraph (c)(2)(ii), the amount realized and adjusted basis allocated to the two floors that were used in both activities during the 12-month period ending on the date of the disposition must also be allocated between such activities. Under these facts, an allocation of 7/12 of such amounts to the rental activity and 5/12 of such amounts to the trade or business activity would reasonably reflect the use of the two floors during the 12-month period ending on the date of the disposition. Example (2). B is a limited partner in a partnership that sells a tractor-trailer. During the 12-month period ending on the date of the sale, the tractor-trailer was used in several activities, and the partnership allocates the amount realized from the disposition and the adjusted basis of the tractor-trailer among the activities based on the number of days during the 12-month period that the partnership used the tractor-trailer in each activity. Under these facts, the partnership's allocation reasonably reflects the use of the tractor-trailer during the 12-month period ending on the date of the sale. Example (3). C sells a personal computer for $8,000. During the 12-month period ending on the date of the sale, 70 percent of C's use of the computer was in a passive activity. Immediately before the sale, the fair market value of all property used in the passive activity (including the personal computer) was $200,000. Under these facts, the computer was predominatly used in the passive activity during the 12-month period ending on the date of the sale, and the value of the computer, as measured by its sale price ($8,000), does not exceed the lesser of (a) $10,000, and (b) 10 percent of the value of all property used in the activity immediately before the sale ($20,000). C allocates the amount realized and the adjusted basis solely to the passive activity. Under this paragraph (c)(2)(ii), C's allocation reasonably reflects the use of the computer during the 12-month period ending on the date of the sale. (iii) Disposition of substantially appreciated property formerly used in nonpassive activity-(A) In general. If an interest in property used in an activity is substantially appreciated at the time of its disposition, any gain from the disposition shall be treated as not from a passive activity unless such interest in property was used in a passive activity for either- (1) 20 percent of the period during which the taxpayer held such interest in property; or (2) The entire 24-month period ending on the date of the disposition. (B) Date of disposition. For purposes of this paragraph (c)(2)(iii), a disposition of an interest in property shall be deemed to occur on the date that such interest in property becomes subject to an oral or written agreement that either requires the

owner or gives the owner an option to transfer such interest in property for consideration that is fixed or otherwise determinable on such date. (C) Substantially appreciated property. For purposes of this paragraph (c)(2)(iii), an interest in property is substantially appreciated if the fair market value of such interest in property exceeds 120 percent of the adjusted basis of such interest. (D) Coordination with paragraph (c)(2)(ii) of this section. If paragraph (c)(2)(ii) of this section applies to the disposition of an interest in property, this paragraph (c)(2)(iii) shall apply only to that portion of the gain from the disposition of such interest in property that is characterized as gain from a passive activity after the application of paragraph (c)(2)(ii) of this section. (E) Coordination with section 163(d). Gain that is treated as not from a passive activity under this paragraph (c)(2)(iii) shall be treated as income described in section 469(e)(1)(A) and paragraph (c)(3)(i) of this section if and only if such gain is from the disposition of an interest in property that was held for investment for more than 50 percent of the period during which the taxpayer held such interest in property in activities other than passive activities. (F) Example. The following example illustrates the application of this paragraph (c)(2)(iii): Example. A acquires a building on January 1, 1987, and uses the building in a trade or business activity in which A materially participates until March 31, 1997. On April 1, 1998, A leases the building to B. On December 31, 1999, A sells the building. Assuming A's lease of the building to B constitutes a rental activity (within the meaning of §1.469-1T(e)(3)), the building is used in a passive activity for 21 months (April 1, 1998, through December 31, 1999). Thus, the building was not used in a passive activity for the entire 24-month period ending on the date of the sale. In addition, the 21-month period during which the building was used in a passive activity is less than 20 percent of A's holding period for the property (13 years). Therefore, the gain from the sale is treated under this paragraph (c)(2)(iii) as not from a pasive activity. (3) Items of portfolio income specifically excluded-(i) In general. Passive activity gross income does not include portfolio income. For purposes of the preceding sentence, portfolio income includes all gross income, other than income derived in the ordinary course of a trade or business (within the meaning of paragraph (c)(3)(ii) of this section), that is attributable to- (A) Interest (including amounts treated as interest under paragraph (e)(2)(ii) of this section, relating to certain payments to partners for the use of capital); annuities; royalties (including fees and other payments for the use of intangible property); dividends on C corporation stock; and income (including dividends) from a real estate investment trust (within the meaning of section 856), regulated investment company (within the meaning of section 851), real estate mortgage investment conduit (within the meaning of section 860D), common trust fund (within the meaning of section 584), controlled foreign corporation (within the meaning of section 957), qualified electing fund (within the meaning of section 1295(a)), or cooperative (within the meaning of section 1381(a));

(B) Dividends on S corporation stock (within the meaning of section 1368(c)(2); (C) The disposition of property that produces income of a type described in paragraph (c)(3)(i)(A) of this section; and (D) The disposition of property held for investment (within the meaning of section 163 (d)). (ii) Gross income derived in the ordinary course of a trade or business. Solely for purposes of paragraph (c)(3)(i) of this section, gross income derived in the ordinary course of a trade or business includes only- (A) Interest income on loans and investments made in the ordinary course of a trade or business of lending money; (B) Interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business; (C) Income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies; (D) Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (but see paragraph (c)(3)(iii)(A) of this section); (E) Royalties derived by the taxpayer in the ordinary course of a trade or business of licensing intangible property (within the meaning of paragraph (c)(3)(iii)(B) of this section); (F) Amount included in the gross income of a patron of a cooperative (within the meaning of section 1381(a), without regard to paragraph (2)(A) or (C) thereof) by reason of any payment or allocation to the patron based on patronage occurring with respect to a trade or business of the patron; and (G) Other income identified by the Commissioner as income derived by the taxpayer in the ordinary course of a trade or business. (iii) Special rules-(A) Income from property held for investment by dealer. For purposes of paragraph (c)(3)(i) of this section, a dealer's income or gain from an item of property is not dervied by the dealer in the ordinary course of a trade or business of dealing in such property if the dealer held the property for investment at any time before such income or gain is recognized. (B) Royalties derived in the ordinary course of the trade or business of licensing intangible property-(1) In general. Royalties received by any person with respect to a license or other transfer of any rights in intangible property shall be considered to be derived in the ordinary course of the trade or business of licensing such property only if such person-

(i) Created such property; or (ii) Performed substantial services or incurred substantial costs with respect to the development or marketing of such property. (2) Substantial services or costs-(i) In general. Except as provided in paragraph (c)(3)(iii)(B)(2)(ii) of this section, the determination of whether a person has performed substantial services or incurred substantial costs with respect to the development or marketing of an item of intangible property shall be made on the basis of all the facts and circumstances. (ii) Exception. A person has performed substantial services or incurred substantial costs for a taxable year with respect to the development or marketing of an item of intangible property if- (a) The expenditures reasonably incurred by such person in such taxable year with respect to the development or marketing of the property exceed 50 percent of the gross royalties from licensing such property that are includible in such person's gross income for the taxable year; or (b) The expenditures reasonably incurred by such person in such taxable year and all prior taxable years with respect to the development or marketing of the property exceed 25 percent of the aggregate capital expenditures (without any adjustment of amortization) made by such person with respect to the property in all such taxable years. (iii) Expenditures taken into account. For purposes of paragraph (c)(3)(iii)(B)(2)(ii) of this section, expenditures in a taxable year include amounts chargeable to capital account for such year without regard to the year or years (if any) in which any deduction for such expenditure is allowed. (3) Passthrough entities. For purposes of this paragraph (c)(3)(iii)(B), in the case of any intangible property held by a partnership, S corporation, estate, or trust, the determination of whether royalties from such property are derived in the ordinary course of a trade or business shall be made by applying the rules of this paragraph (c)(3)(iii)(B) to such entity and not to any holder of an interest in such entity. (4) Cross reference. For special rules applicable to certain gross income from a trade or business of licensing intangible property, see paragraph (f)(7) of this section. (C) Mineral production payments. For purposes of section 469 and the regulations thereunder- (1) If a mineral production payment is treated as a loan under section 636, the portion of any payment in discharge of the production payment that is the equivalent of interest shall be treated as interest; and (2) If a mineral production payment is not treated as a loan under section 636, payments in discharge of the production payment shall be treated as royalties.

(iv) Examples. The following examples illustrate the application of this paragraph (c)(3): Example (1). A, an individual engaged in the trade or business of farming, disposes of farmland in an installment sale. A is not engaged in a trade or business of selling farmland. Therefore, A's interest income from the installment note is not gross income derived in the ordinary course of a trade or business. Example (2). P, a partnership, operates a rental apartment building for low-income tenants in City Y. Under Y's laws relating to the operation of low-income housing, P is required to maintain a reserve fund to pay for the maintenance and repair of the building. P invests the reserve fund in short-term interest-bearing deposits. Because P's interest income from the investment of the reserve fund is not interest income described in paragraph (c)(3)(ii) of this section, such income is not treated as derived in the ordinary course of a trade or business. Accordingly, P's interest income from the deposits is portfolio income (within the meaning of paragraph (c)(3)(i) of this section). Example (3). (i) B is a partner in a partnership that is engaged in an activity involving the conduct of a trade or business of dealing in securities. On February 1, the partnership acquires certain securities for investment (within the meaning of section 163(d)). On February 2, before recognizing any income with respect to the securities, the partnership determines that it would be advisable to hold the securities primarily for sale to customers and subsequently sells them to customers in the ordinary course of its business. (ii) Under paragraph (c)(3)(iii)(A) of this section, income or gain from any security (including any security acquired pursuant to an investment of working capital) held by a dealer for investment at any time before such income or gain is recognized is not treated for purposes of paragraph (c)(3)(i) of this section as derived by the dealer in the ordinary course of its trade or business of dealing in securities. Accordingly, B's distributive share of the partnership's interest, dividends, or gains from the securities acquired by the partnership for investment on February 1 is portfolio income of B, notwithstanding that such securities were held by the partnership, subsequent to February 1, primarily for sale to customers in the ordinary course of the partnership's trade or business of dealing in securities. Example (4). C is a partner in a partnership that is engaged in an activity of trading or dealing in royalty interests in mineral properties. The partnership derives royalty income from royalty interests held in the activity. If the activity is a trade or business activity, C's distributive share of the partnership's royalty income from such royalty interests is treated under paragraph (c)(3)(ii)(D) of this section as derived in the ordinary course of the partnership's trade or business. Example (5). (i) D, a calendar year individual, is a partner in a calendar year partnership that is engaged in an activity of developing and marketing a design for a system that reduces air pollution in office buildings. D has a 10 percent distributive share of all items of partnership income, gain, loss, deduction, and credit. In 1987, the partnership acquired the rights to the design for $100,000. In 1987, 1988, and 1989, the partnership incurs expenditures with respect to the development and marketing of the design, and derives gross royalties from licensing the design, in the amounts set forth in the table below. The expenditures incurred in 1987 and 1988

are currently deductible expenses. The expenditures incurred in 1989 are capitalized and may be deducted only in subsequent taxable years. -------------------------------- ----------------------------------------------- Year Gross royalties Expenditures Cumulative capital expenditures ---------------------------------------------------------- --------------------- 1987 ................... $20,000 $8,000 $100,000 1988 .................... 20,000 12,000 100,000 1989 .................... 60,000 15,000 115,000 1990 ................... 120,000 0 115,000 -------------------------------------------------- ----------------------------- (ii) Under paragraph (c)(3)(iii)(B)(3) of this section, the determination of whether royalties from intangible property are derived in the ordinary course of a trade or business of a partnership is made by applying the rules of paragraph (c)(3)(iii)(B) of this section to the partnership rather than the partners. The expenditures reasonably incurred by the partnership in 1987 with respect to the development or marketing of the design ($8,000) do not exceed 50 percent of the partnership's gross royalties for such year from licensing the design ($20,000). In addition, the sum of such expenditures incurred in 1987 and all prior taxable years ($8,000) does not exceed 25 percent of the aggregate capital expenditures made by the partnership in all such taxable years with respect to the design ($100,000). Accordingly, for 1987, the partnership is not treated under paragraph (c)(3)(iii)(B)(2)(ii) of this section as performing substantial services or incurring substantial costs with respect to the development or marketing of the design. Therefore, unless all of the facts and circumstances indicate that the partnership performed substantial services or incurred substantial costs with respect to the development or marketing of the design, D's distributive share of the partnership's royalty income for 1987 is portfolio income. (iii) As of the end of 1988, the sum of the expenditures reasonably incurred by the partnership during such taxable year and all prior taxable years with respect to the development or marketing of the design ($20,000) does not exceed 25 percent of the aggregate capital expenditures made by the partnership in all such years with respect to the design ($100,000). However, the amount of such expenditures incurred by the partnership in 1988 ($12,000) exceeds 50 percent of the partnership's gross royalties for such year from licensing the design ($20,000). Accordingly, for 1988, under paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section, the partnership is treated as performing substantial services or incurring substantial costs with respect to the development or marketing of the design, and D's distributive share of the partnership's royalty income for 1988 is considered for purposes of paragraph (c)(3)(i) of this section to be derived in the ordinary course of a trade or business and therefore is not portfolio income. (iv) The expenditures reasonably incurred by the partnership in 1989 with respect to the development or marketing of the design ($15,000) do not exceed 50 percent of the partnership's gross royalties for such year from licensing the design ($60,000). However, the sum of such expenditures incurred by the partnership in 1989 and all prior taxable years ($35,000) exceeds 25 percent of the partnership's aggregate capital expenditures made in all such years with respect to the design ($115,000). Accordingly, for 1989, under paragraph (c)(3)(iii)(B)(2)(ii)(b) of this section, the partnership is treated as performing substantial services or incurring substantial costs with respect to the development or marketing of the design, and D's distributive share of the partnership's royalty income in 1989 is considered for

purposes of paragraph (c)(3)(i) of this section to be derived in the ordinary course of a trade or business and therefore is not portfolio income. (v) The result for 1990 is the same as for 1989, notwithstanding that the partnership incurs no expenditures in 1990 with respect to the development or marketing of the design. Example (6). The facts are the same as in example (5), except that, for 1987, D's distributive share of the partnership's development and marketing costs is 15 percent, while D's distributive share of the partnership's gross royalties is 10 percent. Although D's distributive share of the expenditures reasonably incurred by the partnership during 1987 with respect to the development and marketing of the design ($1,200) is more than 50 percent of D's distributive share of the partnership's gross royalties from licensing the design ($2,000), D is not treated as performing substantial services or incurring substantial costs with respect to the development or marketing of the design for 1987 under paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. This is because, under paragraph (c)(3)(iii)(B)(3) of this section, the determination of whether the royalties are derived in the ordinary course of a trade or business is made by applying paragraph (c)(3)(iii)(B) of this section to the partnership, and not to D. (4) Items of personal service income specifically excluded-(i) In general. Passive activity gross income does not include compensation paid to or on behalf of an individual for personal services performed or to be performed by such individual at any time. For purposes of this paragraph (c)(4), compensation for personal services includes only- (A) Earned income (within the meaning of section 911(d)(2)(A)), including gross income from a payment described in paragraph (e)(2) of this section that represents compensation for the performance of services by a partner; (B) Amounts includible in gross income under section 83; (C) Amounts includible in gross income under sections 402 and 403; (D) Amounts (other than amounts described in paragraph (c)(4)(i)(C) of this section) paid pursuant to retirement, pension, and other arrangements for deferred compensation for services; (E) Social security benefits (within the meaning of section 86(d)) includible in gross income under section 86; and (F) Other income identified by the Commissioner as income derived by the taxpayer from personal services; provided, however, that no portion of a partner's distributive share of partnership income (within the meaning of section 704(b)) or a shareholder's pro rata share of income from an S corporation (within the meaning of section 1377(a)) shall be treated as compensation for personal services.

(ii) Example. The following example illustrates the application of this paragraph (c)(4): Example. C owns 50 percent of the stock of X, an S corporation. X owns rental real estate, which it manages. X pays C a salary for services performed by C on behalf of X in connection with the management of X's rental properties. Under this paragraph (c)(4), although C's pro rata share of X's gross rental income is passive activity gross income (even if the salary paid to C is less than the fair market value of C's services), the salary paid to C does not constitute passive activity gross income. (5) Income from section 481 adjustment-(i) In general. If a change in accounting method results in a positive section 481 adjustment with respect to an activity, a ratable portion (within the meaning of paragraph (c)(5)(iii) of this section) of the amount taken into account for a taxable year as a net positive section 481 adjustment by reason of such change shall be treated as gross income from the activity for such taxable year, and such gross income shall be treated as passive activity gross income if and only if such activity is a passive activity for the year of the change (within the meaning of section 481(a)). (ii) Positive section 481 adjustments. For purposes of applying this paragraph (c)(5)- (A) The term "net positive section 481 adjustment" means the increase (if any) in taxable income taken into account under section 481(a) to prevent amounts from being duplicated or omitted by reason of a change in accounting method; and (B) The term "positive section 481 adjustment with respect to an activity" means the increase (if any) in taxable income that would be taken into account under section 481(a) to prevent only the duplication or omission of amounts from such activity by reason of the change in accounting method. (iii) Ratable portion. The ratable portion of the amount taken into account as a net positive section 481 adjustment for a taxable year by reason of a change in accounting method is determined with respect to an activity by multiplying such amount by the fraction obtained by dividing- (A) The positive section 481 adjustment with respect to the activity; by (B) The sum of the positive section 481 adjustments with respect to all of the activities of the taxpayer. (6) Gross income from certain oil or gas properties-(i) In general. Notwithstanding any other provision of the regulations under section 469, passive activity gross income for any taxable year does not include an amount of the taxpayer's gross income for such year from- (A) An oil or gas property, if any loss from a working interest in such property for any prior taxable year beginning after December 31, 1986, was treated by the taxpayer, solely by reason of §1.469-1T(e)(4) (relating to a special rule for losses from oil and gas working interests), and not by reason of the taxpayer's material participation in the activity, as a loss that is not from a passive activity; or

(B) Any property the basis of which is determined in whole or in part by reference to the basis of property described in paragraph(c)(6)(i)(A) of this section; equal to the taxpayer's net income from such property for the taxable year. The preceding sentence applies without regard to whether the taxpayer's interest in the property is held through an entity that limits the taxpayer's liability (within the meaning of §1.469-1T(e)(4)(v)). (ii) Net income from the property. For purposes of this paragraph (c)(6), the taxpayer's net income for the taxable year from any property described in paragraph (c)(6)(i) of this section is the amount, if any, by which the taxpayer's gross income from such property exceeds the taxpayer's deductions for such taxable year (including any deduction treated as a deduction for such year under §1.469-1T(f)(4)) that are reasonable allocable to such property. (iii) Property. For purposes of paragraph (c)(6)(i)(A) of this section, the term "property" does not have the meaning given such term by section 614(a) or the regulations thereunder, but means any property the value of which is directly enhanced by any drilling, logging, seismic testing, or other activities any part of the costs of which were borne by the taxpayer as a result of holding the working interest described in such paragraph (c)(6)(i)(A). (iv) Examples. The following examples illustrate the application of this (c)(6): Example (1). A is a general partner in partnership P and a limited partner in partnership R. P and R own oil and gas working interests in two separate tracts of land acquired from two separate landowners. In 1987, P drills a well on its tract, and A's distributive share of P's losses from drilling the well are treated under §1.469- 1T(e)(4) as not from a passive activity. In the course of selecting the drilling site and drilling the well, P develops information indicating that the reservoir in which the well was drilled underlies R's tract as well as P's. Under these facts, P's and R's tracts are treated as one property for purposes of this paragraph (c)(6), even if A's interests in the mineral deposits in the tracts are treated as separate properties under section 614(a). Accordingly, in 1988 and subsequent years, A's distributive share of both P's and R's income and expenses from their respective tracts is taken into account in computing A's net income from the property for purposes of this paragraph (c)(6). Example (2). B is a general partner in partnership S. S owns an oil and gas working interest in a single tract of land. In 1987, S drills a well, and B's distributive share of S's losses from drilling the well is treated under §1.469-1T(e)(4) as not from a passive activity. In the course of drilling the well, S discovers two oil-bearing formations, one underlying the other. On December 1, 1987, S completes the well in the underlying formation. On January 1, 1988, B converts B's entire general partnership interest in S into a limited partnership interest. In 1988, S completes in, and commences production from, the shallow formation. Under these facts, the two mineral deposits in S's tract are treated as one property for purposes of this paragraph (c)(6), even if they are treated as separate properties under section, 614 (a). Accordingly, B's distributive share of S's income and expenses from both the underlying formation and from recompletion in and production from the shallow formation is taken into account in computing B's net income from the property for purposes of this paragraph (c)(6).

Example (3). C is a general partner in partnership T and a limited partner in partnership U. T and U both own oil and gas working interests in tracts of land in County X. In 1987, T drills a well, and C's distributive share of T's losses from drilling the well is treated under §1.469-1T(e)(4) as not from a passive activity. In the course of selecting the drilling site and drilling the well, T develops information indicating a significant probability that substantial oil and gas reserves underlie most portions of County X. As a result, the value of all oil and gas properties in County X is enhanced. The information developed by T does not, however, indicate that the reservoir in which T's well is drilled underlies U's tract. Under these facts, T's and U's tracts are not treated as one property for purposes of this paragraph (c)(6), because the value of U's tract is not directly enhanced by T's activities. (7) Other items specifically excluded. Notwithstanding any other provision of the regulations under section 469, passive activity gross income does not include the following: (i) Gross income of an individual from intangible property, such as a patent, copyright, or literary, musical, or artistic composition, if the taxpayer's personal efforts significantly contributed to the creation of such property; (ii) Gross income from a qualified low-income housing project (within the meaning of section 502 of the Tax Reform Act of 1986) for any taxable year in the relief period (within the meaning of section 502(b) of such Act; (iii) Gross income attributable to a refund of any state, local, or foreign income, war profits, or excess profits tax; (iv) Gross income of an individual from a covenant by such individual not to compete; and (v) Gross income that is treated as not from a passive activity under any provision of the regulations under section 469, including but not limited to §1.469-1T(h)(6) (relating to income from intercompany transactions of members of an affiliated group of corporations filing a consolidated return) and paragraph (f) of this section (relating to recharacterized passive income). (d) Passive activity deductions-(1) In general. Except as otherwise provided in section 469 and the regulations thereunder, a deduction is a passive activity deduction for a taxable year if and only if such deduction- (i) Arises (within the meaning of paragraph (d)(8) of this section) in connection with the conduct of a activity that is a passive activity for the taxable year; or (ii) Is treated as a deduction from an activity under §1.469-1T(f)(4) for the taxable year. The following example illustrates the application of this paragraph (d)(1): Example. (i) In 1987, A, a calendar year individual, acquires a partnership interest in R, a calendar year partnership. R's only activity is a trade or business activity in which A materially participates for 1987. R incurs a loss in 1987. A's distributive

share of R's 1987 loss is $1,000. However, A's basis in the partnership interest at the end of 1987 (without regard to A's distributive share of partnership loss) is $600; accordingly, section 704(d) disallows any deduction in 1987 for $400 of A's distributive share of R's loss. The remainder of A's distributive share of R's loss would be allowed as a deduction for 1987 if taxable income for all taxable years were determined without regard to sections 469 and 1211. See paragraph (d)(8) of this section. (ii) A does not materially participate in R's activity for 1988. In 1988, R again incurs a loss, and A's distributive share of the loss is again $1,000. At the end of 1988, A's basis in the partnership interest (without regard to A's distributive share of partnership loss) is $2,000; accordingly, in 1988 section 704(d) does not limit A's deduction for either A's $1,000 distributive share of R's 1988 loss or the $400 loss carried over from 1987 under the second sentence of section 704(d). These losses would be allowed as a deduction for 1988 if taxable income for all taxable years were determined without regard to sections 469 and 1211. See paragraph (d)(8) of this section. (iii) Under these facts, only $400 of A's distributive share of R's deductions from the activity are disallowed under section 704(d) in 1987. A's remaining deductions from the activity are treated as deductions that arise in connection with the activity for 1987 under paragraph (d)(8) of this section. Because A materially participates in the activity for 1987, the activity is not a passive activity (within the meaning of §1.469- 1T(e)(1)) of A for such year. Accordingly, the deductions that are not disallowed in 1987 are not passive activity deductions. (iv) A does not materially participate in R's activity for 1988. Accordingly, the activity is a passive activity of A for such year. No portion of A's distributive share of R's deductions from the activity is disallowed under section 704(d) in 1988. Accordingly, A's distributive share of R's deductions for 1988 and the $400 of deductions carried over from 1987 are both treated under paragraph (d)(8) of this section as deductions that arise in 1988. Since the activity is a passive activity for 1988, such deductions are passive activity deductions. (2) Exceptions. Passive activity deductions do not include- (i) A deduction for an item of expense (other than interest) that is clearly and directly allocable (within the meaning of paragraph (d)(4) of this section) to portfolio income (within the meaning of paragraph (c)(3)(i) of this section); (ii) A deduction allowed under section 243, 244, or 245 with respect to any dividend that is not included in passive activity gross income; (iii) Interest expense (other than interest expense described in paragraph (d)(3) of this section); (iv) A deduction for a loss from the disposition of property of a type that produces portfolio income (within the meaning of paragraph (c)(3)(i) of this section);

(v) A deduction that, under section 469(g) and §1.469-6T (relating to the allowance of passive activity losses upon certain dispositions of interests in passive activities), is treated as a deduction that is not a passive activity deduction; (vi) A deduction for any state, local, or foreign income, war profits, or excess profits tax; (vii) A miscellaneous itemized deduction (within the meaning of section 67(b)) that is subject to disallowance in whole or in part under section 67(a) (without regard to whether any amount of such deduction is disallowed under section 67); (viii) A deduction allowed under section 170 for a charitable contribution; (ix) An item of loss or deduction that is carried to the taxable year under section 172(a), section 1212(a)(1)(B) (in the case of corporations), or section 1212(b) (in the case of taxpayers other than corporations); and (x) An item of loss or deduction that would have been allowed for a taxable year beginning before January 1, 1987, but for section 704(d), 1366, or 465. (3) Interest expense. Except as otherwise provided in the regulations under section 469, interest expense is taken into account as a passive activity deduction if and only if such interest expense- (i) Is allocated under §1.163-8T to a passive activity expenditure (within the meaning of §1.163-8T(b)(4)); and (ii) Is not- (A) Qualified residence interest (within the meaning of §1.163-10T); or (B) Capitalized pursuant to a capitalization provision (within the meaning of §1.163- 8T(m)(7)(i)). (4) Clearly and directly allocable expenses. For purposes of section 469 and the regulations thereunder, an expense (other than interest expense) is clearly and directly allocable to portfolio income (within the meaning of paragraph (c)(3)(i) of this section) if and only if such expense is incurred as a result of, or incident to, an activity in which such gross income is derived or in connection with property from which such gross income is derived. For example, general and administrative expenses and compensation paid to officers attributable to the performance of services that do not directly benefit or are not incurred by reason of a particular activity or particular property are not clearly and directly allocable to portfolio income (within the meaning of paragraph (c)(3)(i) of this section). (5) Treatment of loss from disposition-(i) In general. Except as otherwise provided in the regulations under section 469- (A) Any loss recognized in any year upon the sale, exchange, or other disposition (a "disposition") of an interest in property used in an activity at the time of the disposition or of an interest in an activity held through a partnership or S corporation

and any deduction allowed on account of the abandonment or worthlessness of such an interest is treated as a deduction from such activity; and (B) Any such deduction is a passive activity deduction if and only if the activity is a passive activity of the taxpayer for the taxable year of the disposition (or other event giving rise to the deduction). (ii) Disposition of property used in more than one activity in 12-month period preceding disposition. In the case of a disposition of an interest in property that is used in more than one activity during the 12-month period ending on the date of the disposition, the amount realized from the disposition and the adjusted basis of such interest must be allocated among such activities in the manner described in paragraph (c)(2)(ii) of this section. (iii) Other applicable rules-(A) Interest in property. For purposes of this paragraph (d)(5), a taxpayer's interests in property used in an activity and the amounts allocated to such interests shall be determined under paragraph (c)(2)(i)(C) of this section. (B) Dispositions of partnership interests and S corporation stock. A partnership interest or S corporation stock is not property used in an activity for purposes of this paragraph (d)(5). See paragraph (e)(3) of this section for rules treating the loss recognized upon the disposition of a partnership interest or S corporation stock as loss from the disposition of interests in the activities in which the partnership or S corporation has an interest. (6) Coordination with other limitations on deductions that apply before section 469- (i) In general. An item of deduction from a passive activity that is disallowed for a taxable year under section 704(d), 1366(d), or 465 is not a passive activity deduction for the taxable year. Paragraphs (d)(6) (ii) and (iii) of this section provide rules for determining the extent to which items of deduction from a passive activity are disallowed for a taxable year under sections 704(d), 1366(d), and 465. (ii) Proration of deductions disallowed under basis limitations-(A) Deductions disallowed under section 704(d). If any amount of a partner's distributive share of a partnership's loss for the taxable year is disallowed under section 704(d), a ratable portion of the partner's distributive share of each item of deduction or loss of the partnership is disallowed for the taxable year. For purposes of the preceding sentence, the ratable portion of an item of deduction or loss is the amount of such item multiplied by the fraction obtained by dividing- (1) The amount of the partner's distributive share of partnership loss that is disallowed for the taxable year; by (2) The sum of the partner's distributive shares of all items of deduction and loss of the partnership for the taxable year. (B) Deductions disallowed under section 1366(d). If any amount of an S corporation shareholder's pro rata share of an S corporation's loss for the taxable year is disallowed under section 1366(d), a ratable portion of the taxpayer's pro rata share of each item of deduction or loss of the S corporation is disallowed for the taxable

year. For purposes of the preceding sentence, the ratable portion of an item of deduction or loss is the amount of such item multiplied by the fraction obtained by dividing- (1) The amount of the shareholder's pro rata share of S corporation loss that is disallowed for the taxable year; by (2) The sum of the shareholder's pro rata shares of all items of deduction and loss of the corporation for the taxable year. (iii) Proration of deductions disallowed under at-risk limitation. If any amount of the taxpayer's loss from an activity (within the meaning of section 465(c)) is disallowed under section 465 for the taxable year, a ratable portion of each item of deduction or loss from the activity is disallowed for the taxable year. For purposes of the preceding sentence, the ratable portion of an item of deduction or loss is the amount of such item multiplied by the fraction obtained by dividing- (1) The amount of the loss from the activity that is disallowed for the taxable year; by (2) The sum of all deductions from the activity for the taxable year. (iv) Coordination of basis and at-risk limitations. The portion of any item of deduction or loss that is disallowed for the taxable year under section 704(d) or 1366(d) is not taken into account for the taxable year in determining the loss from an activity (within the meaning of section 465(c)) for purposes of applying section 465. (v) Separately identified items of deduction and loss. In identifying the items of deduction and loss from an activity that are not disallowed under sections 704(d), 1366(d), and 465 (and that therefore may be treated as passive activity deductions), the taxpayer need not account separately for any item of deduction or loss unless such item may, if separately taken into account, result in an income tax liability different from that which would result were such item of deduction or loss taken into account separately. For related rules applicable to partnerships and S corporations, see §1.702-1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Items of deduction or loss that must be accounted for separately include (but are not limited to) items of deduction or loss that- (A) Are attributable to separate activities (within the meaning of the rules to be contained in §1.469-4T); (B) Arise in a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in taxable years in which the taxpayer activity participates (within the meaning of section 469(i) and the rules to be contained in

§1.469-9T) in such activity;

(C) Arise in a rental real estate activity (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in taxable years in which the taxpayer does not actively participate (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in such activity;

(D) Arose in a taxable year beginning before 1987 and were not allowed for such taxable year under section 704(d), 1366(d), or 465(a)(2); (E) Are taken into account under section 1211 (relating to the limitation on capital losses) or section 1231 (relating to property used in a trade or business and involuntary conversions); or (F) Are attributable to pre-enactment interests in activities (within the meaning of

§1.469-11T(c)).

(7) Deductions from section 481 adjustment-(i) In general. If a change in accounting method results in a negative section 481 adjustment with respect to an activity, a ratable portion (within the meaning of paragraph (d)(7)(iii) of this section) of the amount taken into account for a taxable year as a net negative section 481 adjustment by reason of such change shall be treated as a deduction from the activity for such taxable year, and such deduction shall be treated as a passive activity deduction if and only if such activity is a passive activity for the year of the change (within the meaning of section 481(a)). See the rules to be contained in

§1.469-1T(k) for the treatment of passive activity deductions from an activity in

taxable years in which the activity is a former passive activity. (ii) Negative section 481 adjustments. For purposes of applying this paragraph (d)(7)- (A) The term "net negative section 481 adjustment" means the decrease (if any) in taxable income taken into account under section 481(a) to prevent amounts from being duplicated or omitted by reason of a change in accounting method; and (B) The term "negative section 481 adjustment with respect to an activity" means the decrease (if any) in taxable income that would be taken into account under section 481(a) to prevent only the duplication or omission of amounts from such activity by reason of the change in accounting method. (iii) Ratable portion. The ratable portion of the amount taken into account as a net negative section 481 adjustments for a taxable year by reason of a change in accounting method is determined with respect to an activity by multiplying such amount by the fraction obtained by dividing- (A) The negative section 481 adjustment with respect to the activity; by (B) The sum of the negative section 481 adjustments with respect to all of the activities of the taxpayer. (8) Taxable year in which item arises. For purposes of this paragraph (d), an item of deduction arises in the taxable year in which such item would be allowable as a deduction under the taxpayer's method of accounting if taxable income for all taxable years were determined without regard to sections 469 and 1211. (e) Special rules for partners and S corporation shareholders-(1) In general. For purposes of section 469 and the regulations thereunder, the character (as an item of passive activity gross income or passive activity deduction) of each item of gross

income and deduction allocated to a taxpayer from a partnership or S corporation (a "passthrough entity") shall be determined, in any case in which participation is relevant, by reference to the participation of the taxpayer in the activity (or activities) that generated such item. Such participation is determined for the taxable year of the passthrough entity (and not the taxable year of the taxpayer). The following example illustrates the application of this paragraph (e)(1): Example. A, a calendar year individual, is a partner in a partnership that has a taxable year ending January 31. During its taxable year ending on January 31, 1988, the partnership engages in a single trade or business activity. For the period from February 1, 1987, through January 31, 1988, A does not materially participate in this activity. In A's calendar year 1988 return, A's distributive share of the partnership's gross income and deductions from the activity must be treated as passive activity gross income and passive activity deductions, without regard to A's participation in the activity from February 1, 1988, through December 31, 1988. See also §1.469- 11T(a)(4) (relating to the effective date of, and transition rules under, section 469 and the regulations thereunder). (2) Payments under sections 707(a), 707(c), and 736(b). Items of gross income and deduction attributable to a transaction described in section 707(a), 707(c), or 736(b) shall be characterized for purposes of section 469 and the regulations thereunder in accordance with the following rules: (i) Section 707(a). Any item of gross income or deduction attributable to a transaction that is treated under section 707(a) as a transaction between a partnership and a partner acting in a capacity other than as a member of such partnership shall be characterized for purposes of section 469 and the regulations thereunder in a manner that is consistent with the treatment of such transaction under section 707(a). (ii) Section 707(c)-(A) In general. Except as provided in paragraph(e)(2)(ii)(B) of this section, any payment to a partner for services or the use of capital that is described in section 707(c) (including any payment described in section 736(a)(2) (relating to guaranteed payments made in liquidation of the interest of a retiring or deceased partner)) shall be characterized as the payment of compensation for services or as the payment of interest, respectively, and not as a distributive share of partnership income. (B) Exception. (1) If section 736(a)(2) applies to a payment made in liquidation of a retiring or deceased partner's interest, any income that- (i) Is taken into account by a retiring partner (or any other person that owns (directly or indirectly) an interest in such partner if such partner is a passthrough entity) or a deceased partner's successor in interest as a result of such payment; and (ii) Is attributable to the portion (if any) of such payment that is allocable to the unrealized receivables (within the meaning of section 751(c)) and goodwill of an activity of the partnership; shall be treated as passive activity gross income if and only if the activity was a passive activity of such retiring or deceased partner (or such other person) for the taxable year of such retiring or deceased partner (or such other person) in which the liquidation of such partner's interest commenced.

(2) If section 736(a)(2) applies to a payment made in liquidation of a retiring or deceased partner's interest, the portion (if any) of such payment that is allocable to the unrealized receivables (within the meaning of section 751(c)) and goodwill of an activity of the partnership is determined, for purposes of this paragraph (e)(2)(ii)(B), by multiplying the amount of such payment by the fraction obtained by dividing- (i) The amount to be paid under section 736(a)(2) in liquidation of such partner's interest in the unrealized receivables and goodwill of such activity of the partnership; by (ii) The sum of all payments to be made under section 736(a)(2) in liquidation of such partner's interest. (iii) Section 736(b). If any gain or loss is taken into account by a retiring partner (or any other person that owns (directly or indirectly) an interest in such partner if such partner is a passthrough entity) or a deceased partner's successor in interest as a result of a payment to which section 736(b) (relating to payments made in exchange for a retiring or deceased partner's interest in partnership property) applies, such gain or loss shall be treated as passive activity gross income or a passive activity deduction only to the extent that such gain or loss would have been passive activity gross income or a passive activity deduction of such retiring or deceased partner (or such other person) if it had been recognized at the time the liquidation of such partner's interest commenced. (3) Sale or exchange of interest in passthrough entity-(i) Application of this paragraph (e)(3). In the case of the sale, exchange, or other disposition (a "disposition") of an interest in a passthrough entity, the amount of the seller's gain or loss from each activity in which such entity has an interest is determined, for purposes of section 469 and the regulations thereunder, under this paragraph (e)(3). In the case of any such disposition, except as otherwise provided in paragraph (e)(3)(iii) or (iv) of this section, paragraph (e)(3)(ii) of this section shall apply. See paragraphs (c)(2) and (d)(5) of this section for rules for determining the character of gain or loss, respectively, recognized upon a disposition of an interest in an activity held through a passthrough entity. (ii) General rule-(A) Allocation among activities. Except as otherwise provided in this paragraph (e)(3)(ii) or in paragraph (e)(3) (iii) or (iv) of this section, if a holder of an interest in a passthrough entity disposes of such interest, a ratable portion (within the meaning of paragraph (e)(3)(ii)(B) of this section) of any gain or loss from such disposition shall be treated as gain or loss from the disposition of an interest in each trade or business, rental, or investment activity in which such passthrough entity owns an interest on the applicable valuation date. (B) Ratable portion-(1) Dispositions on which gain is recognized. The ratable portion of any gain from the disposition of an interest in a passthrough entity that is allocable to an activity described in paragraph (e)(3)(ii)(A) of this section is determined by multiplying the amount of such gain by the fraction obtained by dividing- (i) The amount of net gain (within the meaning of paragraph (e)(3)(ii)(E)(3) of this section) that would have been allocated to the holder of such interest with respect

thereto if the passthrough entity had sold its entire interest in such activity for its fair market value on the applicable valuation date; by (ii) The sum of the amounts of net gain that would have been allocated to the holder of such interest with respect thereto if the passthrough entity had sold its entire interest in each appreciated activity (within the meaning of paragraph (e)(3)(ii)(E)(1) of this section) described in paragraph (e)(3)(ii)(A) of this section for the fair market value of each such activity on the applicable valuation date. (2) Dispositions on which loss is recognized. The ratable portion of any loss from the disposition of an interest in a passthrough entity that is allocable to an activity described in paragraph (e)(3)(ii)(A) of this section is determined by multiplying the amount of such loss by the fraction obtained by dividing- (i) The amount of net loss (within the meaning of paragraph (e)(3)(ii)(E)(4) of this section) that would have been allocated to the holder of such interest with respect thereto if the passthrough entity had sold its entire interest in such activity for its fair market value on the applicable valuation date; by (ii) The sum of the amounts of net loss that would have been allocated to the holder of such interest with respect thereto if the passthrough entity had sold its entire interest in each depreciated activity (within the meaning of paragraph (e)(3)(ii)(E)(2) of this section) described in paragraph (e)(3)(ii)(A) of this section for the fair market value of each such activity on the applicable valuation date. (C) Default rule. If the gain or loss recognized upon the disposition of an interest in a passthrough entity cannot be allocated under paragraph (e)(3)(ii)(A) of this section, such gain or loss shall be allocated among the activities described in paragraph (e)(3)(ii)(A) of this section in proportion to the respective fair market values of the passthrough entity's interests in such activities at the applicable valuation date, and the gain or loss allocated to each activity of the passthrough entity shall be treated as gain or loss from the disposition of an interest in such activity. (D) Special rules. For purposes of this paragraph (e)(3)(ii), the following rules shall apply: (1) Applicable valuation date-(i) In general. Except as otherwise provided in paragraph (e)(3)(ii)(D)(1)(ii) of this section, the applicable valuation date with respect to any disposition of an interest in a passthrough entity is whichever one of the following dates is selected by the passthrough entity: (a) The beginning of the taxable year of the passthrough entity in which such disposition occurs; or (b) The date on which such disposition occurs. (ii) Exception. If, after the beginning of a passthrough entity's taxable year in which a holder's disposition of an interest in such passthrough entity occurs and before the time of such disposition-

(a) The passthrough entity disposes of more than 10 percent of its interest (by value as of the beginning of such taxable year) in any activity; (b) More than 10 percent of the property (by value as of the beginning of such taxable year) used in any activity of the passthrough entity is disposed of; or (c) The holder of such interest contributes to the passthrough entity substantially appreciated property or substantially depreciated property with a total fair market value or adjusted basis, respectively, which exceeds 10 percent of the total fair market value of the holder's interest in the passthrough entity as of the beginning of such taxable year; then the applicable valuation date shall be the date immediately preceding the date on which such disposition occurs. (2) Basis adjustments. Any adjustment to the basis of partnership property under section 743(b) made with respect to the holder of an interest in a partnership shall be taken into account in computing the net gain or net loss that would have been allocated to the holder with respect to such interest if the partnership had sold its entire interest in an activity. (3) Tiered passthrough entities. In the case of a disposition of an interest in a passthrough entity (the "subsidiary passthrough entity") by a holder that is also a passthrough entity, any gain or loss from such disposition that is taken into account by any person that owns (directly or indirectly) an interest in such holder shall be allocated among the activities of the subsidiary passthrough entity by applying the rules of this paragraph (e)(3)(ii) to the person taking such gain or loss into account as if such person has been the holder of an interest in such subsidiary passthrough entity and had recognized such gain or loss as a result of a disposition of such interest. (E) Meaning of certain terms. For purposes of this paragraph (e)(3)(ii)- (1) An activity is an appreciated activity with respect to a holder that has disposed of an interest in a passthrough entity if a net gain would have been allocated to the holder with respect to such interest if the passthrough entity has sold its entire interest in such activity for its fair market value on the applicable valuation date; (2) An activity is a depreciated activity with respect to a holder that has disposed of an interest in a passthrough entity if a net loss would have been allocated to the holder with respect to such interest if the passthrough entity had sold its entire interest in such activity for its fair market value on the applicable valuation date; (3) The term "net gain" means, with respect to the sale of a passthrough entity's entire interest in an activity, the amount by which the gains from the sale of all of the property used by (or representing the interest of) the passthrough entity in such activity exceed the losses (if any) from such sale; (4) The term "net loss" means, with respect to the sale of a passthrough entity's entire interest in an activity, the amount by which the losses from the sale of all of

the property used by (or representing the interest of) the passthrough entity in such activity exceed the gains (if any) from such sale. (iii) Treatment of gain allocated to certain passive activities as not from a passive activity. If, in the case of a disposition of an interest in a passthrough entity- (A) An amount of gain recognized on account of such disposition by the holder of such interest (or any other person that owns (directly or indirectly) an interest in such holder if such holder is a passthrough entity) is allocated to a passive activity of such holder (or such other person) under paragraph (e)(3)(ii) of this section; (B) An amount of gain that would have been treated as gain that is not from a passive activity under paragraph (c)(2)(iii) of this section (relating to substantially appreciated property formerly used in a nonpassive activity) would have been allocated to such holder (or such other person) with respect to such interest if all of the property used in such passive activity had been sold immediately prior to the disposition for its fair market value on the applicable valuation date (within the meaning of paragraph (e)(3)(ii)(D)(1) of this section; and (C) The amount of the gain of the holder (or such other person) described in paragraph (e)(3)(iii)(B) of this section exceeds 10 percent of the amount of the gain of the holder (or such other person) described in paragraph (e)(3)(iii)(A) of this section; then the gain of the holder (or such other person) that is described in paragraph (e)(3)(iii)(A) of this section shall be treated as gain that is not from a passive activity to the extent that such gain does not exceed the amount of the gain of the holder (or such other person) described in paragraph (e)(3)(iii)(B) of this section. For purposes of applying the preceding sentence to the disposition of an interest in a partnership, the amount of gain that would have been allocated to the holder (or such other person) if all of the property used in an activity had been sold shall be determined by taking into account any adjustment to the basis of partnership property made with respect to such holder (or such other person) under section 743(b). (iv) Dispositions occurring in taxable years beginning before February 19, 1988-(A) In general. Except as otherwise provided in this paragraph (e)(3)(iv), if the holder of an interest in a passthrough entity sells, exchanges, or otherwise disposes of all or part of such interest during a taxable year of such entity beginning prior to February 19, 1988, any gain or loss recognized from such disposition shall be allocated among the activities of the passthrough entity under any reasonable method selected by the passthrough entity, and the gain or loss allocated to each activity of the passthrough entity shall be treated as gain or loss from the disposition of an interest in such activity. For purposes of the preceding sentence, a reasonable method shall include the method prescribed by paragraph (e)(3)(ii) of this section. In addition, a method that allocates gain or loss among the passthrough entity's activities on the basis of the fair market value, cost, or adjusted basis of the property used in such activities shall generally be considered a reasonable method for purposes of this paragraph (e)(3)(iv).

(B) Exceptions. This paragraph (e)(3)(iv) shall not apply to any disposition of an interest in a passthrough entity occurring after February 19, 1988, if after such date, but before the holder's disposition of such interest, the holder (or any other person that owns (directly or indirectly) an interest in such holder if such holder is a passthrough entity) contributes to the passthrough entity substantially appreciated portfolio assets or any other substantially appreciated property that was used in any trade or business activity (within the meaning of §1.469-1T(e)) of the holder (or such other person) during- (1) The taxable year of such person in which such contribution occurs; or (2) The immediately preceding taxable year of such person; but only if such person materially participated (within the meaning of

§1.469-5T) in the activity for such year.

(v) Treatment of portfolio assets. For purposes of the paragraph (e)(3), all portfolio assets owned by a passthrough entity shall be treated as held in a single investment activity. (vi) Definitions. For purposes of this paragraph (e)(3)- (A) The term "portfolio asset" means any property of a type that produces portfolio income (within the meaning of paragraph (c)(3)(i) of this section); (B) The term "substantially appreciated property" means property with a fair market value that exceeds 120 percent of its adjusted basis; and (C) The term "substantially depreciated property" means property with an adjusted basis that exceeds 120 percent of its fair market value. (vii) Examples. The following examples illustrate the application of this paragraph (e)(3): Example (1). (i) A owns a one-half interest in P, a calendar year partnership. In 1993, A sells 50 percent of such interest for $50,000. A's adjusted basis for the interest sold is $30,000. Thus, A recognizes $20,000 of gain from the sale. P is engaged in three trade or business activities, X, Y, and Z, and owns marketable securities that are portfolio assets. For 1993, A materially participates in activity Z, but does not participate in activities X and Y. Paragraph (c)(2)(iii) of this section would not have applied to any of the gain that A would have been allocated if, immediately before A's sale, P had disposed of all of the property used in its trade or business activities. During the portion of 1993 preceding A's sale, P did not sell any of the property used in its activities, and A did not contribute any property to P. (ii) Under paragraph (e)(3)(ii) of this section, a ratable portion of A's $20,000 gain is allocated to each appreciated activity in which P owned an interest on the applicable valuation date (within the meaning of paragraph (e)(3)(ii)(D)(1) of this section). For this purpose, paragraph (e)(3)(v) of this section treats the marketable securities owned by P as a single investment activity.

(iii) P selects the beginning of 1993 as the applicable valuation date pursuant to paragraph (e)(3)(ii)(D)(1)(i) of this section. P is not required to use the date of A's sale as the applicable valuation date under paragraph (e)(3)(ii)(D)(1)(ii) of this section because during the portion of 1993 preceding A's sale, P did not sell any of its property and A did not contribute any property to P. At the beginning of 1993, the fair market value and adjusted basis of the property used in P's activities are as follows: ---------------------------------------------------------------------- Adjusted basis Fair market value -------------------------------------------------------------------- -- X ...................................... $68,000 $48,000 Y ....................................... 30,000 62,000 Z ....................................... 20,000 80,000 Marketable securities .................... 2,000 10,000 --------------------------------------- Total .................................. 120,000 200,000 ----------------------------------------------- ----------------------- (iv) Under paragraph (e)(3)(ii)(B) of this section, the portion of A's $20,000 gain that is allocated to an appreciated activity of P (i.e., activities Y and Z and the marketable securities) is the amount of such gain multiplied by the fraction obtained by dividing (a) the net gain that would have been allocated to A with respect to the interest sold by A if P had sold its entire interest in such activity at the beginning of 1993 by (b) the sum of the amounts of net gain that would have been allocated to A with respect to the interest sold by A if P had sold its entire interest in each appreciated activity at the beginning of 1993. (v) If P had sold its entire interest in activities Y and Z and the marketable securities at the beginning of 1993, A would have been allocated the following amounts of net gain with respect to the interest in P that A sold in 1993: ------------------------------- ----------- Activity Net gain ------------------------------------------ Y ................................. $8,000 Z ................................. 15,000 Marketable securities .............. 2,000 ----------- Total ............................. 25,000 -------------- ---------------------------- (vi) Accordingly, under paragraph (e)(3)(ii) of this section, $6,400 of A's $20,000 gain ($20,000 × $8,000/$25,000) is allocated to activity Y, $12,000 of A's $20,000 gain ($20,000 × $15,000/$25,000) is allocated to activity Z, and $1,600 of A's $20,000 gain ($20,000 × $2,000/$25,000) is allocated to the marketable securities. The gain allocated to activity Y is passive activity gross income. None of that gain is treated as gain that is not from a passive activity under paragraph (e)(3)(iii) of this section because paragraph (c)(2)(iii) of this section would not have applied to any of the gain that A would have been allocated if P had sold all of the property used in activity Y immediately prior to A's sale. Example (2). (i) B and C, calendar year individuals, are equal partners in calendar year partnership R, which they formed on January 1, 2005, with contributions of property and money. The only item of property (other than money) contributed by B was a building that B had used for 12 years preceding the contribution in an activity that was not a passive activity during such period. At the time of its contribution, the building had an adjusted basis of $40,000 and a fair market value of $66,000. R is engaged in a single activity: the sale of equipment to customers in the ordinary course of the business of dealing in such property. R uses the building contributed by B in the dealership activity. B did not materially participate in the dealership activity during 2005. On July 1, 2005, D purchases one-half of B's interest in R for $37,500 in cash. At the time of the sale, the balance sheet of R, which uses the accrual

method of accounting, is as follows: ------------------------------------------------------ -------------------- Adjusted basis per books Fair market value ------------------------- ------------------------------------------------- Assets Cash ....................................... $30,000 $30,000 Accounts receivable: Dealership .................................. 20,000 18,000 Inventory: Dealership .................................. 52,000 66,000 Building .................................... 40,000 66,000 ------------------------------------------------ - Total ...................................... 142,000 180,000 ----------------------------------- --------------------------------------- Liabilities and Capital Liabilities ................................ $30,000 $30,000 Capital: B ........................................... 47,000 75,000 C ........................................... 65,000 75,000 ----------------------- -------------------------- Total ...................................... 142,000 180,000 ---------- ---------------------------------------------------------------- Thus, B's gain from the sale is $14,000 ($45,000 amount realized from the sale (consisting of $37,500 of cash and $7,500 of liabilities assumed by the purchaser) minus B's $31,000 adjusted basis for the interest sold (one-half of B's total adjusted basis of $62,000)). (ii) Under paragraph (e)(3)(ii) of this section, all $14,000 of B's gain from the sale is allocated to R's dealership activity, which is a passive activity of B for 2005. If, however, R had sold its interest in the building immediately prior to B's sale for its fair market value on the applicable valuation date (the valuation date selected by R is irrelevant since the building had a fair market value of $66,000 at the beginning of 2005 and at the time of the sale), B would have been allocated $13,000 of gain under section 704(c) with respect to the interest in R that B sold to D. This gain would have been treated as gain that is not from a passive activity under paragraph (c)(2)(iii) of this section and would have exceeded 10 percent of the total amount of B's gain that is allocated to the dealership activity under paragraph (e)(3)(ii) of this section. Accordingly, under paragraph (e)(3)(iii) of this section, B's gain from the sale ($14,000) is treated as gain that is not from a passive activity to the extent that such gain does not exceed the amount of gain subject to paragraph (c)(2)(iii) of this section that B would have been allocated with respect to the interest sold to D if R had sold all of the property used in the dealership activity immediately prior to B's sale ($13,000). Thus, $13,000 of B's gain from the sale is treated as gain that is not from a passive activity. (f) Recharacterization of passive income in certain situations-(1) In general. This paragraph (f) sets forth rules that require income from certain passive activities to be treated as income that is not from a passive activity (regardless of whether such income is treated as passive activity gross income under section 469 or any other provision of the regulations thereunder). For definitions of certain terms used in this paragraph (f), see paragraph (f)(9) of this section. (2) Special rule for significant participation-(i) In general. An amount of the taxpayer's gross income from each significant participation passive activity for the taxable year equal to a ratable portion of the taxpayer's net passive income from such activity for the taxable year shall be treated as not from a passive activity if the taxpayer's passive activity gross income from all significant participation passive activities for the taxable year (determined without regard to paragraphs (f) (2) through (4) of this section) exceeds the taxpayer's passive activity deductions from all such activities for such year. For purposes of this paragraph (f)(2), the ratable

portion of the net passive income from an activity is determined by multiplying the amount of such income by the fraction obtained by dividing- (A) The amount of the excess described in the preceding sentence; by (B) The amount of the excess described in the preceding sentence taking into account only significant participation passive activities from which the taxpayer has net passive income for the taxable year. (ii) Significant participation passive activity. For purposes of this paragraph (f)(2), the term "significant participation passive activity" means any trade or business activity (within the meaning of §1.469-1T(e)(2)) in which the taxpayer significantly participates (within the meaning of §1.469-5T(c)(2)) for the taxable year but in which the taxpayer does not materially participate (within the meaning of §1.469- 5T) for such year. (iii) Example. The following example illustrates the application of this paragraph (f)(2): Example. (i) A owns interests in three trade or business activities, X, Y, and Z. A does not materially participate in any of these activities for the taxable year, but participates in activity X for 110 hours, in activity Y for 160 hours, and in activity Z for 125 hours. A owns no interest in any other trade or business activity in which A does not materially participate for the taxable year but in which A participates for more than 100 hours during the taxable year. A's net passive income (or loss) for the taxable year from activities X, Y, and Z is as follows: ------------------------------- -------------------------------------- X Y Z ------------------------------------------------- -------------------- Passive activity gross income ............ $600 $700 $900 Passive activity deductions ............. (200) (1,000) (300) ------------------------------ Net passive income ........................ 400 (300) 600 ---------------------------------------- ----------------------------- (ii) Under paragraph (f)(2)(ii) of this section, activities X, Y, and Z are A's only significant participation passive activities for the taxable year. A's passive activity gross income from significant participation passive activities ($2,200) exceeds A's passive activity deductions from significant participation passive activities ($1,500) by $700 for such year. Therefore, under paragraph (f)(2)(i) of this section, a ratable portion of A's gross income from activities X and Z (A's significant participation passive activities with net passive income for the taxable year) is treated as gross income that is not from a passive activity. The ratable portion is determined by dividing (a) the amount by which A's passive activity gross income from significant participation passive activities exceeds A's passive activity deductions from significant participation passive activities for the taxable year ($700) by (b) such excess taking into account only A's significant participation passive activities having net passive income for the taxable year ($1,000). Accordingly, $280 of gross income from activity X ($400 x 700/1000) and $420 of gross income from activity Z ($600 x 700/1000) is treated as gross income that is not from a passive activity. (3) Rental of nondepreciable property. If less than 30 percent of the unadjusted basis of the property used or held for use by customers in a rental activity (within the meaning of §1.469-1T(e)(3)) during the taxable year is subject to the allowance for depreciation under section 167, an amount of the taxpayer's gross income from

the activity equal to the taxpayer's net passive income from the activity shall be treated as not from a passive activity. For purposes of this paragraph (f)(3), the term "unadjusted basis" means adjusted basis determined without regard to any adjustment described in section 1016 that decreases basis. The following example illustrates the application of this paragraph (f)(3): Example. C is a limited partner in a partnership. The partnership acquires vacant land for $300,000, constructs improvements on the land at a cost of $100,000, and leases the land and improvements to a tenant. The partnership then sells the land and improvements for $600,000, thereby realizing a gain on the disposition. The unadjusted basis of the improvements ($100,000) equals 25 percent of the unadjusted basis of all property ($400,000) used in the rental activity. Therefore, under this paragraph (f)(3), an amount of C's gross income from the activity equal to the net passive income from the activity (which is computed by taking into account the gain from the disposition, including gain allocable to the improvements) is treated as not from a passive activity. (4) Net interest income from passive equity-financed lending activity-(i) In general. An amount of the taxpayer's gross income for the taxable year from any equity-financed lending activity equal to the lesser of- (A) The taxpayer's equity-financed interest income from the activity for such year; and (B) The taxpayer's net passive income from the activity for such year shall be treated as not from a passive activity. (ii) Equity-financed lending activity-(A) In general. For purposes of this paragraph (f)(4), an activity is an equity-financed lending activity for a taxable year if- (1) The activity involves a trade or business of lending money; and (2) The average outstanding balance of the liabilities incurred in the activity for the taxable year does not exceed 80 percent of the average outstanding balance of the interest-bearing assets held in the activity for such year. (B) Certain liabilities not taken into account. For purposes of paragraph (f)(4)(ii)(A)(2) of this section, liabilities incurred principally for the purpose of increasing the percentage described in paragraph (f)(4)(ii)(A)(2) of this section shall not be taken into account in computing such percentage. (iii) Equity-financed interest income. For purposes of this paragraph (f)(4), the taxpayer's equity-financed interest income from an activity for a taxable year is the amount of the taxpayer's net interest income from the activity for such year multiplied by the fraction obtained by dividing- (A) The excess of the average outstanding balance for such year of the interest-bearing assets held in the activity over the average outstanding balance for such year of the liabilities incurred in the activity; by

(B) The average outstanding balance for such year of the interest-bearing assets held in the activity. (iv) Net interest income. For purposes of this paragraph (f)(4), the net interest income from an activity for a taxable year is- (A) The gross interest income from the activity for such year; reduced by (B) Expenses from the activity (other than interest on liabilities described in paragraph (f)(4)(vi) of this section) for such year that are reasonably allocable to such gross interest income. (v) Interest-bearing assets. For purposes of this paragraph (f)(4), the interest-bearing assets held in an activity include all assets that produce interest income, including loans to customers. (vi) Liabilities incurred in the activity. For purposes of this paragraph (f)(4), liabilities incurred in an activity include all fixed and determinable liabilities incurred in the activity that bear interest or are issued with original issue discount other than debts secured by tangible property used in the activity. In the case of an activity conducted by an entity in which the taxpayer owns a interest, liabilities incurred in an activity include only liabilities with respect to which the entity is the borrower. (vii) Average outstanding balance. For purposes of this paragraph (f)(4), the average outstanding balance of liabilities incurred in an activity or of the interest-bearing assets held in an activity may be computed on a daily, monthly, or quarterly basis at the option of the taxpayer. (viii) Example. The following example illustrates the application of this paragraph (f)(4): Example: (i) A, a calendar year individual, acquires on January 1, 1988, a limited partnership interest in P, a calendar year partnership. Under the partnership agreement, A has a one percent share of each item of income, gain, loss, deduction, and credit of P. A acquires the partnership interest for $90,000, using $50,000 of unborrowed funds and $40,000 of proceeds of a loan bearing interest at an annual rate of 10 percent. A pays $4,000 of interest on the loan in 1988. (ii) P's sole activity is a trade or business of lending money. A does not materially participate in the activity for 1988. During 1988, the average outstanding balance of P's interest-bearing assets (including loans to customers, temporary deposits with other lending institutions, and government and corporate securities) is $20 million. P incurs numerous interest-bearing liabilities in connection with its lending activity, including liabilities for deposits taken from customers, unsecured short-term and long-term loans from other lending institutions, and a mortgage loan secured by the building, owned by P, in which P conducts its business. For 1988, the average outstanding balance of all of these liabilities (other than the mortgage loan) is $11 million. None of these liabilities was incurred by P principally for the purpose of increasing the percentage described in paragraph (f)(4)(ii)(2) of this section.

(iii) The interest income derived by P for 1988 from its interest-bearing assets is $2.2 million. The interest expense paid by P for 1988 with respect to the liabilities incurred in connection with its lending activity (other than the mortgage loan) is $990,000. P's other expenses for 1988 that are reasonably allocable to P's gross interest income (including expenses for advertising, loan processing and servicing, and insurance, and depreciation on P's building) total $250,000. P's interest expense for 1988 on the mortgage loan secured by the building used in P's lending activity is $50,000. All of the interest expense paid or incurred by P for 1988 is allocated under

§1.63-8T to expeditures in connection with P's lending activity.

(iv) Under paragraph (f)(4)(ii) of this section, P's activity is an equity-financed lending activity for 1988, since, for 1988, the activity involves a trade or business of lending money and the average outstanding balance of the liabilities incurred in the activity ($11 million) does not exceed 80 percent of the average outstanding balance of the interest-bearing assets held in the activity ($20 million). Accordingly, under paragraph (f)(4)(i) of this section, an amount of A's gross income from the activity equal to the lesser of (a) A's equity-financed interest income from the activity for 1988, or (b) A's net passive income from the activity for 1988, is treated as income that is not from a passive activity. (v) Under paragraph (f)(4)(iii) of this section, A's equity-financed interest income from the activity for 1988 is determined by multiplying A's net interest income from the activity for 1988 by the fraction obtained by dividing $9 million (the excess of the average interest-bearing assets for 1988 over the average interest-bearing liabilities for 1988) by $20 million (the average interest-bearing assets for 1988). Under paragraph (f)(4)(iv) of this section, A's net interest income from the activity for 1988 is $19,000 (A's distributive share of $2.2 million of gross interest income less A's distributive share of $300,000 of expenses described in paragraph (f)(4)(iv)(B) of this section, including interest expense on the mortgage loan). A's distributive share of P's other interest expense ($990,000) is not taken into account in computing A's net interest income for 1988. Accordingly, A's equity-financed interest income from the activity for 1988 is $8,550 ($19,000 x $9 million/$20 million). (vi) Under paragraph (f)(9)(i) of this section, A's net passive income from the activity for 1988 is determined by taking into account A's distributive share of P's gross income and deductions from the activity for 1988, as well as any interest expense incurred by A individually that is taken into account under §1.163-8T in determining A's income or loss from the activity for 1988. Assuming that for 1988 all $4,000 of interest expense on the loan that A used to finance the acquisition of A's interest in P is allocated under §1.163-8T to expenditures of A in connection with the lending activity for 1988, A's net passive income from the activity for 1988 is $5,100, computed as set forth in the following table: Gross income: Interest income ................................................. $22,000 Deductions: Distributive share of P's expenses from the activity ........... (12,900) Interest expense on A's acquisition debt ........................ (4,000) ----------- Net passive income ................................................ 5,100 (vii) A's net passive income from the activity for 1988 ($5,100) is less than A's equity-financed income form the activity for 1988 ($8,550). Accordingly, under this paragraph (f)(4), $5,100 of A's gross income from the activity for 1988 is treated as not from a passive activity.

(5) Net income from certain property rented incidental to development activity-(i) In general. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property used in a rental activity for such year equal to the net rental activity income for the year from such item of property shall be treated as not from a passive activity if- (A) Any gain from the sale, exchange, or other disposition of the item of property is included in the taxpayer's income for the taxable year; (B) The use of the item of property in an activity involving the rental of such property commenced less than 24 months before the date of the disposition (within the meaning of paragraph (c)(2)(iii)(B) of this section) of such property; and (C) The taxpayer materially participated (within the meaning of §1.469-5T, but without regard to paragraph (e) thereof) or significantly participated (within the meaning of §1.469-5T(c)(2)) for any taxable year in an activity that involved for such year the performance of services for the purpose of enhancing the value of such item of property (or any other item of property if the basis of the item of property that is sold, exchanged, or otherwise disposed of is determined in whole or in part by reference to the basis of such other item of property). (ii) Commencement of use. For purposes of paragraph (f)(5)(i)(B) of this section, the use of an item of property in an activity involving the rental of such property commences when substantially all of the property is first held out for rent and is in a state of readiness for rental. (iii) Services performed for the purpose of enhancing the value of property. For purposes of paragraph (f)(5)(i)(C) of this section, services that are treated as performed for the purpose of enhancing the value of an item of property include but are not limited to- (A) Construction; (B) Renovation; and (C) Lease-up (but only if, as of the time the taxpayer commences using the property in the activity described in paragraph (f)(5)(i)(B), a substantial portion of the property is not leased). (iv) Example. The following example illustrates the application of this paragraph (f)(5): Example. (i) A, a calendar year individual, is a partner in calendar year partnership P, which is engaged in an activity of developing commercial real estate. In 1988, P acquires an interest in undeveloped land, and arranges for the financing and construction of an office building on the land. Beginning on March 1, 1990, substantially all of the building is held out for rent and is in a state of readiness for rental. (ii) P holds the building for rent for the remainder of 1990 and all of 1991 and 1992, and sells the building on January 15, 1993, pursuant to a contract entered into on

January 15, 1992. P did not hold the building for sale to customers in the ordinary course of P's trade or business (see §1.469-1T (e)(3)(vi)(D)). A's distributive share of P's taxable losses from the rental of the building is $50,000, $30,000, and $30,000, respectively, for 1990, 1991, and 1992. All of A's losses from the rental of the building are disallowed under §1.469-1T (a)(1)(i). A's distributive share of the gain recognized by P on the sale of the building is $150,000. A has no other gross income or deductions from the activity of renting the building. (iii) For purposes of paragraph (f)(5)(i)(C), in 1988, 1989, and 1990, P's real estate development activity involves the performance of services for the purpose of enhancing the value of the building. In 1993, the building is sold, and the date on which the use of the building in the rental activity commenced (March 1, 1990) was less then 24 months before the date on which a binding contract for such sale was entered into (January 15, 1992). Accordingly, if A materially participated in P's real estate development activity in 1988, 1989, or 1990 (without regard to whether A materially participated in the activity in more than one of those years), an amount of A's gross rental activity income for 1993 from the building equal to A's net rental activity income for 1993 from such building ($150,000-$110,000 of previously disallowed deductions = $40,000) is treated under this paragraph (f)(5) as gross income that is not from a passive activity. (6) Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property used in a rental activity for such year equal to the net rental activity income for the year from such item of property shall be treated as not from a passive activity if such property- (i) Is rented for use in a trade or business activity (within the meaning of §1.469-1T (e)(2)) in which the taxpayer materially participates (within the meaning of §1.469- 5T, but without regard to paragraph (e) thereof) for the taxable year; and (ii) Is not described in paragraph (f)(5) of this section. (7) Special rules applicable to the acquisition of an interest in a passthrough entity engaged in the trade or business of licensing intangible property-(i) In general. If a taxpayer acquires an interest in an entity described in paragraph (c)(3)(iii)(B)(3) of this section (the "development entity") after the development entity has created an item of intangible property or performed substantial services or incurred substantial costs with respect to the development or marketing of an item of intangible property, an amount of the taxpayer's gross royalty income for the taxable year from such item of property equal to the taxpayer's net royalty income for the year from such item of property shall be treated as not from a passive activity. (ii) Royalty income from property. For purposes of this paragraph (f)(7)- (A) A taxpayer's gross royalty income for a taxable year from an item of property is the taxpayer's share of passive activity gross income for such year (determined without regard to paragraphs (f)(2) through (7) of this section) from the licensing or transfer of any right in such property; and (B) A taxpayer's net royalty income for a taxable year from an item of property is the excess, if any, of-

(1) The taxpayer's gross royalty income for the taxable year from such item of property; over (2) Any passive activity deductions for such taxable year (including any deduction treated as a deduction for such year under §1.469-1T (f)(4)) that are reasonably allocable to such item of property. (iii) Exceptions. Paragraph (f)(7)(i) of this section shall not apply to a taxpayer's gross royalty income for a taxable year from the licensing of an item of intangible property if- (A) The expenditures reasonably incurred by the development entity for the taxable year of the entity ending with or within the taxpayer's taxable year with respect to the development or marketing of such property satisfy paragraph (c)(3)(iii)(B)(2)(ii) (a) of this section; or (B) The taxpayer's share of the expenditures reasonably incurred by the development entity with respect to the development or marketing of such property for all taxable years of the entity beginning with the taxable year of the entity in which the taxpayer acquired the interest in the entity and ending with the taxable year of the entity ending with or within the taxpayer's current taxable year exceeds 25 percent of the fair market value of the taxpayer's interest in such property at the time the taxpayer acquired the interest in the entity. (iv) Capital expenditures. For purposes of paragraph (f)(7)(iii)(B) of this section, a capital expenditure shall be taken into account for the taxable year of the entity in which such expenditure is chargeable to capital account, and the taxpayer's share of such expenditure shall be determined as though such expenditure were allowed as a deduction for such year. (v) Example. The following example illustrates the application of this paragraph (f)(7): Example. (i) The facts are the same as in example (5) in paragraph (c)(3)(iv) of this section, except that, in 1988, D's 10 percent partnership interest is sold to F for $13,000, all of which is attributable to the design licensed by the partnership. (ii) For 1988, the expenditures reasonably incurred by the partnership with respect to the development or marketing of the design satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. Accordingly, under paragraph (f)(7)(iii)(A) of this section, paragraph (f)(7)(i) of this section does not apply to F's distributive share of the partnership's gross income from licensing the design. (iii) For 1989, the expenditures reasonably incurred by the partnership with respect to the development or marketing of the design do not satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. Moreover, F's distributive share of such expenditures reasonably incurred by the partnership for 1988 and 1989 ($27,000 x .10 = $2,700) does not exceed 25 percent of the fair market value of F's interest in the design at the time F acquired the partnership interest ($13,000). Accordingly, neither of the exceptions provided in paragraph (f)(7)(iii) of this section applies for 1989 and, under paragraph (f)(7)(i) of this section, an amount of F's gross royalty

income from the design equal to F's net royalty income from the design is treated as not from a passive activity. (8) Limitation on recharacterized income. The amount of gross income from an activity that is treated as not from a passive activity for the taxable year under subparagraphs (f) (2) through (4) of this paragraph (f) shall not exceed the greatest amount of gross income treated as not from a passive activity under any one of such subparagraphs. (9) Meaning of certain terms. For purposes of this paragraph (f), the terms set forth below shall have the following meanings: (i) The net passive income from an activity for a taxable year is the amount by which the taxpayer's passive activity gross income from the activity for the taxable year (determined without regard to paragraphs (f) (2) through (4) of this section) exceeds the taxpayer's passive activity deductions from the activity for such year; (ii) The net passive loss from an activity for a taxable year is the amount by which the taxpayer's passive activity deductions from the activity for the taxable year exceeds the taxpayer's passive activity gross income from the activity for such year (determined without regard to paragraphs (f) (2) through (4) of this section). (iii) The gross rental activity income for a taxable year from an item of property used in a rental activity for such year is any passive activity gross income for such year (determined without regard to paragraphs (f) (2) through (6) of this section) from the rental or disposition of such item of property; and (iv) The net rental activity income from an item of property for a taxable year is the excess, if any, of- (A) The gross rental activity income from such item of property for the taxable year; over (B) Any passive activity deductions for such taxable year (including any deduction treated as a deduction for such year under §1.469-1T(f)(4)) that are reasonably allocable to the use of such item of property in the rental activity. (10) Coordination with section 163(d). Gross income that is treated as not from a passive activity under paragraph (f) (3), (4), or (7) of this section shall be treated as income described in section 469 (e)(1)(A) and paragraph (c)(3)(i) of this section except in determining whether- (i) Any property is treated for purposes of section 469(e)(1)(A)(ii)(I) and paragraph (c)(3)(i)(C) of this section as property that produces income of a type described in paragraph (c)(3)(i)(A) of this section; (ii) An expense (other than interest expense) is treated for purposes of section 469(e)(1)(A)(i)(II) and paragraph (d)(4) of this section as clearly and directly allocable to portfolio income (within the meaning of paragraph (c)(3)(i) of this section); and

(iii) Interest expense is allocated under §1.163-8T to an investment expenditure (within the meaning of §1.163-8T(b)(3)) or to a passive activity expenditure (within the meaning of §1.163-8T(b)(4)). (11) Effective date. For the effective date of the rules in this paragraph (f), see

§1.469-11T (relating to effective date and transition rules).

§1.469-3T Passive activity credit (temporary).

(a) Computation of passive activity credit. The taxpayer's passive activity credit for the taxable year is the amount (if any) by which- (1) The sum of all of the taxpayer's credits that are subject to section 469 for such year; exceeds (2) The taxpayer's regular tax liability allocable to all passive activities for such year. (b) Credits subject to section 469-(1) In general. Except as otherwise provided in this paragraph (b), a credit is subject to section 469 for a taxable year if and only if- (i) Such credit- (A) Is attributable to such taxable year and arises in connection with the conduct of an activity that is a passive activity for such taxable year; and (B) Is decribed in- (1) Section 38(b) (1) through (5) (relating to general business credits); (2) Section 27(b) (relating to corporations described in section 936); (3) Section 28 (relating to clinical testing of certain drugs); or (4) Section 29 (relating to fuel from nonconventional sources); or (ii) Such credit is allocable to an activity for such taxable year under §1.469- 1T(f)(4). (2) Treatment of credits attributable to qualified progress expenditures. Any credit attributable to an increase in qualified investment under section 46(d)(1)(A) (relating to qualified progress expenditures) with respect to progress expenditure property (as defined in section 46(d)(2)) is subject to section 469 for a taxable year if- (i) Such credit is attributable to such taxable year; (ii) Such credit is described in paragraph (b)(1)(i)(B) of this section; and (iii) It is reasonable to believe that such progress expenditure property will be used in a passive activity of the taxpayer when it is placed in service.

(3) Special rule for partners and S corporation shareholders. The character of a credit of a taxpayer arising in connection with an activity conducted by a partnership or S corporation (as a credit subject to section 469) shall be determined, in any case in which participation is relevant, by reference to the participation of the taxpayer in such activity. Such participation is determined for the taxable year of the partnership or S corporation (and not the taxable year of the taxpayer). See §1.469-2T(e)(1). (4) Exception for pre-1987 credits. A credit is not subject to section 469 if it is attributable to a taxable year of the taxpayer beginning prior to January 1, 1987. (c) Taxable year to which credit is attributable. A credit is attributable to the taxable year in which such credit would be (or would have been) allowed if the credits regard to the limitations contained in sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469. (d) Regular tax liability allocable to passive activities-(1) In general. For purposes of paragraph (a)(2) of this section, the taxpayer's regular tax liability allocable to all passive activities for the taxable year is the excess (if any) of- (i) The taxpayer's regular tax liability for such taxable year; over (ii) The amount of such regular tax liability determined by reducing the taxpayer's income for such year by the excess (if any) of the taxpayer's passive activity gross income for such year over the taxpayer's passive activity deductions for such year. (2) Regular tax liability. For purposes of this section, the term "regulary tax liability" has the meaning given such term in section 26(b). (e) Coordination with section 39. For purposes of section 39 (relating to the carryback and carryforward of unused business credits), any credit described in section 38(b) (1) through (5) is treated as a current year business credit for the first taxable year in which such credit is subject to section 469 and is not disallowed by section 469 and the regulations thereunder. (f) Examples. The following examples illustrate the application of this section: Example (1). (i) A, a calendar year individual, is a general partner in calendar year partnership P. P purchases a building in 1987 and, in 1987, 1988, and 1989, incurs rehabilitation costs with respect to the building. The building is placed in service in the rental activity in 1989. P's rehabilitation costs are qualified rehabilitation expenditures (within the meaning of section 48(g)(2)) and are taken into account in determining the amount of the investment credit for rehabilitation expenditures. P's qualified rehabilitation expenditures are not qualified progress expenditures (within the meaning of section 46(d)). (ii) Because, under section 46(c)(1), the credit is allowable for the taxable year in which the rehabilitated property is placed in service, the credit allowable for P's qualified rehabilitation expenditures arises in connection with the activity in which the property is placed in service. In addition, the credit is attributable to 1989, the year in which the property is placed in service, because it would be allowed for such year if A's credits allowed for all taxable years were determined without regard to the limitations contained in sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469.

Accordingly, under paragraph (b)(1) of this section, A's distributive share of the credit is subject to section 469 for 1989 because the credit arises in connection with a rental activity for such year. Example (2). The facts are the same as in example (1), except that the rehabilitation costs are incurred in anticipation of placing the building in service in a rental activity, the qualified rehabilitation expenditures in 1987 and 1988 are qualified progress expenditures ("QPEs") (within the meaning of section 46(d)(3)), the improvements resulting from the expenditures are progress expenditure property (within the meaning of paragraph (d)(2) of this section), and it is reasonable to expect that such property will be transition property (within the meaning of section 49(e)) when the property is placed in service. Therefore, under section 46(d)(1)(A), the qualified investment for 1987 and 1988 is increased by an amount equal to the aggregate of the applicable percentage of the qualified rehabilitation expenditures incurred in such years. The credits that are based on these expenditures are attributable (under paragraph (c) of this section) to 1987 and 1988, respectively. It is reasonable to believe in 1987 and 1988 that the progress expenditure property will be used in a rental activity when it is placed in service. Accordingly, under paragraph (b)(2) of this section, A's distributive share of the credit for 1987 and 1988 is subject to section 469. Under paragraph (b)(1) of this section (as in example (1)), A's distributive share of the credit for 1989 is also subject to section 469. Example (3). (i) B, a single individual, acquires an interest in a partnership that, in 1988, rehabilitates a building and places it in service in a trade or business activity in which B does not materially participate. For 1988, B has the following items of gross income, deduction, and credit: Gross income: Income other than passive activity gross income ......... $110,000 Passive activity gross income ............................. 20,000 $130,000 ----------- Deductions: Deductions other than passive activity deductions ......... 23,950 Passive activity deductions ............................... 18,000 (41,950) ------------------------ Taxable income ......................................................... 88,050 ----------- Credits: Rehabilitation credit from the passive activity ......................... 8,000 (ii) For 1988, the amount by which B's passive activity gross income exceeds B's passive activity deductions (B's net passive income) is $2,000. Under paragraph (d) of this section, B's regular tax liability allocable to passive activities for 1988 is determined as follows: (A) Taxable income ..................................... $88,050 (B) Regular tax liability ........................... ---------- $24,578.50 (C) Taxable income minus net passive income ............. 86,050 (D) Regular tax liability for taxable income of $86,050.00 ........................................ ---------- 23,918.50 ------------- (E) Regular tax liability allocable to passive activities ((B) minus (D)) ........................ ---------- $660.00 (iii) Under paragraph (a) of this section, B's passive activity credit for 1988 is the amount by which B's credits that are subject to section 469 for 1988 ($8,000) exceed B's regular tax liability allocable to passive activities for 1988 ($660.00). Accordingly, B's passive activity credit for 1988 is $7,340. Example (4). (i) The facts are the same as in example (3) except that, in 1988, B also has additional deductions of $100,000 from a trade or business activity in which B materially participates for 1988. Thus, B has a taxable loss for 1988 of $11,950, determined as follows: Gross income: Income other than passive activity gross

income ........ $110,000 Passive activity gross income ............................ 20,000 $130,000 ----------- Deductions: Deductions other than passive activity deductions ....... 123,950 Passive activity deductions .............................. 18,000 (141,950) -- ----------------------- Taxable income ...................................... ----------- (11,950) (ii) Under section 26(b) and paragraph (d)(2) of this section, the regular tax liability for a taxable year cannot exceed the tax imposed by chapter 1 of subtitle A of the Internal Revenue Code for the taxable year. Therefore, under paragraph (d)(1) of this section, B's regular tax liability allocable to passive activities for 1988 is zero. Although B's net operating loss for the taxable year is reduced by B's net passive income, and B's regular tax liability for other taxable years may increase as a result of the reduction, such an increase does not change B's regular tax liability allocable to passive activities for 1988. Accordingly, B's passive activity credit for 1988 is $8,000.

§1.469-4T Definition of activity (temporary). [Reserved]

§1.469-5T Material participation (temporary).

(a) In general. Except as provided in paragraphs (e) and (h)(2) of this section, an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if- (1) The individual participates in the activity for more than 500 hours during such year; (2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year; (3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year; (4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours; (5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; (6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or (7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

(b) Facts and circumstances-(1) In general. [Reserved] (2) Certain participation insufficient to constitute material participation under this paragraph (b) -(i) Participation satisfying standards not contained in section 469. Except as provided in section 469(h)(3) and paragraph (h)(2) of this section (relating to certain retired individuals and surviving spouses in the case of farming activities), the fact that an individual satisfies the requirements of any participation standard (whether or not referred to as "material participation") under any provision (including sections 1402 and 2032A and the regulations thereunder) other than section 469 and the regulations thereunder shall not be taken into account in determining whether such individual materially participates in any activity for any taxable year for purposes of section 469 and the regulations thereunder. (ii) Certain management activities. An individual's services performed in the management of an activity shall not be taken into account in determining whether such individual is treated as materially participating in such activity for the taxable year under paragraph (a)(7) of this section unless, for such taxable year- (A) No person (other than such individual) who performs services in connection with the management of the activity receives compensation described in section 911(d)(2)(A) in consideration for such services; and (B) No individual performs services in connection with the management of the activity that exceed (by hours) the amount of such services performed by such individual. (iii) Participation less than 100 hours. If an individual participates in an activity for 100 hours or less during the taxable year, such individual shall not be treated as materially participating in such activity for the taxable year under paragraph (a)(7) of this section. (c) Significant participation activity -(1) In general. For purposes of paragraph (a)(4) of this section, an activity is a significant participation activity of an individual if and only if such activity- (i) Is a trade or business activity (within the meaning of §1.469-1T(e)(2)) in which the individual significantly participates for the taxable year; and (ii) Would be an activity in which the individual does not materially participate for the taxable year if material participation for such year were determined without regard to paragraph (a)(4) of this section. (2) Significant participation. An individual is treated as significantly participating in an activity for a taxable year if and only if the individual participates in the activity for more than 100 hours during such year. (d) Personal service activity. An activity constitutes a personal service activity for purposes of paragraph (a)(6) of this section if such activity involves the performance of personal services in-

(A) The fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or (B) Any other trade or business in which capital is not a material income-producing factor. (e) Treatment of limited partners-(1) General rule. Except as otherwise provided in this paragraph (e), an individual shall not be treated as materially participating in any activity of a limited partnership for purposes of applying section 469 and the regulations thereunder to- (i) The individual's share of any income, gain, loss, deduction, or credit from such activity that is attributable to a limited partnership interest in the partnership; and (ii) Any gain or loss from such activity recognized upon a sale or exchange of such an interest. (2) Exceptions. Paragraph (e)(1) of this section shall not apply to an individual's share of income, gain, loss, deduction, and credit for a taxable year from any activity in which the individual would be treated as materially participating for the taxable year under paragraph (a)(1), (5), or (6) of this section if the individual were not a limited partner for such taxable year. (3) Limited partnership interest-(i) In general. Except as provided in paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if- (A) Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or (B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum of the holder's capital contributions to the partnership and contractural obligations to make additional capital contributions to the partnership). (ii) Limited partner holding general partner interest. A partnership interest of an individual shall not be treated as a limited partnership interest for the individual's taxable year if the individual is a general partner in the partnership at all times during the partnership's taxable year ending with or within the individual's taxable year (or the portion of the partnership's taxable year during which the individual (directly or indirectly) owns such limited partnership interest). (f) Participation-(1) In general. Except as otherwise provided in this paragraph (f), any work done by an individual (without regard to the capacity in which the individual does such work) in connection with an activity in which the individual owns (directly or indirectly, other than through a C corporation) an interest at the time the work is done shall be treated for purposes of this section as participation of such individual in the activity.

(2) Exceptions-(i) Certain work not customarily done by owners. Work done in connection with an activity shall not be treated as participation in the activity for purposes of this section if- (A) Such work is not of a type that is customarily done by an owner of such an activity; and (B) One of the principal purposes for the performance of such work is to avoid the disallowance, under section 469 and the regulations thereunder, of any loss or credit from such activity. (ii) Participation as an investor-(A) In general. Work done by an individual in the individual's capacity as an investor in an activity shall not be treated as participation in the activity for purposes of this section unless the individual is directly involved in the day-to-day management or operations of the activity. (B) Work done in individual's capacity as an investor. For purposes of this paragraph (f)(2)(ii), work done by an individual in the individual's capacity as an investor in an activity includes- (1) Studying and reviewing financial statements or reports on operations of the activity; (2) Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use; and (3) Monitoring the finances or operations of the activity in a non-managerial capacity. (3) Participation of spouse. In the case of any person who is a married individual (within the meaning of section 7703) for the taxable year, any participation by such person's spouse in the activity during the taxable year (without regard to whether the spouse owns an interest in the activity and without regard to whether the spouses file a joint return for the taxable year) shall be treated, for purposes of applying section 469 and the regulations thereunder to such person, as participation by such person in the activity during the taxable year. (4) Methods of proof. The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries. (g) Material participation of trusts and estates. [Reserved] (h) Miscellaneous rules-(1) Participation of corporations. For rules relating to the participation in an activity of a personal service corporation (within the meaning of

§1.468-1T(g)(2)(i)) or a closely held corporation (within the meaning of §1.469-

1T(g)(2)(ii)), see §1.469-1T(g)(3). (2) Treatment of certain retired farmers and surviving spouses of retired or disabled farmers. An individual shall be treated as materially participating for a taxable year in any trade or business activity of farming it paragraph (4) or (5) of section 2032A(b) would cause the requirements of section 2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity had the individual died during such taxable year. (i) [Reserved] (j) Material participation for taxable years beginning before January 1, 1987. In any case in which it is necessary to determine whether an individual materially participated in any activity for a taxable year beginning before January 1, 1987 (other than a taxable year of a partnership, S corporation, estate, or trust ending after December 31, 1986), such determination shall be made without regard to paragraphs (a) (2) through (7) of this section. (k) Examples. The following examples illustrate the application of this section: Example (1). A, a calendar year individual, owns all of the stock of X, a C corporation. X is the general partner, and A is the limited partner, in P, a calendar year partnership. P has a single activity, a restaurant, which is a trade or business activity (within the meaning of §1.469-1T(e)(2)). During the taxable year, A works for an average of 30 hours per week in connection with P's restaurant activity. Under paragraphs (a)(1) and (e)(2) of this section, A is treated as materially participating in the activity for the taxable year because A participates in the restaurant activity during such year for more than 500 hours. In addition, under §1.469-1T(g)(3)(i), A's participation will cause X to be treated as materially participating in the restaurant activity. Example (2). The facts are the same as in example (1), except that the partnership agreement provides that P's restaurant activity is to be managed by X, and A's work in the activity is performed pursuant to an employment contract between A and X. Under paragraph (f)(1) of this section, work done by A in connection with the activity in any capacity is treated as participation in the activity by A. Accordingly, the conclusion is the same as in example (1). The conclusion would be the same if A owned no stock in X at any time, although in that case A's participation would not be taken into account in determining whether X materially participates in the restaurant activity. Example (3). B, an individual, is employed fulltime as a carpenter. B also owns an interest in a partnership which is engaged in a van conversion activity, which is a trade or business activity (within the meaning of §1.469-1T(e)(2)). B and C, the other partner, are the only participants in the activity for the taxable year. The activity is conducted entirely on Saturdays. Each Saturday throughout the taxable year, B and C work for eight hours in the activity. Although B does not participate in the activity for more than 500 hours during the taxable year, under paragraph (a)(3) of this section, B is treated for such year as materially participating in the activity because B participates in the activity for more than 100 hours during the taxable

year, and B's participation in the activity for such year is not less than the participation of any other person in the activity for such year. Example (4). C, an individual, is employed full-time as an accountant. C also owns interests in a restaurant and a shoe store. The restaurant and shoe store are trade or business activities (within the meaning of §1.469-1T(e)(2)) that are treated as separate activities under the rules to be contained in §1.469-4T. Each activity has several full-time employees. During the taxable year, C works in the restaurant activity for 400 hours and in the shoe store activity for 150 hours. Under paragraph (c) of this section, both the restaurant and shoe store activities are significant participation activities of C for the taxable year. Accordingly, since C's aggregate participation in the restaurant and shoe store activities during the taxable year exceeds 500 hours, C is treated under paragraph (a)(4) of this section as materially participating in both activities. Example (5). In 1990, D, an individual, acquires stock in an S corporation engaged in a trade or business activity (within the meaning of §1.469-1T(e)(2)). For every taxable year from 1990 through 1994, D is treated as materially participating (without regard to paragraph (a)(5) of this section) in the activity. D retires from the activity at the beginning of 1995, and would not be treated as materially participating in the activity for 1995 and subsequent taxable years if material participation for such years were determined without regard to paragraph (a)(5) of this section. Under paragraph (a)(5) of this section, however, D is treated as materially participating in the activity for taxable years 1995 through 1999 because D materially participated in the activity (determined without regard to paragraph (a)(5) of this section ) for five taxable years during the ten taxable years that immediately precede each of those years. D is not treated under paragraph (a)(5) of this section as materially participating in the activity for taxable years after 1999 because of such years D has not materially participated in the activity (determined without regard to paragraph (a)(5) of this section) for five of the ten immediately preceding taxable years. Example (6). The facts are the same as in example (5), except that D does not acquire any stock in the S corporation until 1994. Under paragraph (f)(1) of this section, D is not treated as participating in the activity for any taxable year prior to 1994 because D does not own as interest in the activity for any such taxable year. Accordingly, D materially participates in the activity for only one taxable year prior to 1995, and D is not treated under paragraph (a)(5) of this section as materially participating in the activity for 1995 or subsequent taxable years. Example (7). (i) E, a married individual filing a separate return for the taxable year, is employed full-time as an attorney. E also owns an interest in a professional football team that is a trade or business activity (within the meaning of §1.469- 1T(e)(2)). E does no work in connection with this activity. E anticipates that, for the taxable year, E's deductions from the activity will exceed E's gross income from the activity and that, if E does not materially participate in the activity for the taxable year, part or all of F's passive activity loss for the taxable year will be disallowed under §1.469-1T(a)(1)(i). Accordingly, E pays E's spouse to work as an office for an average of 15 hours per week during the taxable year. (ii) Under paragraph (f)(3) of this section any participation in the activity by E's spouse is treated as participation in the activity by E. However, under paragraph

(f)(2)(i) of this section, the work done by E's spouse is not treated as participation in the activity because work as an office receptionist is not work of a type customarily done by an owner of a football team, and one of E's principal purposes for paying E's spouse to do this work is to avoid the disallowance under §1.469-1T(a)(1)(i) of E's passive activity loss. Accordingly, E is not treated as participating in the activity for the taxable year. Example (8). (i) F, an individual, owns an interest in a partnership that feeds and sells cattle. The general partner of the partnership periodically mails F a letter setting forth certain proposed actions and decisions with respect to the cattle-feeding operation. Such actions and decisions include, for example, what kind of feed to purchase, how much to purchase, and when to purchase it, how often to feed cattle, and when to sell cattle. The el tters explain the proposed actions and decisions, emphasize that taking or not taking a particular action or decision is solely within the discretion of F and other partners, and ask F to indicate a decision with respect to each proposed action by answering certain questions. The general partner receives a fee that constitutes earned income (within the meaning of section 911 (d)(2)(A)) for managing the cattle-feeding operation. F is not treated as materially participating in the cattle-feeding operation under paragraph (a) (1) through (6) of this section. (ii) F's only participation in the cattle-feeding operation is to make certain managerial decisions. Under paragraph (b)(2)(ii) of this section, such management services are not taken into account in determining whether the taxpayer is treated as materially participating in the activity for a taxable year under paragraph (a)(7) of this section, if any other person performs services in connection with the management of the activity and receives compensation described in section 911(d)(2)(A) for such services. Therefore, F is not treated as materially participating for the taxable year in the cattle-feeding operation.

§1.469-6T Treatment of losses upon certain dispositions (temporary).

[Reserved]

§1.469-7T Treatment of self-charged items of income and expense

(temporary). [Reserved]

§1.469-8T Application of section 469 and the regulations thereunder to

trusts, estates, and their beneficiaries (temporary). [Reserved]

§1.469-10T Application of section 469 to publicly traded partnerships

(temporary). [Reserved]

§1.469-11T Effective date and transition rules (temporary).

(a) Effective date-(1) In general. Except as provided in paragraph (a)(2) of this section, section 469 and the regulations thereunder apply for taxable years beginning after December 31, 1986. (2) Application of certain income recharacterization rules-(i) In general. No amount of gross income shall be treated under §1.469-2T(f)(3) through (7) as income that is not from a passive activity for any taxable year of the taxpayer beginning before January 1, 1988.

(ii) Property rented to a nonpassive activity. In applying §1.469-2T(f)(6) to a taxpayer's rental of an item of property, the taxpayer's net rental activity income (within the meaning of §1.469-2T(f)(9)(iv)) from such property for any taxable year beginning after December 31, 1987, shall not include the portion of such income (if any) that is attributable to the rental of such item of property pursuant to a written binding contract entered into before February 19, 1988. (3) Qualified low-income housing projects. For a transitional rule concerning the application of section 469 to losses from qualified low-income housing projects, see section 502 of the Tax Reform Act of 1986. (4) Effect of events occurring in years prior to 1987. The treatment for a taxable year beginning after December 31, 1986, of any item of income, gain, loss, deduction, or credit as an item of passive activity gross income, passive activity deduction, or credit from a passive activity, shall be determined as if section 469 and the regulations thereunder had been in effect for taxable years beginning before January 1, 1987, but without regard to any passive activity loss or passive activity credit that would have been disallowed for any taxable year beginning before January 1, 1987, if section 469 and the regulations thereunder had been in effect for such year. For example, in determining whether a taxpayer materially participates in an activity under §1.469-5T(a)(5) (relating to taxpayers who have materially participated in an activity for five of the ten immediately preceding taxable years) for any taxable year beginning after December 31, 1986, the taxpayer's participation in the activity for all prior taxable years (including taxable years beginning before 1987) is taken into account. See §1.469-5T(j) (relating to the determination of material participation for taxable years beginning before January 1, 1987). (5) Examples. The following examples illustrate the application of this paragraph (a): Example (1). A, a calendar year individual, is a partner in a partnership with a taxable year ending on January 31. During its taxable year ending January 31, 1987, the partnership was engaged in a single activity involving the conduct of a trade or business. In applying section 469 and the regulations thereunder to A for calendar year 1987, A's distributive share of partnership items for the partnership's taxable year ending January 31, 1987, is taken into account. Therefore, under §1.469- 2T(e)(1) and paragraph (a)(4) of this section, A's participation in the activity throughout the partnership's taxable year beginning February 1, 1986, and ending January 31, 1987, is taken into account for purposes of determining the character under section 469 of the items of gross income, deduction, and credit allocated to A for the partnership's taxable year ending January 31, 1987. Example (2). B, a calendar year individual, is a beneficiary of a trust described in section 651 that has a taxable year ending January 31. The trust conducts a rental activity (within the meaning of §1.469-1T(e)(3)). Because the trust's taxable year ending January 31, 1987, began before January 1, 1987, section 469 and the regulations thereunder do not apply to the trust for such year. Section 469 and the regulations thereunder do apply, however, to B for B's calendar year 1987. Therefore, income of the trust from the rental activity for the trust's taxable year ending January 31, 1987, that is included in B's gross income for 1987 is taken into account in applying section 469 to B for 1987.

(b) Transitional rule for pre-enactment loss and pre-enactment credit-(1) In general. For taxable years beginning after December 31, 1986, and before January 1, 1991, §1.469-1T(a)(1) shall not apply to- (i) An amount of the passive activity loss equal to the applicable percentage of the pre-enactment loss; and (ii) An amount of the passive activity credit equal to the applicable percentage of the pre-enactment credit. (2) Applicable percentage. For purposes of this paragraph (b), the applicable percentage of the pre-enactment loss or the pre-enactment credit for a taxable year shall be determined in accordance with the following table: ---------------------------- --------------------------------------------------- In the case of a taxable year beginning in: The applicable percentage is: ---------------------------------------------- --------------------------------- 1987 ....................................................................... 65 1988 ....................................................................... 40 1989 ....................................................................... 20 1990 ....................................................................... 10 --------------------------------- ---------------------------------------------- (3) Pre-enactment loss. The pre-enactment loss for any taxable year is the lesser of- (i) The amount of the passive activity loss that would be disallowed for the taxable year under §1.469-1T(a)(1)(i) if this section were disregarded; and (ii) The amount of the passive activity loss that would be disallowed for the taxable year under §1.469-1T(a)(1)(i) if this section were disregarded and the following items were not taken into account: (A) Any deduction treated as a deduction from an activity for the taxable year under

§1.469-1T(f)(4); and

(B) Any item from an interest (other than a pre-enactment interest) in any passive activity. (4) Pre-enactment credit. The pre-enactment credit for any taxable year is the lesser of- (i) The amount of the passive activity credit that would be disallowed for the taxable year under §1.469-1T(a)(1)(ii) if this section were disregarded; and (ii) The amount of the passive activity credit that would be disallowed for the taxable year under §1.469-1T(a)(1)(ii) if this section were disregarded and the following items were not taken into account: (A) Any deduction or credit treated as a deduction or credit from an activity for the taxable year under §1.469-1T(f)(4); and

(B) Any item from an interest (other than a pre-enactment interest) in a passive activity. (5) Examples. The following examples illustrate the application of this paragraph (b): Example (1). A, an individual, owns interest in two passive activities, X and Y. A's interest in activity X is a pre-enactment interest (within the meaning of paragraph (c) of this section), while A's interest in activity Y is not a pre-enactment interest. For 1987 A has a $10,000 loss from activity X and $9,000 of income from activity Y. The amount determined under paragraph (b)(3)(i) of this section is $1,000. The amount determined under paragraph (b)(3)(ii) of this section is $10,000. Therefore, A's pre-enactment loss for 1987 is $1,000. Accordingly, §1.469-1T(a)(1)(i) does not apply to $650 ($1,000 × .65) of A's $1,000 passive activity loss for 1987. Example (2). (i) B, an individual, owns an interest in one passive activity, and B's interest in the activity is a pre-enactment interest (within the meaning of paragraph (c) of this section). For 1987 and 1988, B has the following passive activity gross income and passive activity deductions from the activity: ------------------------------ ------------------ 1987 1988 ------------------------------------------------ Gross income ............. $20,000 $20,000 Deductions ............. ($50,000) ($40,000) ------- ----------------------------------------- (ii) Under §1.469-2T(b), B's passive activity loss for 1987 is $30,000 ($50,000 of passive activity deductions minus $20,000 of passive activity gross income). Under paragraph (b)(3) of this section, B's pre-enactment loss for 1987 is $30,000. Accordingly, under paragraphs (b) (1) and (2) of this section, §1.469-1T(a)(1)(i) does not apply to $19,500 ($30,000 × .65) of B's $30,000 passive activity loss for 1987. Under §1.469-1T(a)(1)(i), $10,500 of B's loss for 1987 ($30,000 × .35) is disallowed. Under §1.469-1T(f) (2) and (4), the disallowed loss is allocated among deductions from the activity, and the disallowed deductions are treated as deductions from the activity for 1988. (iii) For 1988, B's pre-enactment loss is computed as shown in the following table: -- ----------------------------------------------------- (b)(3)(i) (b)(3)(ii) -------------------- ----------------------------------- Gross income ................... $20,000 $20,000 Current deductions ............ (40,000) (40,000) sec. 1.469-1T(f)(4) ........... (10,500) -0- --------------------------- Net loss ..................... ($30,500) ($20,000) ------------ ------------------------------------------- Therefore, B's pre-enactment loss for 1988 is $20,000. (iv) Under paragraph (b)(2) of this section, the applicable percentage for 1988 is 40 percent. Therefore, under paragraph (b)(1) of this section §1.469-1T(a)(1)(i) does not apply to $8,000 ($20,000 × .40) of B's $30,500 passive activity loss for 1988. Example (3). (i) C, an individual, owns interests in three passive activities, R, S, and T. C's interest in each activity is a pre-enactment interest. For 1987 and 1988, C's gross income, deductions, and net income (loss) from each of the three activities are as follows: ---------------------------------------------------------------- R S T ----------- ----------------------------------------------------- 1987: Gross income .................. $8,000 $5,000 $2,000 Deductions ................... (9,000) (7,000) (1,400) ------------ ------------ Net income (loss) ........... ($1,000) ($2,000) $600 ------------------------

1988: Gross income .................. $7,000 $6,000 $2,000 Deductions ................... (8,000) (4,500) (3,000) ------------------------ Net income (loss) ........... ($1,000) $1,500 ($1,000) ---------------------------------------------------------------- (ii) Under §1.469-2T(b), C's passive activity loss for 1987 is $2,400 ($17,400 of passive activity deductions less $15,000 of passive activity gross income). Under paragraph (b)(3) of this section, C's pre-enactment loss for 1987 is $2,400. Accordingly, under paragraph (b)(1) and (2) of this section, §1.469-1T (a)(1)(i) does not apply to $1,560 ($2,400 × .65) of C's passive activity loss for 1987. Under §1.469-1T (a)(1)(i), $840 of C's passive activity loss for 1987 ($2,400 x .35) is disallowed. (iii) Under §1.469-1T (f)(2)(i), since a portion of C's passive activity loss for 1987 is disallowed, a ratable portion of the loss from each of C's activities that has a loss for 1987 (activity R and activity S) is disallowed for 1987. Accordingly, $280 of the 1987 loss from activity R ($840 × $1,000/$3,000) and $560 of the 1987 loss from activity S ($840 × $2,000/$3,000) is disallowed for 1987. Under §1.469-1T (f)(2) and (4), corresponding portions of the deductions from each activity are disallowed for 1987 and treated as deductions from activities R and S, respectively, for 1988. The deductions that are disallowed for 1987 and treated as deductions for 1988 are taken into account under paragraph (b)(3)(i) but not paragraph (b)(3)(ii) of this section. Thus, the amounts determined under paragraphs (b)(3)(i) and (b)(3)(ii) of this section for 1988 are as follows: ------------------------------------------ Activity (b)(3)(i) (b)(3)(ii) ------------------------------------------ R ................ ($1,280) ($1,000) S ..................... 940 1,500 T ................. (1,000) (1,000) Total ............ ($1,340) ($500) ------------------------------------------ Therefore, C's pre-enactment loss for 1988 is $500. (iv) Under paragraph (b)(2) of this section, the applicable percentage for 1988 is 40 percent. Therefore, under paragraph (b)(1) of this section, §1.469-1T (a)(1)(i) does not apply to $200 ($500 × .40) of C's $1,340 passive activity loss for 1988. Example (4). (i) D, an individual, has interests in there passive activities, X, Y, and Z. Activities X and Y are rental real estate activities (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) in which D actively participates (within the meaning of section 469(i) and the rules to be contained in §1.469-9T) for the taxable year. D's interest in activity X is a pre-enactment interest, and D's interest in activity Y is not a pre-enactment interest. Activity Z is not a rental real estate activity, and D's interest in activity Z is not a pre-enactment interest. The amount of income (loss) from each activity for the taxable year is as follows: -------- ------------------------------------------ Activity Income (loss) --------------------------- ----------------------- X (pre-enactment rental) ............... ($40,000) Y (other rental) ......................... $30,000 Z (other non-rental) ................... ($20,000) ------------- ------------------------------------- (ii) The amount determined under paragraph (b)(3)(ii) of this section is computed by applying section 469 to D as if D's only interests in passive activities were D's pre-enactment interests in such activities. If D's only interests in passive activities were D's pre-enactment interests in such activities, the amount to which §1.469-1T (a)(1)(i) would not apply, by reason of section 469(i) and the rules to be contained in §1.469-9T, would be $25,000. Taking into account all of D's interests in passive

activities, the amount to which §1.469-1T (a)(1)(i) would not apply, by reason of section 469(i) and the rules to be contained in §1.469-9T, is $10,000. Accordingly, the amounts determined under paragraph (b)(3)(i) and (b)(3)(ii) of this section for the taxable year are as follows: ------------------------------------------------------- Activity (b)(3)(i) (b)(3)(ii) ------------------------------------------------------- X ............................ ($40,000) ($40,000) Y .............................. $30,000 Z ............................ ($20,000) --------------------------- ------------- Subtotal ..................... ($30,000) ($40,000) sec. 469(i) allowance ......... $10,000 $25,000 - -------------------------- Total ........................ ($20,000) ($15,000) ------------------ ------------------------------------- Therefore, D's pre-enactment loss for the taxable year is $15,000. Example (5). E, an individual, has for the taxable year the following items of income, deduction, and credit from passive activities: -------------------------------------------- ----------------------------------- Pre-enactment Other interests Total interests -------- ----------------------------------------------------------------------- Income (deductions) ........................ $100 ($1,00) -0- Credits ...................................... 28 28 $56 --- ---------------------------------------------------------------------------- For the taxable year, E is subject to tax at a marginal rate of 28 percent. Under

§1.469-3T (d), E's regular tax liability allocable to passive activities for the taxable

year is zero. If, however, the only interests in passive activities taken into account were the pre-enactment interests (i.e., if the $100 loss were disregarded), E's regular tax liability allocable to passive activities for the taxable year would be $28. Thus, the amounts determined under paragraphs (b)(4)(i) and (b)(4)(ii) of this section are as follows: --------------------------- (b)(4)(i) (b)(4)(ii) -------------------- ------- $56 ................... -0- --------------------------- Therefore, E's pre-enactment credit for the taxable year is zero, and §1.469-1T (a)(1)(ii) applies to E's $56 passive activity credit for the taxable year. (c) Definition of pre-enactment interest-(1) Geneal rule. Except as otherwise provided in this paragraph (c), the term "pre-enactment interest" means a qualified interest in a pre-enactment activity. (2) Qualified interest-(i) In general. For purposes of this paragraph (c), a qualified interest in an activity is any interest in an activity that was- (A) Held by the taxpayer on October 22, 1986, and at all times thereafter (but only if the activity existed on October 22, 1986); or (B) Acquired by the taxpayer after October 22, 1986, directly or indirectly, pursuant to one or more written binding contracts to which the taxpayer was a party on October 22, 1986, and held by the taxpayer at all times after such acquisistion. See paragraph (c)(7) of this section for rules for determining whether a taxpayer was a party on October 22, 1986, to a written binding contract.

(ii) Stock in a C corporation. For purposes of this paragraph (c)(2), stock in a C corporation is not treated as an interest in any activity of the corporation. The following example illustrates the application of this paragraph (c)(2)(ii): Example. On October 22, 1986, the taxpayer owned all of the stock of a C corporation that conducted a single activity. On December 31, 1986, the corporation liquidated and distributed to the taxpayer the assets used in the activity. Under this paragraph (c)(2)(ii), the taxpayer does not have a qualified interest in the corporation's activity as a result of the liquidation. The result would be the same if, on December 31, 1986, instead of liquidating, the corporation elected under section 1362(a) to be an S corporation. (3) Pre-enactment activity-(i) In general. For purposes of this paragraph (c), an activity is a pre-enactment activity if- (A) The activity was being conducted by any person on October 22, 1986; or (B) At least 50 percent (by value) of the property used in the activity during the taxable year was- (1) In existence or under construction on August 16, 1986; or (2) Acquired or constructed by any person pursuant to a written binding contract (without regard to whether the taxpayer or any person related to the taxpayer was a party to such contract) in effect on August 16, 1986. (ii) Character before 1987 irrelevant. For purposes of this paragraph (c), an activity may be treated as a pre-enactment activity without regard to whether such activity would have been a passive activity of the taxpayer for any taxable year beginning before January 1, 1987, had section 469 and the regulations thereunder been in effect for such year. (4) Examples. The following examples illustrate the application of paragraphs (c) (1), (2), and (3) of this section: Example (1). On October 22, 1986, the taxpayer owned an interest in property used as a personal residence. After October 22, 1986, the taxpayer ceased to use the property as a personal residence and began to use it in a rental activity. The rental activity is a pre-enactment activity (within the meaning of paragraph (c)(3) of this section) because the property used in the rental activity was in existence on August 16, 1986. The taxpayer did not hold any interest in the rental activity on October 22, 1986, however, because the activity did not exist on that date. In addition, the taxpayer did not acquire an interest in the activity after October 22, 1986, pursuant to a written binding contract to which the taxpayer was a party on such date. Accordingly, the taxpayer's interest in the rental activity is not a qualified interest (within the meaning of paragraph (c)(2) of this section), and the taxpayer does not have a pre-enactment interest in the rental activity. Example (2). The taxpayer owns an interest in a partnership, which owns property used in a rental activity. The taxpayer acquired the partnership interest pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986.

The partnership acquired its interest in the rental property pursuant to written binding contracts to which the partnership was a party on October 22, 1986. Construction of the property used in the rental activity commenced prior to August 16, 1986. Under paragraph (c)(7)(ii) of this section, the taxpayer is treated as a party to the contracts to which the partnership was a party on October 22, 1986. Therefore, the taxpayer's interest in the partnership's rental activity is a qualified interest (within the meaning of paragraph (c)(2) of this section) because the taxpayer is treated as acquiring an interest in the partnership's rental activity pursuant to written binding contracts to which the taxpayer was party on October 22, 1986. Since the property used in the rental activity was under construction on August 16, 1986, the partnership's rental activity is a pre-enactment activity (within the meaning of paragraph (c)(3) of this section). Accordingly, the taxpayer's interest in the partnership's rental activity is a pre-enactment interest. Example (3). The facts are the same as in example (2), except that the partnership acquired the property after October 22, 1986, pursuant to a contract entered into after October 22, 1986. The taxpayer's interest in the partnership's rental activity is not a pre-enactment interest because such interest was not acquired pursuant to written binding contracts to which the taxpayer was a party on October 22, 1986. Example (4). The taxpayer owned a pre-enactment interest in an activity on October 22, 1986. After that date, the taxpayer died, and the decedent's interest in the activity passed to the decendent's estate. Since a decedent and the decedent's estate are not the same taxpayer, the estate must independently satisfy the requirements for a pre-enactment interest regardless of the fact that the decendent had a pre-enactment interest in the activity. Since the activity was being conducted by the decedent on October 22, 1986, the activity is a pre-enactment activity (within the meaning of paragraph (c)(3) of this section). Since, however, the estate did not hold any interest in the activity on October 22, 1986, the estate does not have a qualified interest in the activity (within the meaning of paragraph (c)(2) of this section). Accordingly, the estate does not have a pre-enactment interest in the activity. (5) Effect of changes in a taxpayer's interest in a pre-enactment activity-(i) In general. If the taxpayer's share for a taxable year of an item of income, gain, loss, deduction, or credit from a pre-enactment activity was increased or decreased at any time after October 22, 1986, and prior to the end of such taxable year (other than pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986), the share of such item that is attributable to the taxpayer's pre-enactment interest in such activity shall be determined by taking into account- (A) The taxpayer's share for such taxable year of such item as of October 22, 1986; reduced by (B) The greatest amount at any time subsequent to October 22, 1986, by which the sum of all the decreases in the taxpayer's share for such year of such item (other than decreases pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986) exceeds the sum of all the increases in the taxpayer's share for such year of such item (other than increases pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986).

For purposes of this paragraph (c)(5)(i), the taxpayer's share of an item as of October 22, 1986, is determined by taking into account any written binding contract to which the taxpayer was a party on October 22, 1986. (ii) Partnership terminations under section 708(b)(1)(B). A taxpayer's share for a taxable year of an item of income, gain, loss, deduction, or credit from a pre-enactment activity conducted by a partnership shall not be treated as having increased or decreased at any time after October 22, 1986, solely because the partnership is treated as terminating at any time after such date under section 708(b)(1)(B). (iii) Examples. The following examples illustrate the application of this paragraph (c)(5): Example (1). On October 22, 1986, an individual owned a 10 percent interest in a pre-enactment activity. After October 22, 1986, the taxpayer acquires an additional five percent interest in the activity pursuant to a contract entered into after October 22, 1986. Under this paragraph (c)(5), only the 10 percent interest in the activity the taxpayer owned on October 22, 1986, is a pre-enactment interest. Example (2). On October 22, 1986, individuals A and B each owned a rental activity. After October 22, 1986, A and B contribute their rental activities to a partnership in exchange for which each receives a 50 percent interest in all items of income, gain, loss, deduction, and credit of the partnership. Under paragraph (c)(5)(i) of this section, A's 50 percent interest in each partnership item attributable to the rental activity contributed by A is attributable to a pre-enactment interest. None of A's interest in the partnership items attributable to the rental activity contributed by B is attributable to a pre-enactment interest. Example (3). The facts are the same as in example (2), except that under the partnership agreement the items of income, gain, loss, deduction, and credit attributable to the rental activity A contributed to the partnership are allocated 80 percent to A and 20 percent to B. Under paragraph (c)(5)(i) of this section, A's 80 percent interest in each partnership item attributable to the rental activity contributed by A is attributable to a pre-enactment interest. Example (4). The facts are the same as in example (3) except that on January 1, 1988, the partnership liquidates, distributing to A the rental activity contributed by A to the partnership. Under paragraph (c)(5)(i) of this section, only 80 percent of A's interest in the rental activity distributed to A is a pre-enactment interest. Example (5). On October 22, 1986, an individual is the general partner in a limited partnership. Under the partnership agreement in effect on that date, the taxpayer is allocated one percent of each item of partnership income, gain, loss, deduction, and credit for 1987 and 10 percent of each such item for 1988. Since the increase was provided for in a written binding contract to which the taxpayer was a party on October 22, 1986, the increase in the taxpayer's share of each item of partnership income, gain, loss, deduction, and credit is taken into account, under paragraph (c)(5)(i) of this section, as income, gain, loss, deduction, and credit from a pre-enactment interest.

Example (6). The facts are the same as in example (5) except that the partnership agreement is amended on November 30, 1986. The amendment decreases the taxpayer's share of partnership depreciation for 1987 from 10 percent to five percent, but does not affect the partner's share of partnership depreciation for any other year. Since the taxpayer's share of partnership depreciation for 1988 is not decreased by the amendment, the result, for 1988, is the same as in example (5). For 1987, however, only five percent of the partnership depreciation is attributable to the taxpayer's pre-enactment interest even if, after November 30, 1986, another amendment to the partnership agreement restores the taxpayer's 10 percent share of partnership depreciation for 1987. Example (7). (i) A and B, calendar year individuals, own all the stock of X, a calendar year S corporation. On October 22, 1986, A and B each own 50 shares of X stock. On July 1, 1987, X issues an additional 100 shares of stock to B (but does not issue any additional stock to A). On December 1, 1987, A purchases 70 shares of X stock from B. Thus, A and B have the following shares of items of income, gain, loss, deduction, and credit from activities of X: ---------------------------------------------------- Period A's share B's share ---------------------------------------------------- 10/22/86-6/30/87 ................. 50% 50% 7/1/87-11/30/87 .................. 25% 75% 12/1/87- ......................... 60% 40% ---------------------------------------------------- (ii) Under paragraph (c)(5)(i) of this section, A and B each have a 50 percent share of each item of X as of October 22, 1986. Since there are no increases or decreases in their shares before June 30, 1987, their 50 percent shares of items of X assigned to the period from January 1, 1987, through June 30, 1987, are attributable to their pre-enactment interests. (iii) As a result of the decrease in A's share on June 30, 1987, only a 25 percent share of the items of X assigned to the period from July 1, 1987, through November 30, 1987, is attributable to A's pre-enactment interest. In addition, notwithstanding the increase in B's share, only a 50 percent share of such items (B's share as of October 22, 1986) is attributable to B's pre-enactment interest. (iv) As a result of the decrease in B's share on November 30, 1987, only a 40 percent share of the items of X assigned to the period from December 1, 1987, through December 31, 1987, is attributable to B's pre-enactment interest. In addition, notwithstanding the increase in A's share, only a 25 percent share of such items (A's share as of October 22, 1986, reduced by the amount of the decrease in A's share on June 30, 1987) is attributable to A's pre-enactment interest. (6) Special rule for beneficiaries of trusts or estates-(i) In general. If a beneficial interest in a trust or estate was held by a taxpayer on October 22, 1986, and at all times thereafter, any income, directly allocable deductions, and credits taken into account by the taxpayer with respect to such interest shall be treated as income, deductions, and credits, respectively, from a pre-enactment interest of the beneficiary if and only if such income, deductions, and credits are from a pre-enactment interest of the trust or estate. For purposes of the preceding sentence, "directly allocable deductions" means- (A) Depreciation allowable to the beneficiary under section 167(h); (B) Depletion allowable to the beneficiary under section 611(b)(3); and

(C) Amortization apportioned to the beneficiary under section 642(f). The following example illustrates the application of this paragraph (c)(6)(i): Example. The taxpayer is a beneficiary of a trust that conducts a rental activity. The trust's interest in the activity is a pre-enactment interest of the trust. On October 22, 1986, under the trust agreement the trustee had discretion to allocate any amount of the depreciation deductions from the rental activity to the beneficiary. Under this paragraph (c)(6)(i), any depreciation deductions from the rental activity that are allocated to the beneficiary will be treated as deductions attributable to a pre-enactment interest of the beneficiary. (ii) Interests distributed to beneficiaries. A beneficiary of a trust or estate to whom the trust or estate distributes an interest in an activity shall be treated as having a pre-enactment interest in the activity by reason of such distribution if and only if such interest was a pre-enactment interest of the trust or estate, and the beneficiary held a beneficial interest in the trust or estate on October 22, 1986, and at all times thereafter. (7) Written binding contract-(i) In general. A contract shall be treated as a written binding contract of a person for purposes of this section if and only if the contract is enforceable against such person under the applicable State law and does not limit damages to a specified amount (e.g., by use of a liquidated damages provision). For purposes of the preceding sentence, a contractual provision that limits damages to an amount equal to five percent or more of the total contract price is not treated as limiting damages. In general, a contract is binding upon a person even if it is subject to a condition, as long as the condition is not within the control of such person. A contract is not binding on any date with respect to a person if the contract became enforceable against such person only by reason of an assignment occurring after such date. The following example illustrates the application of this paragraph (c)(7)(i): Example. As of October 22, 1986, the taxpayer had signed a subscription agreement to acquire an interest in a partnership. The taxpayer's obligation to purchase an interest in the partnership was contingent on other persons signing subscription agreements by a particular date after October 22, 1986, to acquire a minimum number of the total interests offered for sale. If the taxpayer acquires an interest in the partnership, such interest will be treated as acquired pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986. Although the taxpayer's obligation to acquire an interest in the partnership was subject to a contingency, the contingency was not within the taxpayer's control. (ii) Special rule for contract of partnership or S corporation. For purposes of this section, a person shall be treated as a party to a contract on October 22, 1986, if on such date such person is a partner in a partnership or a shareholder in an S corporation (or is bound by a written contract to acquire an interest in such partnership or stock in such corporation) which itself is a party to such contract (or is treated under this paragraph (c)(7)(ii) as a party to such contract) on such date. (iii) Application of rule to partnership agreements. A provision of a partnership agreement shall be treated as a binding contract with respect to a partner if the requirements of this paragraph (c)(7) are otherwise satisfied and such partner does

not have the power to amend any provision of the partnership agreement without the consent of other partners. There is need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason, it is found impractical to issue this Treasury decision with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection (d) of that section. Lawrence B. Gibbs, Commissioner of Internal Revenue. Approved: February 12, 1988. O. Donaldson Chapoton, Assistant Secretary of the Treasury.

October 11, 1998

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final regulations under sections 46, 48 and 191 relating to an investment tax credit for qualified rehabilitation expenditures to qualified rehabilitated buildings. Changes to the applicable law were made by the Economic Recovery Tax Act of 1981, the Technical Corrections Act of 1982, the Tax Reform Act of 1984, and the Tax Reform Act of 1986. These regulations would provide the public with the guidance needed to comply with the law as amended by these Acts.

DATE

The amendments are generally effective for rehabilitation expenditures incurred after December 31, 1981.

FOR FURTHER INFORMATION CONTACT

Stuart G. Wessler of the Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Ave, NW., Washington, DC 20224 (Attention: CC:LR:T), (202-566-3297, not a toll-free call).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collections of information contained in this final regulation have been reviewed by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-0155. The estimated average burden per respondent/recordkeeper varies from 30 to 70 minutes, depending on individual circumstances, with an estimated average of 45 minutes. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to The Internal Revenue Service, Washington, DC 20224, Attention: IRS Reports Clearance Officer TR:FP, and to the Office of Management and Budget, Washington, DC 20503, Attention Desk Officer for the Internal Revenue Service.

Background

Proposed amendments to the Income Tax Regulations (26 CFR Part 1) were published in the Federal Register (50 FR 26794) on June 28, 1985. Those amendments were proposed to conform the regulations to section 212 of the Economic Recovery Tax Act of 1981 (95 Stat. 235), section 102(f) of the Technical Corrections Act of 1982 (96 Stat. 2371), and section 31(c), 111(e)(8), and 1043(a) of the Tax Reform Act of 1984 (98 Stat. 518, 631, and 1044). Approximately 30 written comments were received in response to the proposed regulations. A public hearing was held on November 15, 1985. Six speakers spoke at the public hearing. Subsequently, the provisions of the Code dealing with the rehabilitation tax credit were amended by section 251 of the Tax Reform Act of the 1986 (100 Stat. 2183). This Treasury decision reflects the revisions made to section 46(b)(4) and 48(g) by that Act. In General Section 38 of the Internal Revenue Code provides for a credit against tax in the case of investment in certain depreciable property (i.e., section 38 property). Section 48(a)(1)(E) of the Code defines section 38 property so as to include the portion of the basis of a qualified rehabilitated building that is attributable to qualified rehabilitation expenditures. Section 48(g) and §1.48-12 define the terms "qualified rehabilitated building" and "qualified rehabilitation expenditure". Section 46(b)(4)(A) provides rules for determining the rehabilitation percentage that is to be applied to qualified rehabilitation expenditures in order to determine the amount of the investment tax credit that is allowable under section 38 to a taxpayer. Rehabilitation Percentage The rehabilitation percentage has been substantially amended by the Tax Reform Act of 1986. As a result of these amendments, there is now a 20 percent credit for rehabilitations of certified historic structures and a 10 percent credit for rehabilitations of other buildings first placed in service before 1936. These percentages apply to property placed in service after December 31, 1986, unless such property qualifies under the transitional rules, in which case the rehabilitation percentage in the case of a certified historic structure remains at 25 percent, and the percentages for rehabilitations of 30-year buildings and 40-year buildings are 10 and 13 percent, respectively. Prior to this amendment, section 46(b)(4) provided for a three-tier rehabilitation percentage in the case of qualified rehabilitation expenditures. In general, section 46(b)(4)(A) provided that the rehabilitation percentage was 15 percent in the case of a 30-year building, 20 percent in the case of 40-year building, and 25 percent in the case of a certified historic structure. These percentages still apply to property placed in service before Janaury 1, 1987. Section 46(b)(4)(C), prior to its repeal in the Tax Reform Act of 1986, provided definitions relating to the three types of buildings. In general, a 30-year building was a building where 30 years have elapsed between the date the building was first placed in service and the date physical work on the rehabilitation began. A 40-year building was a building where 40 years have elapsed between these dates. The final regulations provide for an allocation rule in certain cases where additions have been made to a building.

Section 46(b)(4) provides that the regular percentages and the energy percentages do not apply to that portion of the basis of any property which is attributable to qualified rehabilitation expenditures. Property Used for Lodging In general, section 48(a)(3) provides that section 38 property does not include property which is used predominantly to furnish lodging. The Economic Recovery Tax Act amended section 48(a)(3) to provide an exception to this exclusion in the case of certified historic structures. Qualified Rehabilitated Buildings The term "qualified rehabilitated building" is defined in section 48(g)(1) and §1.48- 12(b). In order to qualify as a qualified rehabilitated building, four requirements must be met. First, the building must have been placed in service before the beginning of the rehabilitation. Second, the building must meet an existing external wall or internal structural framework retention test. Third, the building must meet an age requirement unless it is a certified historic structure. Fourth, the building must have been substantially rehabilitated. The final regulations contain additional restrictions that apply in the cases of buildings that have been moved. Rehabilitation is distinguished from new construction in these final regulations. A quantitative test for substantial rehabilitation is provided in section 48(g)(1)(C) and §1.48-12(b)(2). In general, the qualified rehabilitation expenditures during the appropriate measuring period must exceed the greater of $5,000 or the adjusted basis of the property. The final regulations provide rules for applying the test in various contexts. Qualified Rehabilitation Expenditure The term "qualified rehabilitation expenditure" is defined in section 48(g)(2) and §1.48-12(c). In general, the expenditures must be for property chargeable to capital account and must be incurred after December 31, 1981, for depreciable real property in connection with the rehabilitation of a qualified rehabilitated building. Section 48(g)(2)(B) and §1.48-12(c) exclude certain expenditures from the definition of qualified rehabilitation expenditures. The final regulations clarify that the term "qualified rehabilitation expenditures" is not limited to those expenditures incurred during the relevant measuring period used for purposes of the substantial rehabilitation test. In the case of rehabilitated property placed in service in a taxable year, if the building qualified as a qualified rehabilitated building for that year, the taxpayer can claim as qualified rehabilitation expenditures the expenditures incurred before the beginning of the measuring period, during the measuring period, and after the measuring period but before the end of the taxable year. Certified Historic Structure The term "certified historic structure" is defined in section 48(g)(3) and §1.48-12(d). In general, a certified historic structure is a building (and its structural components) which is listed in the National Register, or which is located in a registered historic district and is certified by the Secretary of the Interior as being of historic

significance to the district. Although procedures for obtaining a National Register listing or a certification of significance are generally within the authority of the Department of Interior, (and therefore outside the scope of the Internal Revenue Code), these final regulations to address the issue of when an investment tax credit can be claimed in the case of a pending application for certification by the Department of Interior. Adjustments To Basis Section 48(q) and §1.48-12(e) provides rules concerning an adjustment to the basis of a qualified rehabilitated building. In general, the increase in the basis of the building that would result from the qualified rehabilitation expenditures must be reduced by the amount of the credit allowed under section 38 (50 percent of the credit in the case of property attributable to a certified historic structure that is either placed in service before January 1, 1987, or qualifies under the transitional rules). Coordination With Other Provisions Section 1.48-12(f) provides rules relating to the coordination between section 48(g) and various other provisions of the Internal Revenue Code of 1986. Rules and cross-references to other provisions of the Code are provided. Section 191 Section 191, relating to amortization of rehabilitation expenditures for certified historic structures, was repealed by the Economic Recovery Tax Act of 1981 for expenditures incurred after December 31, 1981. These final regulations reflect the repeal. Public Comments and Changes in Response To Public Comments Moved Buildings A number of commentators questioned the rule in the proposed regulations concerning buildings other than certified historic structures that have been moved within the last thirty or forty years. Some of these commentators asked for limited exceptions in the case of certain relocations. The Treasury Department continues to believe that the nonhistoric credit provisions were specifically intended to stimulate rehabilitations of buildings at their existing locations. Therefore, no change was made. Substantial Rehabilitation Determination with Respect to Acquiring Taxpayer Several commentators asked that the regulations be modified to provide that a transferor who substantially rehabilitated a building be allowed to transfer the building to an acquiring taxpayer without the acquiring taxpayer making a substantial rehabilitation determination based on his cost basis at the time of transfer. The final regulations require that, in certain cases, an acquiring taxpayer is treated as having incurred the rehabilitation expenditures actually incurred by a transferor. However, section 48(g)(1)(C) requires the taxpayer to determine the adjusted basis of the building for purposes of the substantial rehabilitation test at the beginning of his holding period if he holds the building for less than 24 months. Given this statutory requirement, the Treasury Department continues to believe that

the substantial rehabilitation test must be applied with respect to the transferee rather than being simply carried over from the transferor. A limited exception is provided, however, in the case of lessees who rehabilitate buildings that are transferred by the lessor during the rehabilitation project. Late Certification of Building's Status as Certified Historic Structure A number of commentators asked that the regulations be clarified to provide that in the case of the credit for certified historic structures a building need not have been determined to be a certified historic structure at the time the expenditures were incurred, at the time the rehabilitated expenditures were placed in service, or at the time the credit was claimed so long as there was a pending application for certification at such time which was later approved. Since this was the intent of the proposed rule dealing with late certifications, this clarifying change has been made. Construction Period Interest Incurred in Connection With Acquisition of Building or Land A commentator questioned the rule in the proposed regulations that treated interest incurred on a loan to acquire the building shell or the land on which the building rests as a disqualifying cost of acquisition. The Treasury Department gave careful consideration to this comment, and continues to believe that interest incurred on a loan to acquire or carry the land or shell should not be treated as a qualified rehabilitation expenditure. However, interest incurred on a construction loan used to finance the rehabilitation can be treated as a qualified rehabilitation expenditure if such interest is properly capitalized and added to basis of the building. Other Comments Numerous other comments were received that asked for clarification of the proposed rules. In general, these final regulations provide that clarification. Regulatory Flexibility Act and Executive Order 12291 The Commissioner of Internal Revenue has determined that this final rule is not a major rule as defined in Executive Order 12291. Accordingly, a Regulatory Impact Analysis is not required. Although a notice of proposed rulemaking that solicited public comment was issued, the Internal Revenue Service concluded when the notice was issued that the regulations are interpretative and that the notice and public procedure requirements of 5 U.S.C. 553 do not apply. Accordingly, these regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6).

Drafting Information

The principal author of these final regulations is John G. Schmalz of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, both on matters of style and substance.

List of Subjects

26 CFR 1.0-1-1.58-8 Income taxes, Tax liability, Tax rates, Credits. 26 CFR 1.61-1-1.281-4 Income taxes, Taxable income, Deductions, Exemptions. 26 CFR Part 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR Part 1 and Part 602 are amended as follows:

PART 1-[AMENDED]

Paragraph 1. The authority for Part 1 continues to read in part:

Authority

26 U.S.C. 7805. Section 1.48-12(b)(2) also issued under 26 U.S.C. 48(g)(1)(C) (i) and (iii). Par. 2. Section 1.46-1 is amended by revising paragraphs (a)(2) and (d), by adding a new paragraph (e)(5), and by adding a new paragraph (q) at the end thereof, to read as follows:

§1.46-1 Determination of amount.

(a) Effective dates. (2) Acts covered. This section reflects changes made by the following Acts of

Congress

Act and Section Tax Reduction Act of 1975, section 301. Tax Reform Act of 1976, sections 802, 1701, 1703. Revenue Act of 1978, sections 311, 312, 315. Energy Tax Act of 1978, section 301. Economic Recovery Tax Act of 1981, section 212.

Technical Corrections Act of 1982, section 102(f). Tax Reform Act of 1986, section 251. (d) Credit earned. The credit earned for the taxable year is the sum of the following percentages of qualified investment (as determined under section 46 (c) and (d))- (1) The regular percentage (as determined under section 46), (2) For energy property, the energy percentage (as determined under section 46), and (3) For the portion of the basis of a qualified rehabilitated building (as defined in §1.48-12(b)) that is attributable to qualified rehabilitation expenditures (as defined in §1.48-12(c)), the rehabilitation percentage (as determined under section 46(b)(4)). (e) Designation of credits. The credit available for the taxable year is designated as follows: (5) The credit attributable to the rehabilitation percentage for qualified rehabilitation expenditures is the rehabilitation investment credit. (q) Rehabilitation percentage-(1) General rule-(i) In general. Due to amendments made by the Tax Reform Act of 1986, different rules apply depending on when the property attributable to the qualified rehabilitated expenditures (as defined in §1.48- 12(c)) is placed in service. Paragraph (q)(1)(ii) of this section contains the general rule relating to property placed in service after December 31, 1986. Paragraph (q)(1)(iii) of this section contains rules relating to property placed in service before January 1, 1987. Paragraph (q)(1)(iv) of this section contains rules relating to property placed in service after December 31, 1986, that qualifies for a transition rule. (ii) Property placed in service after December 31, 1986. Except as otherwise provided in paragraph (q)(1)(iv) of this section, in the case of section 38 property described in section 48(a)(1)(E) placed in service after December 31, 1986, the term "rehabilitation percentage" means- (A) 10 percent in the case of qualified rehabilitation expenditures with respect to a qualified rehabilitated building other than a certified historic structure, and (B) 20 percent in the case of qualified rehabilitation expenditures with respect to a certified historic structure. (iii) Property placed in service before January 1, 1987. For qualified rehabilitation expenditures (as defined in §1.48-12(c)) with respect to property placed in service before January 1, 1987, section 46(b)(4)(A) as in effect prior to the enactment of the Tax Reform Act of 1986 provided for a three-tier rehabilitation percentage. The applicable rehabilitation percentage for such expenditures depends on whether the qualified rehabilitated building is a "30-year building," a "40-year building," or a certified historic structure (as defined in section 48(g)(3) and §1.48-12(d)(1)). The rehabilitation percentage for such qualified rehabilitation expenditures incurred with respect to a qualified rehabilitated building is 15 percent to the extent that the building is a 30-year building (i.e., at least 30 years, but less than 40 years, has elapsed between the date the physical work on the rehabilitation began and the date the building was first placed in service), 20 percent to the extent that the building is a 40-year building (i.e., at least 40 years has so elapsed), and 25 percent for certified historic structures, regardless of age. See paragraph (q)(2)(ii) of this section for rules concerning buildings to which additions have been added. (iv) Property placed in service after December 31, 1986, that qualifies under the transition rules. In the case of section 38 property described in section 48(a)(1)(E) placed in service after December 31, 1986, and to which the amendments made by section 251 of the Tax Reform Act of 1986 do not apply because the transition rules

in section 251(d) of that Act and §1.48-12(a)(2)(iv) (B) or (C) apply, the rehabilitation percentage for a "30-year building" (within the meaning of paragraph (q)(1)(iii) of this section) shall be 10 percent, the rehabilitation percentage for a "40-year building" (within the meaning of paragraph (q)(1)(iii) of this section) shall be 13 percent, and the rehabilitation percentage for a certified historic structure shall be 25 percent. (2) Special rules-(i) Moved buildings. With respect to paragraph (q)(1)(ii) of this section, §1.48-12(b)(5) provides that a building (other than a certified historic structure) is not a qualified rehabilitated building unless it has been at the location where it is being rehabilitated since January 1, 1936. In addition, for purposes of paragraph (q)(1) (iii) and (iv) of this section, a building is not a "30-year building" unless it has been at the location where it is being rehabilitated for the thirty-year period immediately preceding the beginning of the rehabilitation process, and is not a "40-year building" unless it has been at the location where it is being rehabilitated for the forty-year period immediately preceding the beginning of the rehabilitation process. (ii) Building to which additions have been added-(A) Property placed in service after December 31, 1986. For purposes of paragraph (q)(1)(ii) of this section, if part of a building meets the definition of a qualified rehabilitated building, and part of the building does not meet the definition of a qualified rehabilitated building because such part is an addition that was placed in service after December 31, 1935, the qualified rehabilitation expenditures made to the building must be allocated to the pre-1936 portion of the building and the post-1935 portion of the building using the principles in §1.48-12(c)(10)(ii). Qualified rehabilitation expenditures attributable to the post-1935 addition shall not qualify for the 10 percent rehabilitation percentage. (B) Property placed in service before January 1, 1987, and property qualifying for a transitional rule. For purposes of paragraph (q)(1) (iii) and (iv) of this section, if part of a building meets the definition of a "40-year building" and part of the building is an addition that was placed in service less than forty years before physical work on the rehabilitation began but more than thirty years before such date, then the qualified rehabilitation expenditures made to the building shall be allocated between the forty year old portion of the building and the thirty year old portion of the building, and a 20 percent rehabilitation percentage shall be applied to the forty year old portion of the building and a 15 percent rehabilitation percentage shall be applied to the thirty year old portion. This allocation shall be made using the principles in §1.48-12(c)(10)(ii). If an allocation cannot be made between the expenditures to the forty year old portion of the building and the thirty year old portion of the building, then the building will be considered to be a 30-year building. Furthermore, for purposes of this paragraph (q), a building (other than a certified historic structure) is not a qualified rehabilitated building to the extent of that portion of the building that is less than 30 years old. If rehabilitation expenditures are incurred with respect to an addition to a qualified rehabilitated building, but the addition is not considered to be part of the qualified rehabilitated building because the addition does not meet the age requirement in section 48(g)(1)(B) (as in effect prior to its amendment by the Tax Reform Act of 1986) and §1.48-12(b)(4)(i)(B), then no rehabilitation percentage will be applied to the expenditures attributable to the rehabilitation of the addition. Thus, for purposes of paragraph (q)(1) (iii) and (iv) of this section, it may be necessary to allocate rehabilitation expenditures inc urred with respect to a building between the original portion of the building and the addition. (iii) Mixed-use buildings. If qualified rehabilitation expenditures are incurred for property that is excluded from section 38 property described in section 48(a)(1)(E) (because, for example, they are made with respect to a portion of the building used for lodging within the meaning of section 48(a)(3) and §1.48-1(h)), an allocation of

the expenditures must be made between the expenditures that result in an addition to basis that is section 38 property and the expenditures that result in an addition to basis that is excluded from the definition of section 38 property since the rehabilitation percentage is applicable only to section 38 property. These allocations should be made using the principles contained in §1.48-12(c)(10)(ii). (3) Regular and energy percentages not to apply. The regular percentage and the energy percentage shall not apply to that portion of the basis of any building that is attributable to qualified rehabilitation expenditures (as defined in §1.48-12(c)). (4) Effective date. The rehabilitation percentage is applicable only to qualified rehabilitation expenditures (as defined in §1.48-12(c)). For rules relating to applicability of the regular percentage to qualified rehabilitation expenditures (as defined in §1.48-11(c)), see §1.48-11. Par. 3. Section 1.48-1 is amended by adding new paragraphs (h)(1)(iii) and (h)(2)(iv) to read as follows:

§1.48-1 Definition of section 38 property.

(h) Property used for lodging-(1) In general. (iii) Notwithstanding any other provision of this paragraph (h), in the case of a qualified rehabilitated building (within the meaning of section 48(g)(1) and §1.48- 12(b)), expenditures for property resulting in basis described in section 48(a)(1)(E) shall not be treated as section 38 property to the extent that such property is attributable to a portion of the building that is used for lodging or in connection with lodging. For example, if expenditures are incurred to rehabilitate a five story qualified rehabilitated building, three floors of which are used for apartments and two floors of which are used as commercial office space, the portion of the basis of the building attributable to qualified rehabilitated expenditures attributable to the commercial part of the building shall not be considered to be expenditures for property, or in connection with property, used predominantly for lodging. Allocation of expenditures between the two portions of the building are to be made using the principles contained in §1.48-12(C)(10)(ii). (2) Exceptions. (iv) Certified historic structures. For purposes of this paragraph (h), regardless of the actual use of a certified historic structure, that portion of the basis of such certified historic structure which is attributable to qualified rehabilitation expenditures (as defined in §1.48-12(c)) shall not be considered as property which is either used predominantly to furnish lodging or predominantly in connection with the furnishing of lodging. Accordingly, such portion of the basis may qualify as section 38 property. (For the definition of "certified historic strucutre," see section 48(g)(3) and §1.48- 12(d).) Par. 4. There is inserted immediately after §1.48-11 a new §1.48-12 to read as follows:

§1.48-12 Qualified rehabilitated building; expenditures incurred after

December 31, 1981. (a) General rule-(1) In general. Under section 48(a)(1)(E), the portion of the basis of a qualified rehabilitated building that is attributable to qualified rehabilitation expenditures (within the meaning of section 48(g) and this section) is section 38 property. Property that is section 38 property by reason of section 48(a)(1)(E) is treated as new section 38 property and, therefore, is not subject to the used property limitation in section 48(c). Section 48(g)(1) and paragraph (b) of this section define the term "qualified rehabilitated building." Section 48(g)(2) and paragraph (c) of this section define the term "qualified rehabilitation expenditure." Section 48(g) (2)(B)(iv) and (3) and paragraph (d) of this section describe the rules applicable to "certified historic structures." Section 48(q) and paragraph (e) of this section provide rules concerning an adjustment to the basis of the rehabilitated

building. Paragraph (f) of this section provides guidance for coordination of these provisions with other sections of the Code, including rules for determining when the rehabilitation credit may be claimed. (2) Effective dates and transition rules-(i) In general. Except as otherwise provided in this paragraph (a)(2)(i), this section applies to expenditures incurred after December 31, 1981, in connection with the rehabilitation of a qualified rehabilitated building. (See paragraph (c)(3)(i) of this section for rules concerning the determination of when an expenditure is incurred.) If, however, physical work on the rehabilitation began before January 1, 1982, and the building does not meet the requirements of paragraph (b) of this section, the rules in §1.48-11 shall apply to the expenditures incurred after December 31, 1981, in connection with such rehabilitation. (See paragraph (b)(6)(i) of this section for rules determining when physical work on a rehabilitation begins.) (ii) Transition rules concerning ACRS lives. (A) For property placed in service before March 16, 1984, and any property subject to the exception set forth in section 111(g)(2) of Pub. L. 98-369 (Deficit Reduction Act of 1984), the references to "19 years" in paragraph (c) (4)(ii) and (7)(v) shall be replaced with "15 years" and the reference to "19-year real property" in paragraph (c)(4)(ii) shall be replaced with "15-year real property." (B) Except as otherwise provided in paragraph (a)(2)(ii)(A) of this section, for property placed in service before May 9, 1985, and any property subject to the exception set forth in section 105(b) (2) and (5) of Pub. L. 99-121 (99 Stat. 501, 511), the reference to "19 years" in paragraph (c) (4)(ii) and (7)(v) shall be replaced with "18 years" and the references to "19-years real property" in paragraph (c)(4)(ii) shall be replaced with "18-year real property." (iii) Transition rule concerning external wall definition. Notwithstanding the definition of external wall contained in paragraph (b)(3)(ii) of this section, in any case in which the written plans and specifications for a rehabilitation were substantially completed on or before June 28, 1985, and the building being rehabilitated would fail to meet the requirement of paragraph (b)(1)(iii) of this section if the definition of external wall in paragraph (b)(3)(ii) of this section were used, the term "external wall" shall be defined as a wall, including its supporting elements, with one face exposed to the weather or earth, and a common wall shall not be treated as an external wall. See paragraph (b)(2)(v) of this section for the definition of written plans and specifications. (iv) Transition rules concerning amendments made by the Tax Reform Act of 1986- (A) In general. Except as otherwise provided in section 251(d) of the Tax Reform Act of 1986 and this paragraph (a)(2)(iv), the amendments made by section 251 of the Tax Reform Act of 1986 shall apply to property placed in service after December 31, 1986, in taxable years ending after that date, regardless of when the rehabilitation expenditures attributable to such property were incurred. If property attributable to qualified rehabilitation expenditures is incurred with respect to a rehabilitation to a building placed in service in segments or phases and some segments are placed in service before January 1, 1987, and the remaining segments are placed in service after December 31, 1986, the amendments under the Tax Reform Act would not apply to the property placed in service before January 1, 1987, but would apply to the segments placed in service after December 31, 1986, unless one of the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section applies. (B) General transition rule. The amendments made by sections 251 and 201 of the Tax Reform Act of 1986 shall not apply to property that qualifies under section 251(d) (2), (3), or (4) of the Tax Reform Act of 1986. Property qualifies for the general transition rule in section 251(d)(2) of the Act if such property is placed in service before January 1, 1994, and if such property is placed in service as part of-

(1) A rehabilitation that was completed pursuant to a written contract that was binding on March 1, 1986, or (2) A rehabilitation incurred in connection with property (including any leasehold interest) acquired before March 2, 1986, or acquired on or after such date pursuant to a written contract that was binding on March 1, 1986, if- (i) Parts 1 and 2 of the Historic Preservation Certificate Application were filed with the Department of the Interior (or its designee) before March 2, 1986, or (ii) The lesser of $1,000,000 or 5 percent of the cost of the rehabilitation is incurred before March 2, 1986, or is required to be incurred pursuant to a written contract which was binding on March 1, 1986. (C) Specific rehabilitations. See section 251(d) (3) and (4) of the Tax Reform Act of 1986 for additional rehabilitations that are exempted from the amendments made by sections 251 and 201 of the Tax Reform Act of 1986. (b) Definition of qualified rehabilitated building- (1) In general. The term "qualified rehabilitated building" means any building and its structural components- (i) That has been substantially rehabilitated (within the meaning of paragraph (b)(2) of this section) for the taxable year, (ii) That was placed in service (within the meaning of §1.46-3(d)) as a building by any person before the beginning of the rehabilitation, and (iii) That meets the applicable existing external wall retention test or the existing external wall and internal structural framework retention test in accordance with paragraph (b)(3) of this section. The requirement in paragraph (b)(1)(iii) of this section does not apply to a certified historic structure. See paragraph (b) (4) and (5) of this section for additional requirements related to the definition of a qualified rehabilitated building. (2) Substantially rehabilitated building-(i) Substantial rehabilitation test. A building shall be treated as having been substantially rehabilitated for a taxable year only if the qualified rehabilitation expenditures (as defined in paragraph (c) of this section) incurred during any 24-month period selected by the taxpayer ending with or within the taxable year exceed the greater of- (A) The adjusted basis of the building (and its structural components), or (B) $5,000. (ii) Date to determine adjusted basis of the building-(A) In general. The adjusted basis of the building (and its structural components) shall be determined as of the beginning of the first day of the 24-month period selected by the taxpayer or the first day of the taxpayer's holding period of the building (within the meaning of section 1250(e)), whichever is later. For purposes of determining the holding period under section 1250(e), any reconstruction that is part of the rehabilitation shall be disregarded. (B) Special rules. In the event that a building is not owned by the taxpayer, the adjusted basis of the building shall be determined as of the date that would have been used if the owner had been the taxpayer. The adjusted basis of a building that is being rehabilitated by a taxpayer other than the owner shall thus be determined as of the beginning of the first day of the 24-month period selected by the taxpayer or the first day of the owner's holding period, whichever is later. Therefore, if a building that is being rehabilitated by a lessee is sold subject to the lease prior to the date that the lessee has substantially rehabilitated the building, the lessee's adjusted basis is determined as of the beginning of the first day of the new lessor's holding period or the beginning of the first day of the 24-month period selected by the lessee (the taxpayer), whichever is later. If, therefore, the first day of the new lessor's holding period were later than the first day of the 24-month period selected by the lessee (the taxpayer), the lessee's adjusted basis for purposes of the substantial

rehabilitation test would be the same as the adjusted basis of the new lessor as determined under paragraph (b)(2)(vii) of this section. If a building is sold after the date that a lessee has substantially rehabilitated the building with respect to the original lessor's adjusted basis, however, the lessee's basis may be determined as of the first day of the 24-month period selected by the lessee or the first day of the original lessor's holding period, whichever is later, and the transfer of the building will not affect the adjusted basis for purposes of the substantial rehabilitation test. The preceding sentence shall not apply, however, if the building is sold to the lessee or a related party within the meaning of section 267(b) or section 707(b)(1). (iii) Adjusted basis of the building-(A) In general. The term "adjusted basis of the building" means the aggregate adjusted basis (within the meaning of section 1011(a)) in the building (and its structural components) of all the parties who have an interest in the building. (B) Special rules. In the case of a building that is leased to one or more tenants in whole or inpart, the adjusted basis of the building is determined by adding the adjusted basis of the owner (lessor) in the building to the adjusted basis of the lessee (or lessees) in the leasehold and any leasehold improvements that are structural components of the building. Similarly, in the case of a building that is divided into condominium units, the adjusted basis of the building means the aggregate adjusted basis of all of the respective condominium owners (including the basis of any el ssee in the leasehold and leasehold improvements) in the building (and its structural components). If the adjusted basis of a building would be determined in whole or in part by reference to the adjusted basis of a person or persons other than the taxpayer (e.g., a rehabilitation by a lessee) and the taxpayer is unable to obtain the required information, the taxpayer must establish by clear and convincing evidence that the adjusted basis of such person or persons in the building on the date specified in paragraph (b)(2)(ii) of this section is an amount that is less than the amount of qualified rehabilitation expenditures incurred by the taxpayer. If no such amount can be so established, the adjusted basis of the building will be deemed to be the fair market value of the building on the relevant date. For purposes of determining the adjusted basis of a building, the portion of the adjusted basis of a building that is allocable to an addition (within the meaning of paragraph (b)(4)(ii) of this section) to the building that does not meet the age requirement in paragraph (b)(4)(i) of this section shall be disregarded. (See paragraph (b)(2)(vii) of this section for the rule applicable to the determination of the adjusted basis of a building when qualified rehabilitation expenditures are treated as incurred by the taxpayer.) (iv) Rehabilitation. Rehabilitation includes renovation, restoration, or reconstruction of a building, but does not include an enlargement (within the meaning of paragraph (c)(10) of this section) of new construction. The determination of whether expenditures are attributable to the rehabilitation of an existing building or to new construction shall be based upon all the facts and circumstances. (v) Special rule for phased rehabilitation. In the case of any rehabilitation that may reasonably be expected to be completed in phases set forth in written architectural plans and specifications completed before the physical work on the rehabilitation begins, paragraphs (b)(2) (i), (ii), and (vii) of this section shall be applied by substituting "60-month period" for "24-month period." A rehabilitation may reasonably be expected to be completed in phases if it consists of two or more distinct stages of development. The determination of whether a rehabilitation consists of distinct stages and therefore may reasonably be expected to be completed in phases shall be made on the basis of all the relevant facts and circumstances in existence before physical work on the rehabilitation begins. For purposes of this paragraph and paragraph (a)(2)(iii) of this section, written plans

that describe generally all phases of the rehabilitation process shall be treated as written architectural plans and specifications. Such written plans are not required to contain detailed working drawings or detailed specifications of the materials to be used. In addition, the taxpayer may include a description of work to be done by lessees in the written plans. For example, where the owner of a vacant four story building plans to rehabilitate two floors of the building and plans to require, as a condition of any lease, that tenants of the other two floors must rehabilitate those floors, the requirements of this paragrpah (b)(2)(v) shall be met if the owner provides written plans for the rehabilitation work to be done by the owner and a description of the rehabilitation work that the tenants will be required to complete. The work required of the tenants may be described in the written plans in terms of minimum specifications (e.g., as to lighting, wiring, materials, appearance) that must be met by such tenants. See paragraph (b)( 6)(i) of this section for the definition of physical work on a rehabilitation. (vi) Treatment of expenses incurred by persons who have an interest in the building. For purposes of the substantial rehabilitation test in paragraph (b)(2)(i) of this section, the taxpayer may take into account qualified rehabilitation expenditures incurred during the same rehabilitation process by any other person who has an interest in the building. Thus, for example, to determine whether a building has been substantially rehabilitated, a lessee may include the expenditures of the lessor and of other lessees; a condominium owner may include the expenditures incurred by other condominium owners; and an owner may include the expenditures of the lessees. (vii) Special rules when qualified rehabilitation expenditures are treated as incurred by the taxpayer. In the case where qualified rehabilitation expenditures are treated as having been incurred by a taxpayer under paragraph (c)(3)(ii) of this section, the transferee shall be treated as having incurred the expenditures incurred by the transferor on the date that the transferor incurred the expenditures with the meaning of paragraph (c)(3)(i) of this section. For purposes of the substantial rehabilitation test in paragrpah (b)(2)(i) of this section, the transferee's adjusted basis in the building shall be determined as of the beginning of the first day of a 24-month period, or the first day of the transferee's holding period, whichever is later, as provided in paragraph (b)(2)(ii) of this section. The transferee's basis as of the first day of the transferee's holding period for purposes of the substantial rehabilitation test in paragraph (b)(2)(i) of this section, however, shall be considered to be equal to the transferee's basis in the building on such date less- (A) The amount of any qualified rehabilitation expenditures incurred (or treated as having been incurred) by the transferor during the 24-month period that are treated as having been incurred by the transferee under paragraph (c)(3)(ii) of this section, and (B) The amount of qualified rehabilitation expenditures incurred before the transfer and during the 24-month period by any other person who has an interest in the building (e.g., a lessee of the transferor). The preceding sentence shall not apply, however, unless the transferee's basis in the building is determined with reference to (1) the transferee's cost of the building (including the rehabilitation expenditures), (2) the transferor's basis in the building (where such basis includes the amount of the expenditures), or (3) any other amount that includes the cost of the rehabilitation expenditures. In the event that the transferee's basis is determined with reference to an amount not described above (e.g., transferee's basis in one building is determined with reference to the transferee's basis in another building under section 1031(d)), the amount of the expenditures incurred by the transferor and treated as having been incurred by the transferee are not deducted from the transferee's basis for purposes of the substantial rehabilitation test. If a transferee's basis is determined under section 1014, any expenditures incurred by the decedent

within the measuring period that are treated as having been incurred by the transferee under paragraph (c)(3)(ii) of this section shall decrease the transferee's basis for purposes of the substantial rehabilitation test. (viii) Statement of adjusted basis, measuring period, and qualified rehabilitation expenditures. In the case of any tax return filed after August 27, 1985, on which an investment tax credit for property, described in section 48(a)(1)(E) is claimed, the taxpayer shall indicate by way of a marginal notation on, or a supplemental statement attached to, Form 3468- (A) The beginning and ending dates for the measuring period selected by the taxpayer under section 48(g)(1)(C)(i) and paragraph (b)(2) of this section, (B) The adjusted basis of the building (within the meaning of paragraph (b)(2) (iii) or (vii) of this section) as of the beginning of such measuring period, and (C) The amount of qualified rehabilitation expenditures incurred, and treated as incurred, respectively, during such measuring period. Furthermore, for returns filed after August 27, 1985, if the adjusted basis of the building for purposes of the substantial rehabilitation test is determined in whole or in part by reference to the adjusted basis of a person, or persons, other than the taxpayer (e.g., a rehabilitation by a lessee), the taxpayer must attach to the Form 3468 filed with the tax return on which the credit is claimed a statement addressed to the District Director, signed by such third party, that states the first day of the third party's holding period and the amount of the adjusted basis of such third party in the building at the beginning of the measuring period or the first day of the holding period, whichever is later. If the taxpayer is unable to obtain the required information, that fact should be indicated and the taxpayer should state the manner in which the adjusted basis was determined and, if different, the fair market value of the building on the relevant date. (ix) Partnerships and S corporations. If a building is owned by a partnership (i.e., the building is partnership property) or an S corporation, the substantial rehabilitation test shall be determined at the entity level. Thus, the entity shall compare the amount of qualified rehabilitation expenditures incurred during the measuring period against its basis in the building at the beginning of its holding period or the beginning of its measuring period, whichever is later. (See section 1223(2) for rules concerning the determination of a partnership's holding period in the case of a contribution of property to the partnership meeting the requirements of section 721.) The adjusted basis of the building to a partnership shall be determined by taking into account any adjustments to the basis of the building made under section 743 and section 734. Any adjustments to the building's basis that are made under section 743 or section 734 after the beginning of the partnership's holding period, but before the end of the measuring period, shall be deemed for purposes of the substantial rehabilitation test to have been made on the first day of the partnership's holding period. However, in such case, the partnership's basis in the building shall be reduced by the amount of qualified rehabilitation expenditures incurred by the partnership. In the case of any tax return filed after January 9, 1989 on which a credit is claimed by a partner or a shareholder of an S corporation for rehabilitation expenditures incurred by a partnership or an S corporation, the partner or shareholder shall indicate on the Form 3468 on which the credit is claimed the name, address, and identification number of the partnership or S corporation that incurred the rehabilitation expenditures, and the partnership or S corporation shall, by way of a marginal notation on or a supplemental statement attached to the entity's return, provide the information required by paragraph (b)(2)(viii) of this section. (x) Examples. The following examples illustrate the application of the substantial rehabilitation test in this paragraph (b)(2):

Example (1). Assume that A, a calendar year taxpayer, purchases a building for $140,000 on January 1, 1982, incurs qualified rehabilitation expenditures in the amount of $48,000 (at the rate of $4,000 per month) in 1982, $100,000 in 1983, and $20,000 (at the rate of $2,000 per month) in the first ten months of 1984, and places the rehabilitated building in service on October 31, 1984. Assume that A did not have written architectural plans and specifications describing a phased rehabilitation within the meaning of paragraph (b)(2)(v) of this section in existence prior to the beginning of physical work on the rehabilitation. For purposes of the substantial rehabilitation test in paragraph (b)(2) of this section, A may select any 24-consecutive-month measuring period that ends in 1984, the taxable year in which the rehabilitated building was placed in service. Assume that on A's 1984 return, A selects a measuring period beginning on February 1, 1982, and ending on January 31, 1984, and specifies that A's basis in the building (within the meaning of section 1011(a)) was $144,000 on February 1, 1982 ($140,000+$4,000). (The $4,000 of rehabilitation expenditures incurred during January 1982 are included in A's basis under section 1011 even though such property has not been placed in service.) The amount of qualified rehabilitation expenditures incurred during the measuring period was $146,000 ($44,000 from February 1 to December 31, 1982, plus $100,000 in 1983, plus $2,000 in January 1984). The building shall be treated as "substantially rehabilitated" within the meaning of this paragraph (b)(2) for A's 1984 taxable year because the $146,000 of expenditures incurred by A during the measuring period exceeded A's adjusted basis of $144,000 at the beginning of the period. If the other requirements of section 48(g)(1) and this paragraph are met, the building is treated as a qualified rehabilit ated building, and A can treat as qualified rehabilitation expenditures the amount of $168,000 (i.e., $146,000 of expenditures incurred during the measuring period, $4,000 of expenditures incurred prior to the beginning of the measuring period as part of the rehabilitation process, and $18,000 of expenditures incurred after the measuring period during the taxable year within which the measuring period ends (See paragraph (c)(6) of this section.)). The result would generally be the same if the property attributable to the rehabilitation expenditures was placed in service as the expenditures were incurred, but A would have $148,000 of qualified rehabilitation expenditures for 1983 and $20,000 of qualified rehabilitation expenditures for 1984. (See paragraph (f)(2) of this section). Example (2). Assume the same facts as in example (1), except that additional rehabilitation expenditures are incurred after the portion of the basis of the building attributable to qualified rehabilitation expenditures was placed in service on October 31, 1984. Such expenditures are incurred through the end of 1984 and in 1985 when the portion of the basis attributable to the additional expenditures is placed in service. The fact that the building qualified as a substantially rehabilitated building for A's 1984 taxable year has no effect on whether the building is a qualified rehabilitated building for property placed in service in A's 1985 taxable year. In order to determine whether the building is a qualified rehabilitated building for A's 1985 taxable year, A must select a measuring period that ends in 1985 and compare the expenditures incurred within that period with the adjusted basis as of the beginning of the period. Solely for the purpose of determining whether the building was substantially rehabilitated for A's 1985 taxable year, expenditures incurred during 1983 and 1984, even though considered in determining whether the building was substantially rehabilitated in 1984, may also be used to determine whether the building was substantially rehabilitated for A's 1985 taxable year, provided the expenditures were incurred during any 24-month measuring period selected by A that ends in 1985. Example (3). (i) Assume the B purchases a building for $100,000 on January 1, 1982, and leases the building to C who rehabilitates the building. Assume that C, a

calendar year taxpayer, places the property with respect to which rehabilitation expenditures were made in service in 1982 and selects December 31, 1982, as the end of the measuring period for purposes of the substantial rehabilitation test. The beginning of the measuring period is January 2, 1982, the beginning of B's holding period under section 1250 (e), and the adjusted basis of the building is $100,000. Accordingly, if C incurred more than $100,000 of qualified rehabilitation expenditures during 1982, the building would be substantially rehabilitated within the meaning of paragraph (b)(2)(i) of this section. (ii) Assume the facts of example (3)(i), except that after C begins physical work on the rehabilitation, but before C incurs $100,000 of expenditures, D acquires the building, subject to C's lease, from B for $200,000. D's holding period under section 1250(e) begins on the day after D acquired the building, and C's adjusted basis for purposes of the substantial rehabilitation test is $200,000, less the the amount of expenditures incurred by C before the transfer. (See paragraph (b)(2) (ii) and (vii) of this section.) Accordingly, if C incurred more than $200,000 (less the amount of expenditures incurred prior to the transfer) of qualified rehabilitation expenditures during 1982, the building would be substantially rehabilitated within the meaning of paragraph (b)(2) of this section. Under paragraph (b)(2)(ii)(B) of this section, however, C's adjusted basis for purposes of the substantial rehabilitation test would be $100,000 if C had substantially rehabilitated the building (i.e., incurred more than $100,000 in rehabilitation expenditures) prior to B's sale to D. Example (4). E owns a building with a basis of $10,000 and E incurs $5,000 of rehabilitation expenditures. Before completing the rehabilitation project, E sells the building to F for $30,000. Assume that F is treated under paragraph (c)(3)(ii) of this section as having incurred the $5,000 of rehabilitation expenditures actually incurred by E. Because F's basis in the building is determined under section 1011 with reference to F's $30,000 cost of the building (which includes the property attributable to E's rehabilitation expenditures), F's basis for purposes of the substantial rehabilitation test is $25,000 ($30,000 cost basis less $5,000 rehabilitation expenditures treated as if incurred by F). (See paragraph (b)(2)(vii) of this section.) F would thus be required to incur more than $20,000 of rehabilitation expenditures (in addition to the $5,000 incurred by E and treated as having been incurred by F) during a measuring period selected by F to satisfy the substantial rehabilitation test. Example (5). G owns Building I with a basis of $10,000 and a fair market value of $20,000. H owns Building II with a basis of $5,000 and a fair market value of $20,000, with respect to which H has incurred $1,000 of rehabilitation expenditures. G and H exchange their buildings in a transaction that qualifies for nonrecognition treatment under section 1031. Assume that G is treated under paragraph (c)(3)(ii) of this section as having incurred $1,000 of rehabilitation expenditures. G's basis in Building II, computed under section 1031(d), is $10,000. G's basis in Building II is not determined with reference to (A) the cost of Building II, (B) H's basis in Building II (including the cost of the rehabilitation expenditures) or (C) any other amount that includes the cost of expenditures, but is instead determined with reference to G's basis in other property (Building I). Therefore, G's basis in Building II for purposes of the substantial rehabilitation test is not reduced by the $1,000 of rehabilitation expenditures treated as if incurred by G. (See paragraph (b)(2)(vii) of this section.) Accordingly, G's basis in Building II for purposes of the substantial rehabilitation test is $10,000, and G must incur additional rehabilitation expenditures in excess of $9,000 within a measuring period selected by G to satisfy the test. (3) Retention of existing external walls and internal structural framework-(i) In general-(A) Property placed in service after December 31, 1986. Except in the case of property that qualifies for the transition rules in paragraph (a)(2)(iv) (B) and (C)

of this section, in the case of property that is placed in service after December 31, 1986, a building (other than a certified historic structure) meets the requirement in paragraph (b)(1)(iii) of this section only if in the rehabilitation process- (1) 50 percent or more of the existing external walls of such building are retained in place as external walls; (2) 75 percent or more of the existing external walls of such building are retained in place as internal or external walls, and (3) 75 percent or more of the internal structural framework of such building (as defined in paragraph (b)(3)(iii) of this section) is retained in place. (B) Expenditures incurred before January 1, 1984, for property placed in service before January 1, 1987. With respect to rehabilitation expenditures incurred before January 1, 1984, for property that is either placed in service before January 1, 1987, or that qualifies for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, a building meets the requirement in paragraph (b)(1)(iii) of this section only if 75 percent or more of the existing external walls of the building are retained in place as external walls in the rehabilitation process. If an addition to a building is not treated as part of a qualified rehabilitated building because it does not meet the 30-year requirement in paragraph (b)(4)(i)(B) of this section, then the external walls of such addition shall not be considered to be existing external walls of the building for purposes of section 48(g)(1)(A)(iii) (as in effect prior to enactment of the Tax Reform Act of 1986), and this section. (C) Expenditures incurred after December 31, 1983, for property placed in service before January 1, 1987. With respect to expenditures incurred after December 31, 1983, for property that is either placed in service before January 1, 1987, or that qualifies for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, the requirement of paragraph (b)(1)(iii) of this section is satisfied only if in the rehabilitation process either the existing external wall retention requirement in paragraph (b)(3)(i) (B) of this section is satisfied, or: (1) 50 percent or more of the existing external walls of the building are retained in place as external walls, (2) 75 percent or more of the existing external walls are retained in place as internal or external walls, and (3) 75 percent or more of the existing internal structural framework of such building is retained in place. (D) Area of external walls and internal structural framework. The determinations required by paragraph (b)(3)(i) (A), (B), and (C) of this section shall be based upon the area of the external walls or internal structural framework that is retained in place compared to the total area of each prior to the rehabilitation. The area of the existing external walls and internal structural framework of a building shall be determined prior to any destruction, modification, or construction of external walls or internal structural framework that is undertaken by any party in anticipation of the rehabilitation. (ii) Definition of external wall. For purposes of this paragraph (b), a wall includes both the supporting elements of the wall and the nonsupporting elements, (e.g., a curtain, windows or doors) of the wall. Except as otherwise provided in this paragraph (b)(3), the term "external wall" includes any wall that has one face exposed to the weather, earth, or an abutting wall of an adjacent building. The term "external wall" also includes a shared wall (i.e., a single wall shared with an adjacent building), generally referred to as a "party wall," provided that the shared wall has no windows or doors in any portion of the wall that does not have one face exposed to the weather, earth, or an abutting wall. In general, the term "external wall" includes only those external walls that form part of the outline or perimeter of the building or that surround an uncovered courtyard. Therefore, the walls of an

uncovered internal shaft, designed solely to bring light or air into the center of a building, which are completely surrounded by external walls of the building and which enclose space not designated for occupancy or other use by people (other than for maintenance or emergency), are not considered external walls. Thus, for example, a wall of a light well in the center of a building is not an external wall. However, walls surrounding an outdoor space which is usable by people, such as a courtyard, are external walls. (iii) Definition of internal structural framework. For purposes of this section, the term "internal structural framework" includes all load-bearing internal walls and any other internal structural supports, including the columns, girders, beams, trusses, spandrels, and all other members that are essential to the stability of the building. (iv) Retained in place. An existing external wall is retained in place if the supporting elements of the wall are retained in place. An existing external wall is not retained in place if the supporting elements of the wall are replaced by new supporting elements. An external wall is retained in place, however, if the supporting elements are reinforced in the rehabilitation, provided that such supporting elements of the external wall are retained in place. An external wall also is retained in place if it is covered (e.g., with new siding). Moreover, an external wall is retained in place if the existing curtain is replaced with a new curtain, provided that the structural framework that provides for the support of the existing curtain is retained in place. An external wall is retained in place notwithstanding that the existing doors and windows in the wall are modified, eliminated, or replaced. An external wall is retained in place if the wall is disassembled and reassembled, provided the same supporting elements are used when the wall is reassembled and the configuration of the external walls of the building after the rehabilitation is the same as it was before the rehabilitation process commenced. Thus, for example, a brick wall is considered retained in place even though the original bricks are removed (for cleaning, etc.) and replaced to form the wall. The principles of this paragraph (b)(3)(iv) shall also apply to determine whether internal structural framework of the building is retained in place. (v) Effect of additions. If an existing external wall is converted into an internal wall (i.e., a wall that is not an external wall), the wall is not retained in place as an external wall for purposes of this section. (vi) Examples. The provisions of this paragraph (b)(3) may be illustrated by the following examples: Example (1). Taxpayer A rehabilitated a building all of the walls of which consisted of wood siding attached to gypsum board sheets (which covered the supporting elements of the wall, i.e., studs). A covered the existing wood siding with aluminum siding as part of a rehabilitation that otherwise qualified under this subparagraph. The addition of the aluminum siding does not affect the status of the existing external walls as external walls and they would be considered to have been retained in place. Example (2). Taxpayer B rehabilitated a building, the external walls of which had a masonry curtain. The masonry on the wall face was replaced with a glass curtain. The steel beam and girders supporting the existing masonry curtain were retained in place. The walls of the building are considered to be retained in place as external walls, notwithstanding the replacement of the curtain. Example (3). Taxpayer C rehabilitated a building that has two external walls measuring 75' × 20' and two other external walls measuring 100'× 20'. C demolished one of the larger walls, including its supporting elements and constructed a new wall. Because one of the larger walls represents more than 25 percent of the area of the building's external walls, C has not satisfied the requirements that 75 percent of the existing external walls must be retained in place as either internal or

external walls. If however, C had not demolished the wall, but had converted it into an internal wall (e.g., by building a new external wall), the building would satisfy the external wall requirements. Example (4). The facts are the same as in example (3), except that C does not tear down any walls, but builds an addition that results in one of the smaller walls becoming an internal wall. In addition, C enlarged 8 of the existing windows on one of the larger walls, increasing them from a size of 3' × 4' to 6' × 8'. Since the smaller wall accounts for less than 25 percent of the total wall area, C has satisfied the requirement that 75 percent of the existing external walls must be retained in place as external walls in the rehabilitation process. The enlargement of the existing windows on the larger wall does not affect its status as an external wall. Example (5). Taxpayer D rehabilitated a building that was in the center of a row of three buildings. The building being rehabilitated by D shares its side walls with the buildings on either side. The shared walls measure 100' × 20' and the rear and front walls measure 75' × 20'. As part of a rehabilitation, D tears down and replaces the front wall. Because the shared walls as well as the front and back walls are considered external walls and the front wall accounts for less than 25 percent of the total external wall area (including the shared walls), D has satisfied the requirement that 75 percent of the existing external walls must be retained in place as external walls in the rehabilitation process. (4) Age requirement-(i) In general-(A) Property placed in service after December 31, 1986. Except in the case of property that qualifies for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, a building other than a certified historic structure shall not be considered a qualified rehabilitated building unless the building was first placed in service (within the meaning of §1.46-3(d)) before January 1, 1936. (B) Property placed in service before January 1, 1987, and property qualifying under a transition rule. In the case of property placed in service before January 1, 1987, and property that qualifies under the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, a building other than a certified historic structure is considered a qualified rehabilitated building only if a period of at least 30 years has elasped between the date physical work on the rehabilitation of the building began and the date the building was first placed in service (within the meaning of §1.46-3(d)) as a building by any person. (ii) Additions. A building that was first placed in service before 1936 in the case described in paragraph (b)(4)(i)(A) of this section, or at least 30 years before physical work on the rehabilitation began in the case described in paragraph (b)(4)(i)(B) of this section, will not be disqualified because additions to such building have been added since 1936 in the case described in paragraph (b)(4)(i)(A) of this section, or are less than 30 years old in the case described in paragraph (b)(4)(i)(B). Such additions, however, shall not be treated as part of the qualified rehabilitated building. The term "addition" means any construction that resulted in any portion of an external wall becoming an internal wall, that resulted in an increase in the height of the building, or that increased the volume of the building. (iii) Vacant periods. The determinations required by paragraph (b)(4)(i) of this section include periods during which a building was vacant or devoted to a personal use and is computed without regard to the number of owners or the identify of owners during the period. (5) Location at which the rehabilitation occurs. A building, other than a certified historic structure is not a qualified rehabilitated building unless it has been located where it is rehabilitated since before 1936 in the case described in paragraph (b)(4)(i)(A) of this section. Similarly, in the case described in paragraph (b)(4)(i)(B) of this section, a building, other than a certified historic structure, is not a qualified

rehabilitation building unless it has been located where it is rehabilitated for the thirty-year period immediately preceding the date physical work on the rehabilitation began in the case of a "30-year building" or the forty-year period immediately preceding the date physical work on the rehabilitation began in the case of a "40-year building." (See >§1.46-1(q)(1)(iii) for the definitions of "30-year building" and "40-year building.") (6) Definition and special rule-(i) Physical work on a rehabilitation. For purposes of this section, "physical work on a rehabilitation" begins when actual construction, or destruction in preparation for construction, begins. The term "physical work on a rehabilitation," however, does not include preliminary activities such as planning, designing, securing financing, exploring, researching, developing plans and specifications, or stabilizing a building to prevent deterioration (e.g., placing boards over broken windows). (ii) Special rule for adjoining buildings that are combined. For purposes of this paragraph (b), if as part of a rehabilitation process two or more adjoining buildings are combined and placed in service as a single building after the rehabilitation process, then, at the election of the taxpayer, all of the requirements for a qualified rehabilitated building in section 48(g)(1) and this section may be applied to the constituent adjoining buildings in the aggregate. For example, if such requirements are applied in the aggregate, any shared walls or abutting walls between the constituent buildings that would otherwise be treated as external walls (within the meaning of paragraph (b)(3) of this section) would not be treated as external walls of the building, and the substantial rehabilitation test in paragraph (b)(2) of this section would be applied to the aggregate expenditures with respect to all of the constituent buildings and to the aggregate adjusted basis of all of the constituent buildings. A taxpayer shall elect the special rule of this paragraph (b)(6)(ii) for adjoining buildings by indicating by way of a marginal notation on, or a supplemental statement attached to, the Form 3468 on which a credit is first claimed for qualified rehabilitation expenditures with respect to such buildings that such buildings are a single qualified rehabilitated building because of the application of the special rule in this paragraph (b)(6)(ii). (c) Definition of qualified rehabilitation expenditures-(1) In general. Except as otherwise provided in paragraph (c)(7) of this section, the term "qualified rehabilitation expenditure" means any amount that is- (i) Properly chargeable to capital account (as described in paragraph (c)(2) of this section), (ii) Incurred by the taxpayer after December 31, 1981 (as described in paragraph (c)(3) of this section), (iii) For property for which depreciation is allowable under section 168 and which is real property described in paragraph (c)(4) of this section, and (iv) Made in connection with the rehabilitation of a qualified rehabilitated building (as described in paragraph (c)(5) of this section). (2) Chargeable to capital account. For purposes of paragraph (c)(1) of this section, amounts are chargeable to capital account if they are properly includible in computing basis of real property under §1.46-3(c). Amounts treated as an expense and deducted in the year they are paid or incurred or amounts that are otherwise not added to the basis of real property described in paragraph (c)(4) of this section do not qualify. For purposes of this paragraph (c), amounts incurred for architectural and engineering fees, site survey fees, legal expenses, insurance premiums, development fees, and other construction related costs, satisfy the requirement of this paragraph (c)(2) if they are added to the basis of real property that is described in paragraph (c)(4) of this section. Construction period interest and taxes that are amortized under section 189 (as in effect prior to its repeal by the Tax Reform Act of

1986. do not satisfy the requirement of this paragraph (c)(2). If, however, such interest and taxes are treated by the taxpayer as chargeable to capital account with respect to property described in paragraph (c)(4) of this section, they shall be treated in the same manner as other costs described in this paragraph (c)(2). Any construction period interest or taxes or other fees or costs incurred in connection with the acquisition of a building, any interest in a building, or land, are subject to paragraph (c)(7)(ii) of this section. See paragraph (c)(9) of this section for additional rules concerning interest. (3) Incurred by the taxpayer-(i) In general. Qualified rehabilitation expenditures are incurred by the taxpayer for purposes of this section on the date such expenditures would be considered incurred under an accrual method of accounting, regardless of the method of accounting used by the taxpayer with respect to other items of income and expense. If qualified rehabilitation expenditures are treated as having been incurred by a taxpayer under paragraph (c)(3)(ii) of this section, the taxpayer shall be treated as having incurred the expenditures on the date such expenditures were incurred by the transferor. (ii) Qualified rehabilitation expenditures treated as incurred by the taxpayer-(A) Where rehabilitation expenditures are incurred with respect to a building by a person (or persons) other than the taxpayer and the taxpayer subsequently acquires the building, or a portion of the building to which some or all of the expenditures are allocable (e.g., a condominium unit to which rehabilitation expenditures have been allocated), the taxpayer acquiring such property shall be treated as having incurred the rehabilitation expenditures actually incurred by the transferor (or treated as incurred by the transferor under this paragraph (c)(3)(ii)) allocable to the acquired property, provided that- (1) The building, or the portion of the building, acquired by the taxpayer was not used (or, if later, was not placed in service (as defined in paragraph (f)(2) of this section)) after the rehabilitation expenditures were incurred and prior to the date of acquisition, and (2) No credit with respect to such qualified rehabilitation expenditures is claimed by anyone other than the taxpayer acquiring the property. For purposes of this paragraph (c)(3)(ii), use shall mean actual use, whether personal or business. In the case of a building that is divided into condominium units, expenditures attributable to the common elements shall be allocable to the individual condominium units in accordance with the principles of paragraph (c)(10)(ii) of this section. Furthermore, for purpose of this paragraph (c)(3)(ii), a condominium unit's share of the common elements shall not be considered to have been used (or placed in Service) prior to the time that the particular condominium unit is used. (B) The amount of rehabilitation expenditures described in paragraph (c)(3)(ii)(A) of this section treated as incurred by the taxpayer under this paragraph shall be the lesser of- (1) The amount of rehabilitation expenditures incurred before the date on which the taxpayer acquired the building (or portion thereof) to which the rehabilitation expenditures are attributable, or (2) The portion of the taxpayer's cost or other basis for the property that is properly allocable to the property resulting from the rehabilitation expenditures described in paragraph (c)(3)(ii)(B)(1) of this section. (C) For purposes of this paragraph (c)(3)(ii), the amount of rehabilitation expenditures treated as incurred by the taxpayer under this paragraph (c) shall not be treated as costs for the acquisition of a building. The portion of the cost of acquiring a building (or an interest therein) that is not treated under this paragraph as qualified rehabilitation expenditures incurred by the taxpayer is not treated as section 38 property in the hands of the acquiring taxpayer. (See paragraph (c)(7)(ii)

of this section.) (See paragraph (b)(2)(vii) for rules concerning the application of the substantial rehabilitation test when expenditures are treated as incurred by the taxpayer.) (iii) Examples. The provisions of this paragraph (c) may be illustrated by the following examples: Example (1). In 1981, A, a taxpayer using the cash receipts and disbursements method of accounting, commenced the rehabilitation of a 30-year old building. In June 1981, A signed a contract with a plumbing contractor for replacement of the plumbing in the building. A agreed to pay the contractor as soon as the work was completed. The work was completed in December 1981, but A did not pay the amount due until January 15, 1982. The expenditures for the plumbing are not qualified rehabilitation expenditures (within the meaning of this paragraph (c)) because they were not incurred under an accrual method of accounting after December 31, 1981. Example (2). B incurred qualified rehabilitation expenditures of $300,000 with respect to an existing building between January 1, 1982, and May 15, 1982, and then sold the building to C on June 1, 1982. The portion of the building to which the expenditures were allocable was not used by B or any other person during the period from January 1, 1982, to June 1, 1982, and neither B nor any other person claimed the credit. Consequently, C will be treated as having incurred the expenditures on the dates that B incurred the expenditures. Example (3). D, a taxpayer using the cash receipts and disbursements method of accounting, begins the rehabilitation of a building on January 11, 1982. Prior to May 1, 1982, D makes rehabilitation expenditures of $16,000. On May 3, 1982, D sells the building, the land, and the property attributable to the rehabilitation expenditures to E for $35,000. The purchase price is properly allocable as follows: Land ........................................................... $5,000 Existing building .............................................. 11,000 Property attributable to rehabilitation expenditures ........... 19,000 --------- Total purchase price ........................................... 35,000 The property attributable to the rehabilitation expenditures is placed in service by E on September 5, 1982. E may treat a portion of the $35,000 purchase price as rehabilitation expenditures paid or incurred by him. Since the rehabilitation expenditures paid by D ($16,000) are less than the portion of the purchase price properly allocable to property attributable to these expenditures ($19,000), E may treat only $16,000 as rehabilitation expenditures paid or incurred by him. The excess of the purchase price allocable to rehabilitation expenditures ($19,000) over the rehabilitation expenditures paid by D ($16,000), or $3,000, is treated as the cost of acquiring an interest in the building and is not a qualified rehabilitation expenditure treated as incurred by E. Example (4). The facts are the same as in example (3), except that the purchase price properly allocable to the property attributable to rehabilitation expenditures is $15,000. Under these circumstances, E may treat only $15,000 of D's $16,000 expenditures as rehabilitation expenditures paid by D. The excess of the rehabilitation expenditures paid by D ($16,000) over the purchase price allocable to rehabilitation expenditures ($15,000), or $1,000, is treated as the cost of acquiring an interest in the building and is not a qualified rehabilitation expenditure treated as incurred by E. (4) Incurred for depreciable real property-(i) Property placed in service after December 31, 1986. Except as otherwise provided in paragraph (c)(4)(ii) of this section (relating to certain property that qualifies under a transition rule), in the case of property placed in service after December 31, 1986, an expenditure is incurred for

depreciable real property for purposes of paragraph (c)(1)(iii) of this section, only if it is added to the depreciable basis of depreciable property which is- (A) Nonresidential real property, (B) Residential rental property, (C) Real property which has a class life of more than 12.5 years, or (D) An addition or improvement to property described in paragraph (c)(4)(i) (A), (B), or (C) of this section. For purposes of this paragraph (c)(4)(i), the terms "nonresidential real property", "residential rental property", and "class life" have the respective meanings given to such terms by section 168 and the regulations thereunder. (ii) Property placed in service before January 1, 1987, and property that qualifies under a transition rule. In the case of property placed in service before January 1, 1987, and property placed in service after December 31, 1986, that qualifies for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, an expenditure attributable to such property shall be a qualified rehabilitation expenditure only if such expenditure is incurred for property that is real property (or additions or improvements to real property) with a recovery period (within the meaning of section 168 as in effect prior to its amendment by the Tax Reform Act of 1986) of 19 years (15 years for low-income housing) and if the other requirements of this paragraph (c) are met. For purposes of this section, an expenditure is incurred for recovery property having a recovery period of 19 years only if the amount of the expenditure is added to the basis of property which is 19-year real property or 15-year real property in the case of low-income housing. For purposes of this section, the term "low-income housing" has the meaning given such term by section 168(c)(2)(F) (as in effect prior to the amendments made by the Tax Reform Act of 1986). (5) Made in connection with the rehabilitation of a qualified rehabilitated building. In order for an expenditure to be a qualified rehabilitation expenditure, such expenditure must be incurred in connection with a rehabilitation (as defined in paragraph (b)(2)(iv) of this section) of a qualified rehabilitated building. Expenditures attributable to work done to facilities related to a building (e.g., sidewalk, parking lot, landscaping) are not considered made in connection with the rehabilitation of a qualified rehabilitated building. (6) When expenditures may be incurred. An expenditure is a qualified rehabilitation expenditure only if the building with respect to which the expenditures are incurred is substantially rehabilitated (within the meaning of paragraph (b)(2) of this section) for the taxable year in which the property attributable to the expenditures is placed in service (i.e., the building is substantially rehabilitated during a measuring period ending with or within the taxable year in which a credit is claimed). (See paragraph (f)(2) of this section for rules relating to when property is placed in service.) Once the substantial rehabilitation test is met for a taxable year, the amount of qualified rehabilitation expenditures upon which a credit can be claimed for the taxable year is limited to expenditures incurred: (i) Before the beginning of a measuring period during which the building was substantially rehabilitated that ends with or within the taxable year, provided that the expenditures were incurred in connection with the rehabilitation process that resulted in the substantial rehabilitation of the building; (ii) Within a measuring period during which the building was substantially rehabilitated that ends with or within the taxable year, and (iii) After the end of a measuring period during which the building was substantially rehabilitated but prior to the end of the taxable year with or within which the measuring period ends.

(7) Certain expenditures excluded from qualified rehabilitation expenditures. The term "qualified rehabilitation expenditures" does not include the following expenditures: (i) Except as otherwise provided in paragraph (c)(8) of this section, any expenditure with respect to which the taxpayer does not use the straight line method over a recovery period determined under section 168 (c) and (g). (ii) The cost of acquiring a building, any interest in a building (including a leasehold interest), or land, except as provided in paragraph (c)(3)(ii) of this section. (iii) Any expenditure attributable to an enlargement of a building (within the meaning of paragraph (c)(10) of this section). (iv) Any expenditure attributable to the rehabilitation of a certified historic structure or a building located in a registered historic district, unless the rehabilitation is a certified rehabilitation. (See paragraph (d) of this section which contains definitions and special rules applicable to rehabilitations of certified historic structures and buildings located in registered historic districts.) (v) Any expenditure of a lessee of a building or a portion of a building, if, on the date the rehabilitation is completed with respect to property placed in service by such lessee, the remaining term of the lease (determined without regard to any renewal period) is less than the recovery period determined under section 168(c) (or 19 years in the case of property placed in service before January 1, 1987, and property placed in service that qualifies under the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section). (vi) Any expenditure allocable to that portion of a building which is (or may reasonably be expected to be) tax-exempt use property (within the meaning of section 168 and the regulations thereunder), except that the exclusion in this paragraph (c)(7)(vi) shall not apply for purposes of determining whether the building is a substantially rehabilitated building under paragraph (b)(2) of this section. (8) Requirement to use straight line depreciation-(i) Property placed in service after December 31, 1986. The requirement in section 48(g)(2)(B)(i) and paragraph (c)(7)(i) of this section to use straight line cost recovery does not apply to any expenditure to the extent that the alternative depreciation system of 168(g) applies to such expenditure by reason of section 168(g)(1) (B) or (C). In addition, the requirement in section 48(g)(2)(B)(i) and paragraph (c)(7)(i) of this section applies only to the depreciation of the portion of the basis of a qualified rehabilitated building that is attributable to qualified rehabilitation expenditures. (ii) Property placed in service before January 1, 1987, and property placed in service after December 31, 1986, that qualifies for a transition rule. In the case of expenditures attributable to property placed in service before January 1, 1987, and property that qualifies for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, the term "qualified rehabilitation expenditure" does not include an expenditure with respect to which an election was not made under section 168(b)(3) as in effect prior to its amendment by the Tax Reform Act of 1986, to use the straight line method of depreciation. In such case, the requirement that an election be made to use straight line cost recovery applies only to the cost recovery of the portion of the basis of a qualified rehabilitated building that is attributable to qualified rehabilitation expenditures. See section 168(f)(1), as in effect prior to its amendment by the Tax Reform Act of 1986, for rules relating to the use of different methods of cost recovery for different components of a building. In addition, such requirement shall not apply to any expenditure to the extent that section 168(f)(12) or (j), as in effect prior to the amendments made by the Tax Reform Act of 1986, applied to such expenditure. (9) Cost of acquisition. For purposes of paragraph (c)(7)(ii) of this section, cost of acquisition includes any interest incurred on indebtedness the proceeds of which are

attributable to the acquisition of a building, an interest in a building, or land open which a building exists. Interest incurred on a construction loan the proceeds of which are used for qualified rehabilitation expenditures, however, is not treated as a cost of acquisition. (10) Enlargement defined-(i) In general. A building is enlarged to the extent that the total volume of the building is increased. An increase in floor space resulting from interior remodeling is not considered an enlargement. The total volume of a building is generally equal to the product of the floor area of the base of the building and the height from the underside of the lowest floor (including the basement) to the average height of the finished roof (as it exists or existed). For this purpose, floor area is measured from the exterior faces of external walls (other than shared walls that are external walls) and from the centerline of shared walls that are external walls. (ii) Rehabilitation that includes enlargement. If expenditures for property only partially qualify as qualified rehabilitation expenditures because some of the expenditures are attributable to the enlargement of the building, the expenditures must be apportioned between the original portion of the building and the enlargement. The expenditures must be specifically allocated between the original portion of the building and the enlargement to the extent possible. If it is not possible to make a specific allocation of the expenditures, the expenditures must be allocated to each portion on some reasonable basis. The determination of a reasonable basis for an allocation depends on factors such as the type of improvement and how the improvement relates functionally to the building. For example, in the case of expenditures for an air-conditioning system or a roof, a reasonable basis for allocating the expenditures among the two portions generally would be the volume of the building, excluding the enlargement, served by the air-conditioning system or the roof relative to the volume of the enlargement served by the improvement. (d) Rules applicable to rehabilitations of certified historic structures-(1) Definition of certified historic structure. The term "certified historic structure" means any building (and its structural components) that is- (i) Listed in the National Register of Historic Places ("National Register"); or (ii) Located in a registered historic district and certified by the Secretary of the Interior to the Internal Revenue Service as being of historic significance to the district. For purposes of this section, a building shall be considered to be a certified historic structure at the time it is placed in service if the taxpayer reasonably believes on that date the building will be determined to be a certified historic structure and has requested on or before that date a determination from the Department of Interior that such building is a certified historic structure within the meaning of this paragraph (d) (1) (i) or (ii) and the Department of Interior later determines that the building is a certified historic structure. (2) Definition of registered historic district. The term "registered historic district" means any district that is- (i) Listed in the National Register, or (ii) (A) Designated under a statute of the appropriate State or local government that has been certified by the Secretary of the Interior to the Internal Revenue Service as containing criteria that will substantially achieve the purpose of preserving and rehabilitating buildings of historic significance to the district, and (B) certified by the Secretary of the Interior as meeting substantially all of the requirements for the listing of districts in the National Register.

(3) Definition of certified rehabilitation. The term "certified rehabilitation" means any rehabilitation of a certified historic structure that the Secretary of the Interior has certified to the Internal Revenue Service as being consistent with the historic character of the building and, where applicable, the district in which such building is located. The determination of the scope of a rehabilitation shall be made on the basis of all the facts and circumstances surrounding the rehabilitation and shall not be made solely on the basis of ownership. The Secretary of the Interior shall take all of the rehabilitation work performed as part of a single rehabilitation, including any post-certification work, into account in determining whether the rehabilitation complies with the Department of Interior standards for rehabilitation and whether the certification should be granted, revoked, or otherwise invalidated. (4) Revoked or invalidated certification. If the Department of Interior revokes or otherwise invalidates a certification after it has been issued to a taxpayer, the basis attributable to rehabilitation of the decertified property shall cease to be section 38 property described in section 48 (a) (1) (E). Such cessation shall be effective as of the date the activity giving rise to the revocation or invalidation commenced. See section 47 for the rules applicable to property that ceases to be section 38 property. (5) Special rule for certain buildings located in registered historic districts. The exclusion in paragraph (c) (7) (iv) of this section does not apply to a building in a registered historic district if- (i) Such building was not a certified historic structure during the rehabilitation process; and (ii) The Secretary of the Interior certified to the Internal Revenue Service that such building was not of historic significance to the district. In general, the certification referred to in paragraph (d) (5) (ii) of this section must be requested by the taxpayer prior to the time that physical work on the rehabilitation began. If, however, the certification referred to in paragraph (d) (5) (ii) of this section is requested by the taxpayer after physical work on the rehabilitation of the building has begun, the taxpayer must certify to the Internal Revenue Service that, prior to the date that physical work on the rehabilitation began, the taxpayer in good faith was not aware of the requirement of paragraph (d) (5) (ii) of this section. The certification referred to in the previous sentence must be attached to the Form 3468 filed with the tax return for the year in which the credit is claimed. (6) Special rule for certain rehabilitations begun before an area is designated as a registered historic district. In general, the exclusion from the definition of qualified rehabilitation expenditure in paragraph (c) (7) (iv) of this section applies to any rehabilitation expenditures that are incurred after a building becomes a certified historic structure within the meaning of section 48 (g) (3) (A) and paragraph (d) (1) of this section or the area in which a building is located becomes a registered historic district within the meaning of section 48 (g) (3) (B) and paragraph (d) (2) of this section. Rehabilitation expenditures incurred prior to such date, however, are not disqualified. In addition, rehabilitation expenditures made after the date the area in which a building is located becomes a registered historic district shall not be disqualified under paragraph (c) (7) (iv) of this section in any case in which physical work on the rehabilitation of a building begins prior to the date the taxpayer knows or has reason to know of an intention to nominate the area in which such building is located as a registered historic district. For purposes of this paragraph (d) (6), the taxpayer knows or has reason to know of such an intention if there is (A) a communication (written or oral) to the owner of any building within the district from the Department of the Interior, or any agency or instrumentality of the appropriate state or local government (or a designee of such agency or instrumentality) that the

district in which the building is located is being considered for designation as a registered historic district, (B) a legal notice of such consideration published in a newspaper, or (C) a public meeting held to discuss such consideration. In order to take advantage of the special rule of this paragraph (d) (6), the taxpayer must attach to the Form 3468 filed for the taxable year in which the credit is claimed a statement that the taxpayer in good faith did not know, or have reason to k now, of an intention to nominate the area in which the building is located as a registered historic district. (7) Notice of certification-(i) In general. Except as otherwise provided in paragraph (d)(7)(ii) of this section, a taxpayer claiming the credit for rehabilitation of a certified historic structure (within the meaning of section 48(g)(3) and paragraph (d)(1) of this section) must attach to the Form 3468 filed with the tax return for the taxable year in which the credit is claimed a copy of the final certification of completed work by the Secretary of the Interior, and for returns filed after January 9, 1989, evidence that the building is a certified historic structure. (ii) Late certification. If the final certification of completed work has not been issued by the Secretary of the Interior at the time the tax return is filed for a year in which the credit is claimed, a copy of the first page of the Historic Preservation Certification Application-Part 2-Description of Rehabilitation (NPS Form 10-168a), with an indication that it has been received by the Department of the Interior or its designate, together with proof that the building is a certified historic structure (or that such status has been requested), must be attached to the Form 3468 filed with the return. A notice from the Department of the Interior or the State Historic Preservation Officer, stating that the nomination or application has been received, or a date-stamped nomination or application shall be sufficient indication that the nomination or application has been received. The building need not be either listed in the National Register or be determined to be of historic significance to a registered historic district at the time the return is filed for the year in which the credit is claimed. (See paragraph (d)(1) of this section.) The taxpayer must submit a copy of the final certification as an attachment to Form 3468 with the first income tax return filed after the receipt by the taxpayer of the certification. If the final certification is denied by the Department of Interior, the credit will be disallowed for any taxable year in which it was claimed. If the taxpayer fails to receive final certification of completed work prior to the date that is 30 months after the date that the taxpayer filed the tax return on which the credit was claimed, the taxpayer must submit a written statement to the District Director stating such fact prior to the last day of the 30th month, and the taxpayer shall be requested to consent to an agreement under section 6501(c)(4) extending the period of assessmen t for any tax relating to the time for which the credit was claimed. The procedure permitted by the preceding sentence shall be used whenever the entire rehabilitation project is not fully completed by the date that is 30 months after the taxpayer filed the tax return upon which the credit was claimed (e.g. a phased rehabilitation) and the Secretary of the Interior has thus not yet certified the rehabilitation. (e) Adjustment to basis-(1) General rule. Except as otherwise provided by this paragraph (e), if a credit is allowed with respect to property attributable to qualified rehabilitation expenditures incurred in connection with the rehabilitation of a qualified rehabilitated building, the increase in the basis of the rehabilitated property that would otherwise result from the qualified rehabilitation expenditures must be reduced by the amount of the credit allowed. See section 48(q) and the regulations there under for other rules concerning adjustments to basis in the case of section 38 property. (2) Special rule for certain property relating to certified historic structures. If a rehabilitation investment credit is allowed with respect to property that is placed in

service before January 1, 1987, or property that qualifies for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, and such property is attributable to qualified rehabilitation expenditures incurred in connection with the rehabilitation of a certified historic structure, the increase in the basis of the rehabilitated property that would otherwise result from the qualified rehabilitation expenditures must be reduced by one-half of the amount of the credit allowed. (3) Recapture of rehabilitation investment credit. If during any taxable year there is a recapture amount determined with respect to any credit that resulted in a basis adjustment under paragraph (e) (1) or (2) of this section, the basis of such building (immediately before the event resulting in such recapture) shall be increased by an amount equal to such recapture amount. For purposes of the preceding sentence, the term "recapture amount" means any increase in tax (or adjustment in carrybacks or carryovers) determined under section 47(a)(5). (f) Coordination with other provisions of the Code-(1) Credit claimed by lessee for rehabilitation performed by lessor. A lessee may take the credit for rehabilitation performed by the lessor if the requirements of this section and section 48(d) are satisfied. For purposes of applying section 48(d), the fair market value of section 38 property described in section 48(a)(1)(E) shall be limited to that portion of the lessor's basis in the qualified rehabilitated building that is attributable to qualified rehabilitation expenditures. In the case of a portion of a building that is divided into more than one leasehold interest, the qualified rehabilitation expenditures attributable to the common elements shall be allocated to the individual leasehold interests in accordance with the principles of paragraph (c)(10)(ii) of this section. Furthermore, a leasehold interest's share of the common elements shall not be considered to have been placed in service prior to the time that the particular leasehold interest is placed in service. (2) When the credit may be claimed-(i) In general. The investment credit for qualified rehabilitation expenditures is generally allowed in the taxable year in which the property attributable to the expenditure is placed in service, provided the building is a qualified rehabilitated building for the taxable year. See paragraph (b) of this section and section 46(c) and §1.46-3(d). Under certain circumstances, however, the credit may be available prior to the date the property is placed in service. See section 46(d) and §1.46-5 (relating to qualified progress expenditures). Solely for purposes of section 46(c), property attributable to qualified rehabilitation expenditures will not be treated as placed in service until the building with respect to which the expenditures are made meets the definition of a qualified rehabilitated building (as defined in section 48(g)(1) and paragraph (b) of this section) for the taxable year. Accordingly, in the first taxable year for which the building becomes a qualified rehabilitated building, the property described in section 48(a)(1)(E) attributable to expenditures described in paragraph (c) of this section shall be considered to be placed in service, if such property was considered placed in service under section 46(c) and the regulations thereunder without regard to this paragraph (f)(2)(i) in that taxable year or a prior taxable year. For purposes of the preceding sentence, the requirement of section 48(g)(1)(A)(iii) and paragraph (b)(3) of this section relating to the definition of a qualified rehabilitated building shall be deemed to be met if the taxpayer reasonably expects that no rehabilitation work undertaken during the remainder of the rehabilitation process will result in a failure to satisfy the requirements of paragraph (b)(3) of this section. If the requirements of paragraph (b)(3) are not satisfied, however, the credit shall be disallowed for the taxable year in which it was claimed. If a taxpayer fails to comple te physical work on the rehabilitation prior to the date that is 30 months after the date that the taxpayer filed a tax return on which the credit is claimed, the taxpayer must submit a written statement to the District Director stating such fact prior to the last day of the 30th

month, and shall be requested to consent to an agreement under section 6501(c)(4) extending the period of assessment for any tax relating to the item for which the credit was claimed. (ii) Section 38 property described in section 48(a)(1)(E). In the case of section 38 property described in section 48(a)(1)(E), the section 38 property is not the building. Instead, the section 38 property is the portion of the basis of the building that is attributable to qualified rehabilitation expenditures. Therefore, for example, for purposes of the determination of when such section 38 property is placed in service, a determination must be made regarding when property attributable to the portion of the basis of the building attributable to qualified rehabilitation expenditures is placed in service. The issue of when the building is placed in service is thus not relevant. In fact, under this test, the building itself may never have been taken out of service during the rehabilitation process. If the building is rehabilitated over several years in stages (e.g., by floors), section 38 property attributable to qualified rehabilitation expenditures to a qualified rehabilitated building placed in service in each taxable year shall, generally, be treated as a separate item of section 38 property. (iii) Example. The application of this paragraph (f)(2) may be illustrated by the following example: Example. Assume that A, a calendar year taxpayer, purchases a four-story building on January 1, 1983, for $100,000, and incurs $10,000 of qualified rehabilitation expenditures in 1983 to rehabilitate floor one, $50,000 of qualified rehabilitation expenditures in 1984 to rehabilitate floor two, $70,000 of qualified rehabilitation expenditures in 1985 to rehabilitate floor three, and $60,000 of qualified rehabilitation expenditures in 1986 to rehabilitate floor four. Assume further that A places the property attributable to these expenditures in service on the last day of the year in which the respective expenditures were incurred and that the building is never taken out of service since as each floor is rehabilitated, the other three floors are occupied by tenants. Under the rule in this paragraph (f)(2), the portion of the basis of the building that is attributable to qualified rehabilitation expenditures incurred with respect to floor one and two are deemed to be placed in service in 1985, because that is the first year that the substantial rehabilitation test described in paragraph (b) of this section is met ($120,000 of expenditures incurred by A during a measuring period ending on December 31, 1985 is greater than the $110,000 basis at the beginning of the period). Assume that as of December 31, 1985, at least 75 percent of the external walls of the building have been retained during the rehabilitation process and that A has a reasonable expectation that no work during the remainder of the rehabilitation process will result in less than 75 percent of the external walls being retained. A may claim a credit for A's 1985 taxable year on $130,000 of qualified rehabilitation expenditures ($10,000 in 1983, $50,000 in 1984, and $70,000 in 1985). (See paragraph (c)(6) of this section for rules applicable to when qualified expenditures may be incurred. In addition, see section 46 (d) and §1.46-5 for rules relating to qualified progress expenditures.) The fact that the building was a qualified rehabilitated building for A's 1985 taxable year, however, has no effect on whether the building is a qualified rehabilitated building for A's 1986 taxable year. In order to determine whether A is entitled to claim a credit on A's 1986 return for the $60,000 of qualified rehabilitation expenditures incurred in 1986, A must select a measuring period ending in 1986 and must determine whether the building is a qualified rehabilitated building for that year. Solely for purposes of determining whether the building was substantially rehabilitated, expenditures incurred in 1984 and 1985, even though considered in determining whether the building was substantially rehabilitated for A's 1985 taxable year, may be used in addition to the expenditures incurred in 1986 to determine whether the building was substantially rehabilitated for A's 1986 taxable year,

provided the expenditures were incurred during any measuring period selected by A that ends in 1986. (3) Coordination with section 47. If property described in section 48(a)(1)(E) is disposed of by the taxpayer, or otherwise ceases to be "section 38 property," section 47 may apply. Property will cease to be section 38 property, and therefore section 47 may apply, in any case in which the Department of Interior revokes or otherwise invalidates a certification of rehabilitation after the property is placed in service or a building (other than a certified historic structure) is moved from the place where it is rehabilitated after the property is placed in service. If, for example, the taxpayer made modifications to the building inconsistent with Department of Interior standards, the Secretary of the Interior might revoke the certification. In addition, if all or a portion of a substantially rehabilitated building becomes tax-exempt use property (see paragraph (c)(7)(vi) of this section) for the first time within five years after the credit is claimed, the credit will be recaptured under section 47 at that time as if the building or portion of the building which becomes tax-exempt use property had then been sold. Par. 5. Section 1.191-1 is amended by revising paragraphs (a), (b) (1)(i) and (3), and (c)(2)(iii), and by adding a new paragraph (f) to read as follows:

§1.191-1 Amortization of certain rehabilitation costs for certified historic

structures. (a) In general. Section 191 allows an owner of a certified historic structure who rehabilitates the structure to elect to amortize over a 60-month period certain expenditures attributable to certified rehabilitation. The election may be made only if the certified historic structure (as defined in §1.191-1(a)) and the improvements made are otherwise of a character subject to depreciation under section 167. In general, only those rehabilitation expenditures which result in additions to capital account after June 14, 1976, and before January 1, 1984, are eligible for this special amortization procedure. To qualify for the election, the rehabilitation must be certified by the Secretary of the Interior to the Internal Revenue Service as consistent with the historic character of the structure. See §1.191-2(d) for the definition of certified rehabilitation. Along with the amortization deductions, the taxpayer may continue otherwise allowable depreciation deductions of the basis of the structure, exclusive of rehabilitation costs which are a part of the amortizable basis (as defined in §1.191-2(e)). (b) Allowance of deduction-(1) Determination of amortization period-(i) General rule. The taxpayer may elect to begin the 60-month amortization period with the month following the month in which the amortizable basis is acquired, or with the first month of the succeeding taxable year. Generally amortizable basis must be acquired after June 14, 1976, and before January 1, 1984. For purposes of this section, the month in which the amortizable basis is acquired is the latest of the month in which the work (or a component part of the work) is completed, the month in which costs are added to capital account, or the month in which depreciation deductions under section 167 would be first allowable with respect to the structure. See, however, §1.191-2(e)(8) for special rules for certified rehabilitations in part occurring outside the effective period of section 191. No amortization deduction may be claimed before a building is used (or held for use) in a trade or business or for the production of income. (3) Relation to section 167(o) and other provisions. If an election involving a certified historic structure is made under section 191, no election may be made under section 167(o) either for the same rehabilitation or for any subsequent rehabilitation of the same structure undertaken by the taxpayer making an election under section 191. Additionally, no election is permitted under section 191 if depreciation deductions or credits against tax based upon any part of the costs qualifying for amortization under

section 191, are at any time claimed (or allowable) under any depreciation or other provision of the Internal Revenue Code of 1954. However, this limitation with respect to investment tax credits under section 38 applies only to structures placed in service after October 31, 1978. Except as provided in paragraph (f)(3) of this section, if section 191 treatment is timely elected on a structure placed in service after October 31, 1978, the investment tax credit under section 38 is considered not to have been allowable with respect to that structure for the same rehabilitation. However, the rule in the preceding sentence does not preclude a taxpayer from claiming an investment tax credit with respect to a separate and distinct rehabilitation to a structure on which a section 191 election was previously made. (c) Person to claim deduction. (2) Exceptions and special rules. (iii) Certain transferees of historic structures. If expenditures for certified rehabilitation are in fact made by the owner of a certified historic structure, and if one or more transferees then acquire the ownership of the rehabilitated structure directly from that owner before the structure is placed in service in its rehabilitated use, the transferees, solely for purposes of section 191, may be treated as having incurred the rehabilitation expenditures actually incurred by the transferor on the date that the transferor actually incurred those expenditures. Transferees acquiring structures in transfers occurring after the structure is placed in service after its rehabilitation but before the first day of the following taxable year, are not eligible for section 191 treatment, because depreciation deductions for rehabilitation costs are allowable to the transferor before the transfer. The amount of rehabilitation expenditures treated as made by the transferees under this subdivision (iii) is the lesser amount of- (A) The rehabilitation expenditures actually made before the date on which the transferee acquired ownership of the structure, or (B) The portion of the transferee's cost or other basis for the property (determined according to the rules of section 167) which is attributable to rehabilitation expenditures made before the date on which the transferee acquires ownership of the structure. (f) Termination-(1) In general. Except as provided in paragraph (f)(2) of this section, section 191, this section, §§1.191-2, and 1.191-3 shall not apply to expenditures incurred after December 31, 1981, in taxable years ending after such date. (2) Transition rule. Section 191 and this section shall continue to apply to expenditures incurred after December 31, 1981, and before January 1, 1984, for the rehabilitation of a building if- (i) The physical work on the rehabilitation began before January 1, 1982, and (ii) The building does not meet the requirements of §1.48-12(b). (3) Coordination with section 38. The fact that section 191 has been timely elected with respect to expenditures incurred prior to January 1, 1982, shall not prevent the investment tax credit under section 38 from being allowed with respect to qualified rehabilitation expenditures (within the meaning of section 48(g)(2) and §1.48-12(c)) incurred after December 31, 1981, as part of the same rehabilitation. Par. 6. Section 1.191-2 is amended by revising paragraph (e)(8) to read as follows:

§1.191-2 Definitions and special rules.

(e) Amortizable basis. (8) Time when amounts are added to capital account. Under section 191, expenditures are treated as added to capital account at the time they are actually made (paid or accrued). However, amortizable basis includes only expenditures attributable to component parts of the structure completed before January 1, 1984. Therefore, expenditures for improvements completed after December 31, 1983, are not a part of the taxpayer's amortizable basis even though they may have been paid

or accrued prior to that date. In the case of a single and continuous rehabilitation project all of which is certified by the Secretary of the Interior, expenditures for rehabilitation begun before June 14, 1976, but completed and charged thereafter, are a part of the taxpayer's amortizable basis. However, even where there is a single and continuous rehabilitation project, expenditures made for any component part of the improvements completed and charged before June 14, 1976, are not a part of the taxpayer's amortizable basis. Par. 7. Section 1.191-3 is amended by revising paragraph (b)(4) to read as follows:

§1.191-3 Time and manner of making election.

(b) Special rules. (4) Elections to begin amortization deductions after December 31, 1983. Notwithstanding the rules of §1.191-1(b)(1)(i), expenditures for component parts of a rehabilitation project which is not completed and placed in service until after December 31, 1983, are included in amortizable basis if the component parts are completed and the expenditures are added to capital account under §1.191-2(e)(8) by that date. Amortization deductions for the costs of such component parts are allowable beginning with the month in which the entire rehabilitation would qualify under §1.191-1(b)(1), but for the expiration of section 191 on December 31, 1983.

PART 602-[AMENDED]

Par. 8. The authority for Part 602 continues to read as follows:

Authority

26 U.S.C. 7805.

§602.101 [Amended]

Par. 9. Section 602.101(c) is amended by inserting in the appropriate place in the table: §1.48-12(b)(2)(vii) .....1545-0155 §1.48-12(b)(6)(ii) .....1545-0155 §1.48-12(d)(5) .....1545-0155 §1.48-12(d)(6) .....1545-0155 §1.48-12(d)(7) .....1545-0155 This Treasury decision includes amendments that conform the regulations to the amendments made to sections 46, 48, and 191 of the Internal Revenue Code of 1954 by the Economic Recovery Tax Act of 1981, the Technical Corrections Act of 1982, the Tax Reform Act of 1984, and the Tax Reform Act of 1986. The rules prescribed reflecting these changes are interpretative. For this reason and because there is need for immediate guidance the requirement for notice and public procedure under subsection (b) of section 553 of title 5 of the United States Code and the effective date limitation of subsection (d) of that section are found to be inapplicable. Lawrence B. Gibbs, Commissioner of Internal Revenue. Approved: August 19, 1988. O. Donaldson Chapoton, Assistant Secretary of the Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary regulations relating to the definition of "activity" for purposes of applying the limitations on passive activity losses and passive activity credits and amends previously issued temporary regulations relating to the limitations. Changes to the applicable tax law were made by the Tax Reform Act of 1986, the Revenue Act of 1987, and the Technical and Miscellaneous Revenue Act of 1988. The temporary regulations affect taxpayers subject to the limitations on passive activity losses and passive activity credits and provide them with the guidance needed to comply with the law. The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations for the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register.

EFFECTIVE DATE

These regulations are effective for taxable years beginning after December 31, 1986, except for §§1.469-2T(f) (3) through (7), which are effective for taxable years beginning after December 31, 1987.

FOR FURTHER INFORMATION CONTACT

Robert Stoddart or Michael J. Grace at 202-566-4751 (not a toll-free number), or at Internal Revenue Service, 1111 Constitution Avenue NW., Room 4429, Washington, DC 20224 (Attn: CC:CORP:T:R (PS-001-89)).

Supplementary information

Paperwork Reduction Act

This regulation is being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the requirements for collecting information contained in this regulation have been reviewed and, pending receipt and evaluation of public comments, approved for use through January 31, 1991, by the Office of Management and Budget (OMB) under control number 1545-1037. The estimated annual burden per respondent for making a written election varies from 5 minutes to 15 minutes, depending on individual circumstances, with an estimated average of 6 minutes. These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require more or less time, depending on their circumstances.

For further information concerning this collection of information, and where to submit comments on this collection of information, the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble to the cross-reference notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register. Issuance of Proposed Regulation and Submission to Small Business Administration The rules contained in this document are also being issued as proposed regulations by the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register. Pursuant to section 7805(f) of the Internal Revenue Code, a copy of the rules will be submitted to the Administrator of the Small Business Administration for comment on their impact on small business.

Background

Temporary regulations under section 469 were published in the Federal Register for February 25, 1988 (53 FR 5686, T.D. 8175). Those regulations added §§1.469-0T, 1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T, and 1.469-11T to Title 26 of the Code of Federal Regulations, and indicated that the definition of activity would be contained in §1.469-4T. This document adds rules for identifying activities in §1.469-4T and amends §§1.469-0T, 1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T, and 1.469-11T in certain respects. The temporary regulations reflect the amendment of the Internal Revenue Code by sections 501 and 502 of the Tax Reform Act of 1986 (Pub. L. 99-514), which added section 469, and the amendment of section 469 by section 10212 of the Revenue Act of 1987 (Pub. L. 100-203) and sections 1005(a) and 2004(g) of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 100-647). Section 469 disallows the passive activity loss and the passive activity credit for the taxable year. Section 469(l)(1) provides that the Secretary of the Treasury or his delegate shall prescribe such regulations as may be necessary or appropriate to carry out provisions of section 469, including regulations which specify what constitutes an activity. Definition of Activity I. Description of Provisions A. Scope and Structure of §1.469-4T Section 1.469-4T provides rules under which endeavors to which the passive loss and credit limitations apply (business and rental operations) are treated as one or more activities for purposes of those limitations. In general, these rules are divided into three groups: (i) rules that identify the business and rental operations that constitute an undertaking (the undertaking rules); (ii) rules that identify the undertaking or undertakings that constitute an activity (the activity rules); and (iii) rules that apply only under certain special circumstances (the special rules). B. Undertaking Rules

The undertaking is generally the smallest unit that can constitute an activity, and an undertaking may include diverse business and rental operations. The basic undertaking rule identifies the business and rental operations that constitute an undertaking by reference to their location and ownership. Under this rule, business and rental operations that are conducted at the same location and are owned by the same person are generally treated as part of the same undertaking. Conversely, business and rental operations generally constitute separate undertakings to the extent that they are conducted at different locations or are not owned by the same person. In some circumstances the undertaking in which business and rental operations are included does not depend on the location at which the operations are conducted. Operations that are not conducted at any fixed place of business or that are conducted at the customer's place of business are treated as part of the undertaking with which the operations are most closely associated. In addition, operations that are conducted at a location but do not relate to the production of property at that location or to the transaction of business with customers at that location are treated, in effect, as part of the undertaking or undertakings that the operations support. The basic undertaking rule is also modified if the undertaking determined under that rule includes both rental and nonrental operations. In such cases, the rental operations and the nonrental operations generally must be treated as separate undertakings. This rule does not apply, however, if more than 80 percent of the income of the undertaking determined under the basic rule is attributable to one class of operations (i.e., rental or nonrental) or if the rental operations would not be treated as part of a rental activity because of the exceptions contained in §1.469- 1T(e)(3)(ii). For purposes of this rule, short-term rentals of real property (e.g., hotel-room rentals) are generally treated as nonrental operations. The regulations also treat oil and gas wells that are subject to the working-interest exception in

§1.469-1T(e)(4) as separate undertakings.

C. Activity Rules The basic activity rule treats each undertaking in which a taxpayer owns an interest as a separate activity of the taxpayer. In the case of trade or business undertakings, professional service undertakings, and rental real estate undertakings, additional rules may either require or permit the aggregation of two or more undertakings into a single activity. Trade or business undertakings include all nonrental undertakings other than oil and gas undertakings described above and professional service undertakings decribed below. An aggregation rule treats trade or business undertakings that are both similar and controlled by the same interests as part of the same activity. This rule is, however, generally inapplicable to small interests held by passive investors in such undertakings, except to the extent such interests are held through the same passthrough entity. Undertakings are similar for purposes of this rule if more than half (by value) of their operations are in the same line of business (as defined in a revenue procedure that the Service is issuing in conjunction with these regulations) or if the undertakings are vertically integrated. All the facts and circumstances are taken into account in determining whether undertakings are controlled by the same interests. If, however, each member of a group of five or fewer persons owns a

substantial interest in each of the undertakings, the undertakings may be rebuttably presumed to be controlled by the same interests. Trade or business undertakings (including undertakings that are aggregated under the rules described above) are also subject to a second aggregation rule. Under this rule, undertakings that constitute an integrated business and are controlled by the same interests must be treated as part of the same activity. Broader aggregation rules apply to professional service undertakings (i.e., undertakings that predominantly involve the provision of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting). In general, professional service undertakings that are either similar, related, or controlled by the same interests must be treated as part of the same activity. The rules for determining whether trade or business undertakings are controlled by the same interests also apply with respect to professional service undertakings. Professional service undertakings are similar, however, if more than 20 percent (by value) of their operations are in the same field, and two professional service undertakings are related if one of the undertakings derives more than 20 percent of its gross income from persons who are customers of the other undertaking. The rules for aggregating rental real estate undertakings are generally elective. They permit taxpayers to treat any combination of rental real estate undertakings as a single activity. Taxpayers may also divide their rental real estate undertakings and then treat portions of the undertakings as separate activities or recombine the portions into activities that include parts of different undertakings. The fragmentation of rental real estate into separate activities is limited by two consistency requirements. Taxpayers may not fragment their rental real estate in a manner that is inconsistent with their treatment of such property in prior taxable years or with the treatment of such property by the passthrough entity through which it is held. There are no comparable limitations on the aggregation of rental real estate into a single activity. A coordination rule provides, however, that a rental real estate undertaking must be treated as a separate activity if income or gain from the undertaking is subject to recharacterization under §1.469-2T(f)(3) (relating to the rental of nondepreciable property). Another elective rule permits taxpayers to treat a nonrental undertaking as a separate activity even if the undertaking would be treated as part of a larger activity under the aggregation rules applicable to the undertaking. This elective rule is limited by consistency requirements similar to those that apply to rental real estate operations. Moreover, in cases in which a taxpayer elects to treat a nonrental undertaking as a separate activity, the taxpayer's level of participation (i.e., material, significant, or otherwise) in the separate activity is the same as the taxpayer's level of participation in the larger activity in which the undertaking would be included but for the election. D. Special Rules Special rules apply to the business and rental operations of consolidated groups of corporations and publicly traded partnerships. Under these rules, a consolidated group is treated as one taxpayer in determining its activities and those of its members, and business and rental operations owned through a publicly traded

partnership cannot be aggregated with operations that are not owned through the partnership. There is also a special rule for taxable years ending before August 10, 1989. In those years, taxpayers may organize business and rental operations into activities under any reasonable method. A taxpayer will also be permitted to use any reasonable method to allocate disallowed deductions and credits among activities for the first taxable year in which the taxpayer's activities are determined under the general rules of §1.469-4T. II. Significant Policy Issues A. Definition of Undertaking Under the regulations, an activity of a taxpayer generally consists of either a single undertaking or a combination of two or more undertakings. Thus, the definition of undertaking should be broad enough to provide a useful intermediate step in determining a taxpayer's activities, but not so broad that unrelated business and rental operations are inappropriately combined in the same activity. Moreover, an undertaking should be defined with such precision that the business and rental operations that constitute an activity can be determined with reasonable certainty. The Service recognizes that no single definition of undertaking can reconcile these objectives in all cases. It believes, however, that a definition that strikes a reasonable balance among these competing objectives is essential to carry out the purposes of section 469 and to comply with section 469(l)(1), which directs the service to prescribe regulations that specify what constitutes an activity. Location and ownership are the primary factors used to identify the business and rental operations that constitute an undertaking. Thus, the number of a taxpayer's undertakings is generally limited to the number of locations at which the taxpayer conducts business directly plus the number of locations at which business is conducted by passthrough entities in which the taxpayer owns an interest. In most cases, the number of undertakings should be small enough to avoid the need for extensive application of the aggregation rules contained in the regulations. In fact, for the large number of taxpayers who conduct all their business operations at a single location, either directly or through a single passthrough entity, the determination that such operations constitute a single undertaking is generally the only analysis that the regulations require. The use of location and ownership as the primary factors in determining undertakings also contributes to certainty in the determination of activities. While some uncertainty is likely in the case of operations that are included in an undertaking without regard to the location at which the operations are conducted (i.e., operations that are not conducted at a fixed place of business, operations that are conducted at the customer's place of business, and support operations), the Service contemplates that reasonable methods will be used in determining the undertaking with which such operations are associated and that any reasonable method will be respected. The Service invites public comment regarding the desirability of detailed rules for determining the undertakings with which such operations are associated.

The Service recognizes that unrelated business operations may be treated as part of a single undertaking under these rules. In the typical case, however, operations that are conducted at the same location and are owned by the same person constitute an integrated and interrelated economic unit. Moreover, identification of the exceptional case in which such operations do not constitute an integrated and interrelated economic unit and might appropriately be treated as multiple undertakings would require additional analysis that would greatly undermine the certainty that these regulations are intended to provide. In addition, the accurate measurement of gain or loss from, and participation in, such multiple undertakings would generally require unduly burdensome allocations of income, expenses, and participation among the undertakings. For these reasons, the regulations do not provide an exception to the basic undertaking rule for those few cases in which, based on all the facts and circumstances, the operations conducted at a single location might appropriately be treated as multiple undertakings. B. Rental Undertaking All rental activities are passive, but other activities are passive only if the taxpayer does not materially participate. Because of this difference in treatment, it is inappropriate in most cases to combine rental operations and nonrental operations in a single activity. In the absence of a special rule, however, the basic undertaking rule would often treat rental operations and nonrental operations that are conducted at the same location as part of the same undertaking. To prevent this, the regulations provide in such cases that the rental operations and the nonrental operations are generally treated as two separate undertakings. In some cases, however, it is appropriate to treat rental operations and nonrental operations as part of the same activity. For example, operations that are incidental to other operations should be treated as part of the same activity even if they are not in the same class (i.e., rental or nonrental) as such other operations. Although all the facts and circumstances should be taken into account in determining whether operations in one class are incidental to operations in the other class, one of the most significant factors is the substantiality of the operations in each class relative to those in the other class. Moreover, even though it is generally more appropriate to separate rental and nonrental operations, the separation of those operations increases accounting burdens because of the need to allocate income, expenses, and participation between the rental and nonrental undertakings. As a result, it is difficult to justify treating rental and nonrental operations that are conducted at the same location as separate undertakings unless substantial operations are included in each undertaking. For these reasons, the rule separating rental and nonrental operations conducted at the same location does not apply if more than 80 percent of the aggregate income from the operations is attributable to one class of operations. C. Aggregation of Nonrental Undertakings The purpose of the aggregation rules applicable to nonrental undertakings is to identify undertakings that constitute an integrated and interrelated economic unit. This purpose suggests that all the facts and circumstances should be taken into account in determining whether undertakings are aggregated into a single activity. On the other hand, a rule requiring consideration of all relevant facts and circumstances would necessitate difficult and time-consuming analyses of the relationships between undertakings and would also introduce substantial uncertainty

into the identification of activities. Accordingly, the regulations generally limit the relevant factors to the two that the Service believes are most significant (similarity and control) and provide specific rules for taking those factors into account. The first of these factors, similarity, involves either common lines of business or different stages in the production or distribution of the same product or group of products. The function of this factor is to ascertain whether the nature of the businesses in which the undertakings are engaged is such that there can be meaningful interactions among undertakings, whether in the form of economies of scale, transactions between undertakings, or otherwise. Such interactions are an essential characteristic of an integrated and interrelated economic unit and do not typically occur between businesses that are conducted at different locations unless the businesses are similar within the meaning of the regulations. Businesses that, by their nature, could constitute an integrated and interrelated economic unit may, nevertheless, be competitors (if they involve a common line of business) or adversarial in their dealings (if they involve different stages in production or distribution) unless they serve and are coordinated by common interests. Conversely, businesses that are commonly controlled are typically integrated if the nature of the businesses is such that integration would result in economies of scale or other efficiencies. Accordingly, the second factor that must be taken into account under the regulations is control of the undertakings. The rules for determining whether undertakings are similar and are controlled by the same interests further limit the need to consider all relevant facts and circumstances. The regulations provide bright-line tests for determining whether undertakings are similar. Under these tests, the only relevant factors are the line of business (if any) from which more than 50 percent of an undertaking's gross income is derived and whether the undertaking provides more than 50 percent (by value) of its property and services to related undertakings or obtains more than 50 percent (by value) of its property and services from a related undertaking. Moreover, the lines of business used to determine similarity are generally adapted from the Standard Industrial Classification (SIC) of the United States, and thus are consistent with an established method of distinguishing and categorizing business operations. Similarly, the regulations simplify and minimize the uncertainty in determinations of common control by providing a rebuttable presumption under which undertakings are generally presumed to be controlled by the same interests if more than 50 percent of the interests in the undertakings are owned by the members of a group of five or fewer persons. The Service recognizes that unrelated business operations may be treated as part of the same activity under these rules. This raises essentially the same issue as treating unrelated business operations as part of the same undertaking, and the considerations taken into account in that context are equally applicable here. Accordingly, the regulations do not provide an exception to the aggregation rules for those few cases in which, based on all the facts and circumstances, similar and commonly-controlled undertakings might appropriately be treated as multiple activities. The aggregation rules are generally inapplicable to small interests held by passive investors in the undertakings, except to the extent such interests are held through the same passthrough entity. The purpose of this exception is not to ascertain more

accurately whether undertakings constitute an integrated and interrelated business activity, but rather to simplify the determination of activities for the taxpayers to whom it applies. In general, such taxpayers may accept a passthrough entity's identification and aggregation of undertakings and need not engage in further analysis to determine whether undertakings held through the entity should be aggregated with undertakings held directly or through other passthrough entities. In some cases, businesses that are not similar within the meaning of the regulations nonetheless constitute an integrated business if all the facts and circumstances are taken into account. The Service believes that a rule requiring such businesses to be treated as a single activity, if applied after the rule aggregating similar and commonly controlled undertakings, would not affect a large number of taxpayers. Moreover, even though such a rule requires consideration of all relevant facts and circumstances, this should not be a substantial burden if the only analysis required is of the relationships among a few large groups of operations. Accordingly, the regulations provide that one or more undertakings (or groups of undertakings that have been aggregated because of their similarity) are treated as a single activity if the undertakings (or groups of undertakings) are controlled by the same interests and, based on all the facts and circumstances, their operations constitute a single integrated business. Special aggregation rules are provided for professional service undertakings. These rules are necessary, in part, because of the material participation rule applicable to personal service activities. Thus, the rules do not permit the aggregation of professional service activities and other activities. In addition, the rules are significantly broader than those applicable to other nonrental undertakings. The Service believes that broader aggregation rules are appropriate in this context because all professional services share certain similarities and it is increasingly common for professional-service firms to provide services in more than one field. Morever, a professional-service firm's success in one field is more likely to be attributable to expertise and goodwill developed in another field than is the case with other nonrental businesses. D. Rental Real Estate Undertakings The treatment of a taxpayer's nonrental operations as one or more activities significantly affects the computation of the taxpayer's passive activity loss and credit, primarily because material and significant participation are measured on an activity-by-activity basis and because certain rules that recharacterize income associated with nonrental operations also apply on an activity-by-activity basis. Thus, to prevent avoidance of the passive loss rules by inappropriately grouping operations into activities that do not constitute integrated and interrelated economic units, taxpayers are required to conform to precise rules for identifying the operations that are included in a nonrental activity. The organization of rental operations into activities does not provide comparable opportunities for avoidance of the passive loss rules because the character of the income or loss from rental operations is generally not affected by the taxpayer's participation in the activity in which the operations are included and the rules recharacterizing income from rental operations generally apply on a property-by-property basis. A taxpayer's participation is relevant in computing the $25,000 offset for rental real estate activities. The purpose of the offset, however, it to provide

targeted relief to moderate income taxpayers, and its amount and the taxpayers to which it applies are limited accordingly. Thus, the Service does not believe it is necessary to provide rules in these regulations that further restrict the availability of the offset. Because specific rules similar to those applicable to nonrental operations are not necessary in the case of rental operations, the regulations generally permit taxpayers to organize their rental real estate operations into activities in any manner they find convenient or advantageous. Taxpayers are not permitted, however, to fragment their rental real estate operations into separate activities to a greater extent than in preceding taxable years or to a greater extent than such operations are fragmented by the passthrough entity through which they are held. The first limitation prevents taxpayers from treating operations as an activity in cases in which their records are not likely to contain sufficient detail to permit them to compute the suspended loss from the activity. Similarly, the second limitation prevents taxpayers from treating operations as an activity in cases in which the accounting information provided to them by the passthrough entity is unlikely to be detailed enough to permit them to compute the net income or loss from the activity. A third limitation provides that a rental real estate undertaking must be treated as a separate activity if income from the undertaking is subject to recharacterization under §1.469-2T(f)(3). This limitation is necessary to maintain the integrity of the recharacterization rule. The rules described above apply only to rental operations involving real property. The Service invites public comment regarding the desirability of providing similar flexibility with respect to rental operations involving personal property. E. Election to Treat Nonrental Undertakings as Separate Activities Although a nonrental undertaking may, with other nonrental undertakings, constitute an integrated and interrelated economic unit, the synergistic effects resulting from the conduct of the undertaking as part of an integrated business generally cease when there is a disposition of the undertaking. Thus, the activity that remains after such a disposition is fundamentally different from the activity conducted before the disposition. As a result, the disposition of an undertaking will often be an appropriate time to measure economic income or loss. Moreover, an undertaking generally consists of identifiable operations that are conducted at a single location, and a disposition of such operations should, in most cases, permit the accurate measurement of the economic income or loss from the portion of a business that is conducted at the location. For the reasons described above, the Service believes that an undertaking may constitute an appropriate unit for measuring gain or loss even in cases in which it is part of a larger integrated business. Accordingly, the regulations permit taxpayers to elect to treat a nonrental undertaking as a separate activity (other than for purposes of measuring participation) even though under the aggregation rules the undertaking would be treated as part of a larger activity. This election is not available, however, if the taxpayer treated the undertaking as part of a larger activity in a preceding taxable year or if the passthrough entity through which the undertaking is held treats it as part of a larger activity. The purpose of these exceptions is the same as the purpose of the similar limitations that apply to the election to treat rental real estate operations as separate activities.

In some cases, an undertaking may be conducted in a manner that enhances the value of other undertakings to the detriment of its own value. In such cases, the economic income or loss from an undertaking cannot be accurately measured at the time of its disposition. Accordingly, the Service is considering a rule that would provide in such cases that a disposition of a taxpayer's interest in such an undertaking is not treated as a disposition of the taxpayer's entire interest in an activity for purposes of section 469(g). If adopted, this rule would be contained in the regulations to be issued under §1.469-6T (relating to the treatment of losses upon certain dispositions of passive and former passive activities). Amendments Made to Existing Regulations This document also amends portions of the existing regulations under section 469 to coordinate those regulations with the definition of activity contained in §1.469-4T and to make certain clarifying and corrective changes to the existing regulations. The significant changes made to the existing regulations by these amendments are described below. I. Section 1.469-1T The determination of whether an activity is a rental activity under §1.469-1T(e)(3) generally requires the computation of an average period of customer use for the activity. The average period of customer use, as defined in §1.469-1T(e)(3)(iii), is not weighted to reflect differences in the rental value of the activity's property. Thus, property that produces an insignificant amount of an activity's rental income might significantly affect the activity's average period of customer use. Therefore, this document amends the definition of average period of customer use to take into account the amount of income generated by an item of property. This document also amends the rule contained in §1.4469-1T(f)(4) (relating to the allocation of disallowed deductions and credits among activities) to reflect the possibility that the composition of an activity may change from year to year. II. Section 1.469-2T This document amends §1.469-2T (c) and (d) to provide rules for characterizing the gain and loss from the sale of property held in a dealing activity at the time of the sale. For purposes of characterizing the gain or loss from the sale of any such property that was used predominantly in one or more nondealing activities and was not acquired for the principal purpose of dealing in such property, the rules provide that holding the property in the dealing activity is treated as the use of the property in the last nondealing activity in which such property was used before its sale. In all other cases, the rules provide that the property is treated as used in the dealing activity, and treat such property as used in a dealing activity for any period during which it is simultaneously offered for sale to customers and used in a nondealing activity. These rules replace the provision contained in §1.469-1T(e)(3)(vi)(D) of the existing regulations. Under that provision, certain rentals of property were treated as incidental to an activity of dealing in such property rather than as part of a rental activity. The Service has received numerous comments regarding the income-recharacterization rule contained in §1.469-2T(f)(5), relating to the treatment of net

income from certain property rented incidental to a developent activity. Some commentators have argued that there are a substantial number of cases in which the gain on the dispositon of property that is used in a rental activity for less than 24 months after its development is predominantly attributable to its use in a rental activity rather than to the development of the property. Other commentators have argued that there should be no special recharacterization rule with respect to development activities. After careful consideration, it has been determined that

§1.469-2T(f)(5) should apply only if the use of an item of property in an activity

involving the rental of such property commenced less than 12 months prior to its sale (or contracting for its sale). Accordingly, this document amends the existing regulations to provide for this result. III. Section 1.469-5T Under §1.469-4T, the business and rental operations that constitute an activity may change from year to year. The existing regulations do not address how the material participation tests that are based on participation in prior years will apply in cases in which such changes occur. Accordingly, this document amends §1.469-5T to provide that, for purposes of the material participation tests that are based on participation in prior years, a taxpayer is treated as materially participating in an activity for a prior taxable year if the activity includes an undertaking involving substantially the same operations as an undertaking that was included in an activity in which the taxpayer materially participated during such prior taxable year.

Special Analyses

These rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required.

Drafting Information

The principal author of these regulations is Michael J. Grace, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations on matters of both substance and style.

List of Subjects

26 CFR 1.441-1 through 1.483-2 Accounting, Deferred compensation plans, Income taxes. 26 CFR Part 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, Title 26, Chapter 1, Parts 1 and 602 of the Code of Federal Regulations are amended as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

1953 Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority

26 U.S.C. 7805. Section 1.469-4T also issued under 26 U.S.C. 469(l)(1). Par. 2. Section 1.469-OT is revised to read as follows:

§1.469-OT Table of contents (temporary).

This section lists the captions that appear in the temporary regulations under section 469. Section 1.469-1T General rules (temporary). (a) Passive activity loss and credit disallowed. (1) In general. (2) Exceptions. (b) Taxpayers to whom these rules apply. (c) Cross references. (1) Definition of passive activity. (2) Passive activity loss. (3) Passive activity credit. (4) Effect of rules for other purposes. (5) Special rule for oil and gas working interests. (6) Treatment of disallowed losses and credits. (7) Corporations subject to section 469. (8) Consolidated groups. (9) Joint returns. (10) Material participation. (11) Effective data and transition rules.

(12) Future regulations. (d) Effect of section 469 and the regulations thereunder for other purposes. (1) Treatment of items of passive activity income and gain. (2) Coordination with sections 613A (d) and 1211. (3) Treatment of passive activity losses. (e) Definition of "passive activity." (1) In general. (2) Trade or business activity. (3) Rental activity. (i) In general. (ii) Exceptions. (iii) Average period of customer use. (A) In general. (B) Average use factor. (C) Average period of customer use for class of property. (D) Period of customer use. (E) Class of property. (F) Gross rental income and daily rent. (iv) Significant personal services. (A) In general. (B) Excluded services. (v) Extraordinary personal services. (vi) Rental of property incidental to a nonrental activity of the taxpayer. (A) In general. (B) Property held for investment.

(C) Property used in a trade or business. (D) Lodging rented for convenience of employer. (E) Unadjusted basis. (vii) Property made available for use in a nonrental activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest. (viii) Examples. (4) Special rule for oil and gas working interests. (i) In general. (ii) Exception for deductions attributable to a period during which liability is limited. (A) In general. (B) Coordination with rules governing the identification of disallowed passive activity deductions. (C) Meaning of certain terms. (1) Allocable deductions. (2) Disqualified deductions. (3) Net loss. (4) Ratable portion. (iii) Examples. (iv) Definition of "working interest." (v) Entitles that limit liability. (A) General rule. (B) Other limitations disregarded. (C) Examples. (vi) Cross reference to special rule for income from certain oil or gas properties. (5) Rental of dwelling unit. (6) Activity of trading personal property.

(i) In general. (ii) Personal property. (iii) Example. (f) Treatment of disallowed passive activity losses and credits. (1) Scope of this paragraph. (2) Identification of disallowed passive activity deductions. (i) Allocation of disallowed passive activity loss among activities. (A) General rule. (B) Loss from an activity. (C) Significant participation passive activities. (D) Examples. (ii) Allocation with loss activities. (A) In general. (B) Excluded deductions. (iii) Separately identified deductions. (3) Identification of disallowed credits from passive activities. (i) General rule. (ii) Coordination rule. (iii) Separately identified credits. (4) Carryover of disallowed deductions and credits. (i) In general. (ii) Operations continued through C corporations or similar entities. (iii) Examples. (g) Application of these rules to C corporations. (1) In general.

(2) Definitions. (3) Participation of corporations. (i) Material participation. (ii) Significant participation. (iii) Participation of individual. (4) Modified computation of passive activity loss in the case of closely held corporations. (i) In general. (ii) Net active income. (iii) Examples. (5) Allowance of passive activity credit of closely held corporations to extent of net active income tax liability. (i) In general. (ii) Net active income tax liability. (h) Special rules for affiliated group filing consolidated return. (1) In general. (2) Definitions. (3) Disallowance of consolidated group's passive activity loss or credit. (4) Status and participation of members. (i) Determination by reference to status and participation of group. (ii) Determination of status and participation of consolidated group. (5) Modification of rules for identifying disallowed passive activity deductions and credits. (i) Identification of disallowed deductions. (ii) Ratable portion of disallowed passive activity loss. (iii) Identification of disallowed credits.

(6) Transactions between members of a consolidated group. (i) Scope. (ii) Recharacterization of gain or loss from intercompany transactions other than deferred intercompany transactions. (A) In general. (B) Recharacterization of gain or loss as portfolio items. (iii) Deferred intercompany transactions. (A) In general. (B) Deferred intercompany transactions involving property subject to depreciation, amortization, or depletion. (C) Restoration of deferred gain or loss of dispositions. (D) Certain recharacterized items treated as portfolio items. (E) Property involved in deferred intercompany transaction. (iv) Definitions. (A) Deferred intercompany transactions. (B) Directly related. (C) Intercompany transaction. (D) Purchasing member. (E) Selling member. (7) Disposition of stock of a member of an affiliated group. (8) Dispositions of property used in multiple activities. (i) [Reserved] (j) Spouses filing joint return. (1) In general. (2) Exceptions of treatment as one taxpayer. (i) Identification of disallowed deductions and credits.

(ii) Treatment of deductions disallowed under sections 704(d), 1366(d), and 465. (iii) Treatment of losses from working interests. (3) Joint return no longer filed. (4) Participation of spouses. (k) Former passive activities and changes in status of corporations. [Reserved] Section 1.469-2T Passive activity loss (temporary). (a) Scope of this section. (b) Definition of passive activity loss. (1) In general. (2) Cross references. (c) Passive activity group income. (1) In general. (2) Treatment of gain from disposition of an interest in an activity or an interest in property used in an activity. (i) In general. (A) Treatment or gain. (B) Dispositions of partnership interests and S corporation stock. (C) Interest in property. (D) Examples. (ii) Disposition of property used in more than one activity in 12-month period preceding disposition. (iii) Disposition of substantially appreciated property formerly used in nonpassive activity. (A) In general. (B) Date of disposition. (C) Substantially appreciated property.

(D) Investment property. (E) Coordination with paragraph (c)(2)(ii) of this section. (F) Coordination with section 163(d). (G) Examples. (iv) Taxable acquisitions. (v) Property held for sale to customers. (A) Sale incidental to another activity. (1) Applicability. (i) In general. (ii) Principal purpose. (2) Dealing activity not taken into account. (B) Use in a nondealing activity incidental to sale. (C) Examples. (3) Items of portfolio income specifically excluded. (i) In general. (ii) Gross income derived in the ordinary course of a trade or business. (iii) Special rules. (A) Income from property held for investment by dealer. (B) Royalties derived in the ordinary course of the trade or business of licensing intangible property. (1) In general. (2) Substantial services or costs. (i) In general. (ii) Exception. (iii) Expenditures taken into account.

(3) Passthrough entities. (4) Cross reference. (C) Mineral production payments. (iv) Examples. (4) Items of personal service income specifically excluded. (i) In general. (ii) Example. (5) Income from section 481 adjustment. (i) In general. (ii) Positive section 481 adjustments. (iii) Ratable portion. (6) Gross income from certain oil or gas properties. (i) In general. (ii) Gross and net passive income from the property. (iii) Property. (iv) Examples. (7) Other items specifically excluded. (d) Passive activity deductions. (1) In general. (2) Exceptions. (3) Interest expense. (4) Clearly and directly allocable expenses. (5) Treatment of loss from disposition. (i) In general.

(ii) Disposition of property used in more than one activity in 12-month period preceding disposition. (iii) Other applicable rules. (A) Applicability of rules in paragraph (c)(2). (B) Dispositions of partnership interests and S corporation stock. (6) Coordination with other limitations on deductions that apply before section 469. (i) In general. (ii) Proration of deductions disallowed under basis limitations. (A) Deductions disallowed under section 704 (d). (B) Deductions disallowed under section 1366 (d). (iii) Proration of deductions disallowed under at-risk limitation. (iv) Coordination of basis and at-risk limitations. (v) Separately identified items of deduction and loss. (7) Deductions from section 481 adjustment. (i) In general. (ii) Negative section 481 adjustments. (iii) Ratable portion. (8) Taxable year in which item arises. (e) Special rules for partners and S corporation shareholders. (1) In general. (2) Payments under sections 707(a), 707(c), and 736(b). (i) Section 707(a). (ii) Section 707(c). (iii) Payments in liquidation of a partner's interest in partnership property. (A) In general.

(B) Payments in liquidation of a partner's interest in unrealized receivables and goodwill under section 736(a). (3) Sale or exchange of interest in passthrough entity. (i) Application of this paragraph (e)(3). (ii) General rule. (A) Allocation among activities. (B) Ratable portion. (1) Dispositions on which gain is recognized. (2) Dispositions on which loss is recognized. (C) Default rule. (D) Special rules. (1) Applicable valuation date. (i) In general. (ii) Exception. (2) Basis adjustments. (3) Tiered passthrough entities. (E) Meaning of certain terms. (iii) Treatment of gain allocated to certain passive activities as not from a passive activity. (iv) Dispositions occurring in taxable years beginning before February 19, 1988. (A) In general. (B) Exceptions. (v) Treatment of portfolio assets. (vi) Definitions. (vii) Examples. (f) Recharacterization of passive income in certain situations.

(1) In general. (2) Special rule for significant participation. (i) In general. (ii) Significant participation passive activity. (iii) Example. (3) Rental of nondepreciable property. (4) Net interest income from passive equity- financed lending activity. (i) In general. (ii) Equity-financed lending activity. (A) In general. (B) Certain liabilities not taken into account. (iii) Equity-financed interest income. (iv) Net interest income. (v) Interest-bearing assets. (vi) Liabilities incurred in the activity. (vii) Average outstanding balance. (viii) Example. (5) Net income from certain property rented incidental to development activity. (i) In general. (ii) Commencement of use. (iii) Services performed for the purpose of enhancing the value of property. (iv) Example. (6) Property rented to a nonpassive activity. (7) Special rules applicable to the acquisition of an interest in a passthrough entity engaged in the trade or business of licensing intangible property.

(i) In general. (ii) Royalty income from property. (iii) Exceptions. (iv) Capital expenditures. (v) Example. (8) Limitation on recharacterized income. (9) Meaning of certain terms. (10) Coordination with section 163(d). (11) Effective date. Section 1.469-3T Passive activity credit (temporary). (a) Computation of passive activity credit. (b) Credits subject to section 469. (1) In general. (2) Treatment of credits attributable to qualified progress expenditures. (3) Special rule for partners and S corporation shareholders. (4) Exception for pre-1987 credits. (c) Taxable year to which credit is attributable. (d) Regular tax liability allocable to passive activities. (1) In general. (2) Regular tax liability. (e) Coordination with section 38(b). (f) Coordination with section 47. (g) Examples. Section 1.469-4T Definition of activity (temporary). (a) Overview.

(1) Purpose and effect of overview. (2) Scope and structure of §1.469-4T. (3) Undertaking rules. (i) In general. (ii) Basic undertaking rule. (iii) Circumstances in which location is disregarded. (iv) Rental undertakings. (v) Oil and gas wells. (4) Activity rules. (i) In general. (ii) Aggregation of trade or business undertakings. (A) Trade or business undertakings. (B) Similar, commonly-controlled undertakings treated as a single activity. (C) Integrated businesses treated as a single activity. (iii) Aggregation of professional service undertakings. (iv) Rules for rental real estate. (A) Taxpayers permitted to determine rental real estate activities. (B) Limitations on fragmentation and aggregation of rental real estate. (v) Election to treat nonrental undertakings as separate activities. (5) Special rules. (i) Consolidated groups and publicly traded partnerships. (ii) Transitional rule. (b) General rule and definitions of general application. (1) General rule. (2) Definitions of general application.

(i) Passthrough entity. (ii) Business and rental operations. (A) In general. (B) Operations conducted through nonpassthrough entities. (c) Undertaking. (1) In general. (2) Operations treated as a separate source of income production. (i) In general. (ii) Treatment of support operations. (A) In general. (B) Support operations. (iii) Location. (iv) Income-producing operations. (v) Ownership by the same person. (3) Facts and circumstances determinations. (4) Examples. (d) Rental undertaking. (1) In general. (2) Exceptions. (3) Rental operations. (i) General rule. (ii) Real property provided for short-term use. (iii) Property made available to licensees. (4) Examples. (e) Special rules for certain oil and gas operations.

(1) Wells treated as nonpassive under §1.469-1T(e)(4)(i). (2) Business and rental operations that constitute an undertaking. (3) Examples. (f) Certain trade or business undertakings treated as part of the same activity. (1) Applicability. (i) In general. (ii) Trade or business undertaking. (2) Treatment as part of the same activity. (3) Substantial indirect interest. (i) In general. (ii) Coordination rule. (4) Similar undertakings. (i) In general. (ii) Predominant operations. (iii) Vertically-integrated undertakings. (A) Supplier undertaking similar to recipient undertaking. (B) Recipient undertaking similar to supplier undertaking. (C) Coordination rules. (iv) Lines of business. (5) Examples. (g) Integrated businesses. (1) Applicability. (i) In general. (ii) Trade or business activity. (2) Treatment as a single activity.

(3) Facts and circumstances tests. (4) Examples. (h) Certain professional service undertakings treated as a single activity. (1) Applicability. (i) In general. (ii) Professional service undertaking. (2) Treatment as a single activity. (i) Undertakings controlled by the same interests. (ii) Undertakings involving significant similar or significant related services. (iii) Coordination rule. (3) Significant similar or significant related services. (4) Examples. (i) [Reserved] (j) Control by the same interests and ownership percentage. (1) In general. (2) Presumption. (i) In general. (ii) Common-ownership group. (iii) Special aggregation rule. (3) Ownership percentage. (i) In general. (ii) Passthrough entities. (iii) Attribution rules. (A) In general. (B) Determination of common-ownership percentage.

(C) Related person. (4) Special rule for trade or business activities. (5) Examples. (k) Identification of rental real estate activities. (1) Applicability. (i) In general. (ii) Rental real estate undertaking. (2) Identification of activities. (i) Multiple undertakings treated as a single activity or multiple activities by taxpayer. (ii) Multiple undertakings treated as a single activity by passthrough entity. (iii) Single undertaking treated as multiple undertakings. (3) Treatment in succeeding taxable years. (4) Applicable return of passthrough entity. (5) Evidence of treatment required. (6) Coordination rule for rental of nondepreciable property. (7) Coordination rule for rental of dwelling unit. (8) Examples. (l) [Reserved] (m) Consolidated groups. (1) In general. (2) Examples. (n) Publicly traded partnerships. (o) Elective treatment of undertakings as separate activities. (1) Applicability.

(2) Undertakings treated as separate activities. (3) Multiple undertakings treated as a single activity by passthrough entity. (4) Multiple undertakings treated as a single activity for a preceding taxable year. (5) Applicable return of passthrough entity. (6) Participation. (7) Election. (i) In general. (ii) Written statement. (8) Examples. (p) Special rule for taxable years ending before August 10, 1989. (1) In general. (2) Unreasonable methods. (3) Allocation of disallowed deductions in succeeding taxable year. Section 1.469-5T Material participation (temporary). (a) In general. (b) Facts and circumstances. (1) In general. [Reserved] (2) Certain participation insufficient to constitute material participation under this paragraph (b). (i) Participation satisfying standards not contained in section 469. (ii) Certain management activities. (iii) Participation less than 100 hours. (c) Significant participation activity. (1) In general. (2) Significant participation.

(d) Personal service activity. (e) Treatment of limited partners. (1) General rule. (2) Exceptions. (3) Limited partnership interest. (i) In general. (ii) Limited partner holding general partner interest. (f) Participation. (1) In general. (2) Exceptions. (i) Certain work not customarily done by owners. (ii) Participation as an investor. (A) In general. (B) Work done in individual's capacity as an investor. (3) Participation of spouse. (4) Methods of proof. (g) Material participation of trusts and estates. [Reserved] (h) Miscellaneous rules. (1) Participation of corporations. (2) Treatment of certain retired farmers and surviving spouses of retired or disabled farmers. (3) Coordination with rules governing the treatment of passthrough entities. (i) [Reserved] (j) Material participation for preceding taxable years. (1) In general.

(2) Material participation for taxable years beginning before January 1, 1987. (k) Examples. Section 1.469-6T Treatment of losses upon certain dispositions (temporary). [Reserved] Section 1.469-7T Treatment of self-charged items of income and expense (temporary). [Reserved] Section 1.469-8T Application of section 469 to trusts, estates, and their beneficiaries (temporary). [Reserved] Section 1.469-9T Treatment of income, deductions, and credits from certain rental real estate activities (temporary). [Reserved] Section 1.469-10T Application of section 469 to publicly traded partnerships (temporary). [Reserved] Section 1.469-11T Effective date and transition rules (temporary). (a) Effective date. (1) In general. (2) Application of certain income recharacterization rules. (i) In general. (ii) Property rented to a nonpassive activity. (3) Qualified low-income housing projects. (4) Effect of events occurring in years prior to 1987. (5) Examples. (b) Transitional rule for pre-enactment loss and pre-enactment credit. (1) In general. (2) Applicable percentage. (3) Pre-enactment loss. (4) Pre-enactment credit. (5) Examples.

(c) Definition of pre-enactment interest. (1) General rule. (2) Qualified interest. (i) In general. (ii) Stock in a C corporation. (3) Pre-enactment activity. (i) In general. (ii) Character before 1987 irrelevant. (4) Examples. (5) Effect of changes in a taxpayer's interest in a pre-enactment activity. (i) In general. (ii) Partnership terminations under section 708(b)(1)(B). (iii) Examples. (6) Special rule for beneficiaries of trusts or estates. (i) In general. (ii) Interests distributed to beneficiaries. (7) Written binding contract. (i) In general. (ii) Special rule for contract of partnership or S corporation. (iii) Application of rule to partnership agreements.

§1.469-1T [Amended]

Par. 3. Section 1.469-1T is amended as follows: 1. Paragraph (d)(2) is amended by revising the heading and first sentence to read as follows: (d)

(2) Coordination with sections 613A(d) and 1211. A passive activity deduction that is not disallowed for the taxable year under section 469 and the regulations thereunder may nonetheless be disallowed for the taxable year under section 613A(d) or 1211. 2. Paragraph (e)(2) is revised to read as follows: (e) (2) Trade or business activity. An activity (within the meaning of §1.469-4T) is a trade or business activity for a taxable year if and only if such activity- (i) Is not a rental activity for such taxable year; and (ii) Involves the conduct during such taxable year of business or rental operations (within the meaning of §1.469-4T(b)(2)(ii)) that are not treated under paragraph (e)(3)(vi)(B) of this section as incidental to an activity of holding property for investment. 3. Paragraph (e)(3)(iii) is revised to read as follows: (e) (3) (iii) Average period of customer use-(A) In general. For purposes of this paragraph (e)(3), the average period of customer use for property held in connection with an activity (the "activity's average period of customer use") is the sum of the average use factors for each class of property held in connection with the activity. (B) Average use factor. The average use factor for a class of property held in connection with an activity is the average period of customer use for such class of property multiplied by the fraction obtained by dividing- (1) The activity's gross rental income attributable to such class of property; by (2) The activity's gross rental income. (C) Average period of customer use for class of property. In determining an activity's average period of customer use for a taxable year, the average period of customer use for a class of property held in connection with an activity is determined by dividing- (1) The aggregate number of days in all periods of customer use for property in such class (taking into account only periods that end during such taxable year or that include the last day of such taxable year); by (2) The number of such periods of customer use. (D) Period of customer use. Each period during which a customer has a continuous or recurring right to use an item of property held in connection with the activity

(without regard to whether the customer uses the property for the entire period or whether such right to use the property is pursuant to a single agreement or to renewals thereof) is treated for purposes of this paragraph (e)(3)(iii) as a separate period of customer use. The duration of a period of customer use that includes the last day of a taxable year may be determined on the basis of reasonable estimates. (E) Class of property. Taxpayers may organize property into classes for purposes of this paragraph (e)(3)(iii) using any method under which items of property for which the daily rent differs significantly are not included in the same class. (F) Gross rental income and daily rent. In determining an activity's average period of customer use for a taxable year- (1) The activity's gross rental income is the gross income from the activity for such taxable year taking into account only income that is attributable to amounts paid for the use of property; (2) The activity's gross rental income attributable to a class of property is the gross income from the activity for such taxable year taking into account only income that is attributable to amounts paid for the use of property in such class; and (3) The daily rent for items of property may be determined on any basis that reasonably reflects differences during the taxable year in the amounts ordinarily paid for one day's use of such items of property. 4. Paragraph (e)(3)(vi) is amended by removing paragraph (e)(3)(vi)(D) and by redesignating paragraph (e)(3)(vi)(E) and (F) as paragraph (e)(3)(vi)(D) and (E). 5. Paragraph (e)(4)(iv) is revised to read as follows: (e) (4) (iv) Definition of "working interest." For purposes of section 469 and the regulations thereunder, the term "working interest" means a working or operating mineral interest in any tract or parcel of land (within the meaning of §1.612-4(a)). 6. Paragraph (e)(5) is revised to read as follows: (e) (5) Rental of dwelling unit. An activity involving the rental of a dwelling unit is not a passive activity of a taxpayer for any taxable year in which section 280A (c)(5) applies to the taxpayer's use of such dwelling unit. 7. Paragraph (f)(4) is revised to read as follows: (f)

(4) Carryover of disallowed deductions and credits-(i) In general. If any deductions or credits from an activity of a taxpayer (the loss activity) are disallowed for a taxable year under paragraph (f)(2) or (f)(3) of this section- (A) The disallowed deductions or credits shall be allocated among the taxpayer's activities for the succeeding taxable year in a manner that reasonably reflects the extent to which each such activity continues the business and rental operations that constituted the loss activity; and (B) The disallowed deductions or credits allocated to an activity under paragraph (f)(4)(i)(A) of this section shall be treated as deductions or credits from such activity for the succeeding taxable year. (ii) Operations continued through C corporations or similar entities. (A) If a taxpayer continues part or all of the business and rental operations that constitute a loss activity through a C corporation or similar entity, the taxpayer's interest in such entity shall be treated for purposes of this paragraph (f)(4) as an interest in a passive activity that continues such operations. An entity is similar to a C corporation for this purpose if the owners of interests in the entity derive only portfolio income (within the meaning of §1.469-2T(c)(3)(i)) from such interests. (B) If, after the application of this paragraph (f)(4)(ii), an interest in a C corporation or similar entity is a loss activity for a taxable year, such interest shall be treated for purposes of applying this paragraph (f)(4) in the succeeding taxable year as an interest in a passive activity that continues the business and rental operations of such loss activity. (iii) Examples. The following examples illustrate the application of this paragraph (f)(4). In each example, the taxpayer is an individual whose taxable year is the calendar year. Example (1). (i) The taxpayer owns interests in a convenience store and an apartment building. In each taxable year, the taxpayer's interests in the convenience store and the apartment building are treated under § 1.469-4T as interests in two separate passive activities of the taxpayer. A $5,000 loss from the convenience-store activity and a $3,000 loss from the apartment-building activity are disallowed under paragraph (f)(2) of this section for 1989. (ii) Under paragraph (f)(2) of this section, the $5,000 loss from the convenience-store activity is allocated among the passive activity deductions from that activity for 1989, and the $3,000 loss from the apartment-building activity is treated similarly. In 1990, the business and rental operations that constituted the convenience-store activity are continued in a single activity, and the business and rental operations that constituted the apartment-building activity are similarly continued in a separate activity. Thus, the disallowed deductions from the convenience-store activity for 1989 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's convenience-store activity in 1990. Similarly, the disallowed deductions from the apartment-building activity for 1989 must be allocated to the taxpayer's apartment-building activity in 1990. Under paragraph (f)(4)(i)(b) of this section, the disallowed deductions allocated to the convenience-store activity in 1990 are treated as deductions from that activity for 1990, and the disallowed deductions allocated to the

apartment-building activity for 1990 are treated as deductions from the apartment-building activity for 1990. Example (2). (i) In 1991, the taxpayer acquires a restaurant and a catering service. In 1991 and 1992, the restaurant and the catering service are conducted at the same location, and the taxpayer's interests in the restaurant and catering service are treated under §1.469-4T as an interest in a single passive activity of the taxpayer. A $10,000 loss from the activity is disallowed under paragraph (f)(2) of this section for 1992. In 1993, the restaurant and the catering service are conducted at different locations, and the taxpayer's interests in the restaurant and the catering service are treated under §1.469-4T as interests in two separate passive activities of the taxpayer. (ii) Under paragraph (f)(2) of this section, the $10,000 loss from the restaurant and catering activity is allocated among the passive activity deductions from that activity for 1992. In 1993, the business and rental operations that constituted the restaurant and catering activity are continued, but are treated as two separate activities under

§1.469-4T. Thus, the disallowed deductions from the restaurant and catering activity

for 1992 must be allocated under paragraph (f)(4)(i)(A) of this section between the restaurant activity and the catering activity in 1993 in a manner reasonably reflects the extent to which each of the activities continues the operations of the restaurant and catering activity. Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions allocated to the restaurant activity in 1993 are treated as deductions from the restaurant activity for 1993, and the disallowed deductions allocated to the catering activity in 1993 are treated as deductions from the catering activity for 1993. Example (3). (i) The facts are the same as in example (2). In addition, a $20,000 loss from the activity was disallowed under paragraph (f)(2) of this section for 1991, and the gross income and deductions (including deductions that were disallowed for 1991 under paragraph (f)(2) of this section) from the restaurant and catering service for 1991 and 1992 are as follows: -------------------------------------------------------- ----------------------- Restaurant Catering service --------------------------------------- ---------------------------------------- 1991: Gross income ................................. $20,000 $60,000 Deductions .................................... 40,000 60,000 --------------- -------------------------------- Net income (loss) ........................... (20,000) --------- -------------- 1992: Gross income .................................. 40,000 50,000 Deductions .............................. [] 30,000 [] 70,000 ---------------------------------- ------------- Net income (loss) ............................. 10,000 (20,000) ----------------- -------------------------------------------------------------- 1 Includes $8,000 of deductions that were disallowed for 1991 ($20,000x$40,000/$100,000). 2 Includes $12,000 of deductions that were disallowed for 1991 ($20,000x$60,000/$100,000). (ii) Under paragraph (f)(4)(i)(A) of this section, the disallowed deductions from the restaurant and catering operations must be allocated among the taxpayer's activities for the succeeding year in a manner that reasonably reflects the extent to which such activities continue the restaurant and catering operations. The remainder of this example describes a number of allocation methods that will ordinarily satisfy the requirement of paragraph (f)(4)(i)(A) of this section. One or more of the allocation methods described in this example may, however, be unreasonable in certain cases. In addition, the description of specific allocation methods in this example does not

preclude the use of other reasonable allocation methods for purposes of paragraph (f)(4)(i)(A) of this section. (iii) Ordinarily, an allocation of disallowed deductions from the restaurant operations to the restaurant activity and disallowed deductions from the catering operations to the catering activity would satisfy the requirement of paragraph (f)(4)(i)(A) of this section. Under paragraph (f)(2)(ii) of this section, a ratable portion of each deduction from the restaurant and catering activity is disallowed for 1992. Thus, $3,000 of the 1992 deductions from the restaurant operations are disallowed ($10,000×$30,000/$100,000), and $7,000 of the 1992 deductions from the catering operations are disallowed ($10,000×$70,000/$100,000). Thus, the taxpayer can ordinarily treat $3,000 of the disallowed deductions as deductions from the restaurant activity for 1993, and $7,000 of the disallowed deductions as deductions from the catering activity for 1993. (iv) Ordinarily, an allocation of disallowed deductions between the restaurant and catering activities in proportion to the losses from the restaurant operations and the catering operations for 1992 would also satisfy the requirement of paragraph (f)(4)(i)(A) of this section. If the restaurant operations and the catering operations had been treated as separate activities in 1992, the restaurant activity would have had net income of $10,000 and the catering activity would have had a $20,000 loss. Thus, the taxpayer can ordinarily treat all $10,000 of disallowed deductions as deductions from the catering activity for 1993. (v) Ordinarily, an allocation of disallowed deductions between the restaurant and catering activities in proportion to the losses from the restaurant operations and catering operations for 1992 (determined as if the restaurant operations and the catering operations had been separate activities for all taxable years) would also satisfy the requirement of paragraph (f)(4)(i)(A) of this section. If the restaurant operations and the catering operations had been treated as separate activities for all taxable years, the entire $20,000 loss from the restaurant operations in 1991 would have been allocated to the restaurant activity in 1992, and the gross income and deductions from such separate activities for 1992 would be as follows: ---------------- --------------------------------------------- Restaurant Catering service ----------------- -------------------------------------------- Gross income ................... $40,000 $50,000 Deductions ...................... 42,000 58,000 ---------------------------------- Net income (loss) .............. (2,000) (8,000) -------------------------------------------- ----------------- Thus, the taxpayer can ordinarily treat $2,000 of the disallowed deductions as deductions from the restaurant activity for 1993, and $8,000 of the disallowed deductions as deductions from the catering activity for 1993. Example (4). (i) The taxpayer is a partner in a law partnership that acquires a building in December 1988 for use in the partnership's law practice. In taxable year 1989, four floors that are not needed in the law practice are leased to tenants; in taxable year 1990, two floors are leased to tenants; in taxable years after 1990, only one floor is leased to tenants. Under §1.469-4T(d), the law practice and the rental operations with respect to the leased property are treated as a trade or business activity and a separate rental activity for taxable years 1989 and 1990 and as a single trade or business activity for taxable years after 1990. The trade or business activity is not a passive activity of the taxpayer. The rental activity, however, is a

passive activity. Under paragraph (f)(2) of this section, a $12,000 loss from the rental activity is disallowed for 1989, and a $9,000 loss from rental activity is disallowed for 1990. (ii) Under paragraph (f)(2) of this section, the $12,000 loss from the rental activity for 1989 is allocated among the passive activity deductions from that activity for 1989. In 1990, the business and rental operations that constituted the rental activity are continued in two separate activities. Only the business and rental operations with respect to two floors of the building are continued in the rental activity, and the other two floors (i.e., the floors that were leased to tenants in 1989, but not in 1990) are used in the taxpayer's law-practice activity. Thus, the disallowed deductions from the rental activity for 1989 must be allocated under paragraph (f)(4)(i)(A) of this section between the rental activity and the law-practice activity in a manner that reasonably reflects the exent to which each of the activities continues the operations with respect to the four floors that were leased to tenants in 1989. In these circumstances, the requirement of paragraph (f)(4)(i)(A) of this section would ordinarily be satisfied by any of the allocation methods illustrated in example (3) or by an allocation of 50 percent of the disallowed deductions ($6,000) to each activity. Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions allocated to the rental activity in 1990 are treated as deductions from the rental activity for 1990, and the disallowed deductions allocated to the law-practice activity in 1990 are treated as deductions from the law-practice activity for 1990. (iii) Under paragraph (f)(2) of this section, the $9,000 loss from the rental activity for 1990 is allocated among the passive activity deductions from that activity for 1990. In 1991, the business and rental operations that constituted the rental activity are continued in the taxpayer's law-practice activity. Thus, the disallowed deductions from the rental activity for 1990 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's law-practice activity in 1991. Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions allocated to the law-practice activity are treated as deductions from the law-practice activity for 1991. (iv) Rules relating to former passive activities will be contained in paragraph (k) of this section. Under those rules, any disallowed deductions from the rental activity that are treated as deductions from the law-practice activity will be treated as unused deductions that are allocable to a former passive activity. Example (5). (i) The taxpayer owns stock in a corporation that is an S corporation for the taxpayer's 1991 taxable year and a C corporation thereafter. The only activity of the corporation is a rental activity. For 1991, the taxpayer's pro rata share of the corporation's loss from the rental activity is $5,000, and the entire loss is disallowed under paragraph (f)(2) of this section. (ii) Under paragraph (f)(2) of this section, the taxpayer's $5,000 loss from the rental activity is allocated among the taxpayer's deductions from that activity for 1991. In 1992, the business and rental operations that constituted the rental activity are continued through a C corporation, and the taxpayer's interest in the C corporation is treated under paragraph (f)(4)(ii)(A) of this section as a passive activity that continues such operations (the C corporation activity). Thus, the disallowed deductions from the rental activity for 1991 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation activity in 1992, and are

treated under paragraph (f)(4)(i)(B) of this section as deductions from the C corporation activity for 1992. (iii) Treating the taxpayer's interest in the C corporation as an interest in a passive activity that continues the operations of the rental activity does not change the character of the taxpayer's dividend income from the C corporation. Thus, the taxpayer's dividend income is portfolio income (within the meaning of §1.469- 2T(c)(3)(i)) and is not included in passive activity gross income. Accordingly, the taxpayer's loss from the C corporation activity for 1992 is $5,000. Example (6). (i) The facts are the same as in example (5), except that the taxpayer has income from other passive activities for 1992, and only 60 percent of the taxpayer's loss from the C corporation activity ($3,000) is disallowed for 1992 under paragraph (f)(2) of this section. (ii) Under paragraph (f)(2) of this section, the $3,000 disallowed loss from the C corporation activity is allocated among the passive activity deductions from that activity for 1992. In effect, therefore, 60 percent of each disallowed deduction from the rental activity for 1991 is again disallowed for 1992. (iii) Under paragraph (f)(4)(ii)(B) of this section, the taxpayer's interest in the C corporation is treated for years after 1992 as an interest in a passive activity that continues the business and rental operations of the C corporation activity. Thus, the disallowed deductions from the C corporation activity for 1992 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation activity in 1993, and are treated under paragraph (f)(4)(i)(B) of this section as deductions from that activity for 1993. 8. Paragraph (g)(4)(ii)(C) is amended by removing "§1.469-2T(c)(2)(iii)(E)" and adding in its place "§1.469-2T(c)(2)(iii)(F)". 9. Paragraph (h)(4) is amended by removing the word "material" from the captions of paragraphs (h)(4) and (h)(4)(ii) and by adding the words "or significantly" immediately after the word "materially" in paragraph (h)(4)(ii).

§1.469-2T [Amended]

Par. 4. Section 1.469-2T is amended as follows: 1. Paragraphs (c)(2)(iii)(D) through (c)(2)(iii)(F) are redesignated as paragraphs (c)(2)(iii)(E) through (c)(2)(iii)(G) and the following new paragraph (c)(2)(iii)(D) is added: (c) (2) (iii) (D) Investment property. For purposes of this paragraph (c)(2)(iii), an interest in property shall be treated as an interest in property used in an activity other than a

passive activity and as an interest in property held for investment for any period during which such interest is held through a C corporation or similar entity. An entity is similar to a C corporation for this purpose if the owners of interests in the entity derive only portfolio income (within the meaning of paragraph (c)(3)(i) of this section) from such interests. 2. Paragraph (c)(2)(iii)(G) (as redesignated by this Treasury decision) is revised to read as follows: (c) (2) (iii) (G) Examples. The following examples illustrate the application of this paragraph (c)(2)(iii): Example (1). A acquires a building on January 1, 1987, and uses the building in a trade or business activity in which A materially participates until March 31, 1998. On April 1, 1998, A leases the building to B. On December 31, 1999, A sells the building. At the time of the sale, A's interest in the building is substantially appreciated (within the meaning of paragraph (c)(2)(iii)(C) of this section). Assuming A's lease of the building to B constitutes a rental activity (within the meaning of §1.469-1T(e)(3)), the building is used in a passive activity for 21 months (April 1, 1998, through December 31, 1999). Thus, the building was not used in a passive activity for the entire 24-month period ending on the date of the sale. In addition, the 21-month period during which the building was used in a passive activity is less than 20 percent of A's holding period for the building (13 years). Therefore, the gain from the sale is treated under this paragraph (c)(2)(iii) as not from a passive activity. Example (2). (i) A, an individual, is a stockholder of corporation X. X is a C corporation until December 31, 1990, and is an S corporation thereafter. X acquires a building on January 1, 1990, and sells the building on March 1, 1991. At the time of the sale, A's interest in the building held through X is substantially appreciated (within the meaning of paragraph (c)(2)(iii)(C) of this section). The building is leased to various tenants at all times during the period in which it is held by X. Assume that the lease of the building would constitute a rental activity (within the meaning of

§1.469-1T(e)(3)) with respect to a person that holds the building directly or through

an S corporation. (ii) Paragraph (c)(2)(iii)(D) of this section provides that an interest in property is treated for purposes of this paragraph (c)(2)(iii) as used in an activity other than a passive activity and as held for investment for any period during which such interest is held through a C corporation. Thus, for purposes of determining the character of A's gain from the sale of the building, A's interest in the building is treated as an interest in property held for investment for the period from January 1, 1990 to December 31, 1990, and as an interest in property used in a passive activity for the period from January 1, 1991 to February 28, 1991.

(iii) A's interest in the building was not used in a passive activity for the entire 24-month period ending on the date of the sale. In addition, the 2-month period during which A's interest in the building was used in a passive activity is less than 20 percent of the period during which A held an interest in the building (14 months). Therefore, the gain from the sale is treated under this paragraph (c)(2)(iii) as not from a passive activity. (iv) Under paragraph (c)(2)(iii)(F) of this section, gain that is treated as nonpassive under this paragraph (c)(2)(iii) is treated as portfolio income (within the meaning of paragraph (c)(3)(i) of this section) if the gain is from the disposition of an interest in property that was held for investment for more than 50 percent of the period during which the taxpayer held such interest in activities other than passive activities. In this case, A's interest in the building was treated as held for investment for the entire period during which it was used in activities other than passive activities (i.e., the 12-month period from January 1, 1990 to December 31, 1990). Accordingly, A's gain from the sale is treated under this paragraph (c)(2)(iii) as portfolio income. 3. New paragraphs (c)(2)(iv) and (c)(2)(v) are added to read as follows: (c) (2) (iv) Taxable acquisitions. If a taxpayer acquires an interest in property in a transaction other than a nonrecognition transaction (within the meaning of section 7701(a)(45)), the ownership and use of such interest in property before such transaction shall not be taken into account for purposes of applying this paragraph (c)(2) to any subsequent disposition of such interest in property by the taxpayer. For example, if a taxpayer is a partner in a partnership that owns an interest in property and the taxpayer acquires such interest in property from the partnership in a fully taxable sale or exchange, such interest shall be treated, in applying this paragraph (c)(2) to any subsequent disposition of such interest, as an interest in property that was not held by the taxpayer until the date on which such interest was acquired from the partnership and that was not used before such date in any activity of the taxpayer. (v) Property held for sale to customers-(A) Sale incidental to another activity-(1)- Applicability-(i) In general. This paragraph (c)(2)(v)(A) applies to the disposition of a taxpayer's interest in property if and only if- (A) At the time of the disposition, the taxpayer holds the interest in property in an activity that involves holding similar property that is treated for purposes of section 1221(1) as property held primarily for sale to customers in the ordinary course of a trade or business (a "dealing activity"); (B) One or more other activities of the taxpayer do not involve holding similar property for sale to customers in the ordinary course of a trade or business ("nondealing activities") and the interest in property was used in such activity or activities for more than 80 percent of the period during which the taxpayer held such interest in property; and

(C) The interest in property was not acquired and held by the taxpayer for the principal purpose of selling such interest to customers in the ordinary course of a trade or business. (ii) Principal purpose. For purposes of this paragraph (c)(2)(v)(A), a taxpayer is rebuttably presumed to have acquired and held an interest in property for the principal purpose of selling such interest to customers in the ordinary course of a trade or business if- (A) The period during which the interest in property was used in nondealing activities of the taxpayer does not exceed the lesser of 24 months or 20 percent of the recovery period (within the meaning of section 168) applicable to such property; or (B) The interest in property was simultaneously offered for sale to customers and used in a nondealing activity of the taxpayer for more than 25 percent of the period during which such interest in property was used in nondealing activities of the taxpayer. For purposes of the preceding sentence, an interest in property shall not be considered to be offered for sale to customers solely because a lessee of the property has been granted an option to purchase the property. (2) Dealing activity not taken into account. If this paragraph (c)(2)(v)(A) applies to the disposition of a taxpayer's interest in property, holding such interest in the dealing activity shall, for purposes of this paragraph (c)(2), be treated as the use of such interest in the last nondealing activity of the taxpayer in which such interest in property was used prior to its disposition. (B) Use in a nondealing activity incidental to sale. If paragraph (c)(2)(v)(A) of this section does not apply to the disposition of a taxpayer's interest in property that is held in a dealing activity of the taxpayer at the time of disposition, the use of such interest in property in a nondealing activity of the taxpayer for any period during which such interest in property is also offered for sale to customers shall, for purposes of this paragraph (c)(2), be treated as the use of such interest in property in the dealing activity of the taxpayer. (C) Examples. The following examples illustrate the application of this paragraph (c)(2)(v): Examples (1). (i) The taxpayer acquires a residential apartment building on January 1, 1987, and uses the building in a rental activity. In January 1990, the taxpayer converts the apartments into condominium units. After the conversion, the taxpayer holds the condominium units for sale to customers in the ordinary course of a trade or business of dealing in such property. (Assume that these dealing operations are treated as a separate activity under §1.469-4T, and that the taxpayer materially participates in this activity.) In addition, the taxpayer continues to use the units in the rental activity until they are sold. The units are first held for sale on January 1, 1990, and the last unit is sold on December 31, 1990. (ii) This paragraph (c)(2)(v) provides that holding an interest in property in a dealing activity (the marketing of the property) is treated for purposes of this paragraph

(c)(2) as the use of such interest in a nondealing activity if the marketing of the property is incidental to such use. Under paragraph (c)(2)(v)(A)(2) of this section, such interests in property are treated as used in the last nondealing activity in which they were used prior to their disposition. In addition, paragraph (c)(2)(v)(A)(1) of this section provides rules for determining whether the marketing of the property is incidental to the use of an interest in property in a nondealing activity. Under these rules, the marketing of the property is treated as incidental to such use if (a) the interest in property was used in nondealing activities for more than 80 percent of the taxpayer's holding period in the property (the holding period requirement) and (b) the taxpayer did not acquire and hold the interest in property for the principal purpose of selling it to customers in the ordinary course of a trade or business (a dealing purpose). (iii) In this case, the apartments were used in a rental activity for the entire period during which they were held by the taxpayer. Thus, the apartments were used in a nondealing activity for more than 80 percent of the taxpayer's holding period in the property, and the marketing of the property satisfies the holding period requirement. (iv) Paragraph (c)(2)(v)(A)(1)(ii) of this section provides that a taxpayer is rebuttably presumed to have a dealing purpose unless the interest in property was used in nondealing activities for more than 24 months or 20 percent of the property's recovery period (whichever is less). The same presumption applies if the interest in property was offered for sale to customers during more than 25 percent of the period in which the interest was held in nondealing activities. In this case, the taxpayer used each apartment in a nondealing activity (the rental activity) for a period of 36 to 48 months (i.e., from January 1, 1987, to the date of sale in the period from January through December 1990). Thus, the apartments were used in nondealing activities for more than 24 months, and the first of the rebuttable presumptions described above does not apply. In addition, the apartments were offered for sale to customers for up to 12 months (depending on the month in which the apartment was sold) during the period in which the apartments were used in a nondealing activity. The percentage obtained by dividing the period during which an apartment was held for sale to customers by the period during which the apartment was used in nondealing activities ranges from zero in the case of apartments sold on January 1, 1990, to 25 percent (i.e., 12 months/48 months) in the case of apartments sold on December 31, 1990. Thus, no apartment was offered for sale to customers during more than 25 percent of the period in which it was used in nonrental activities, and the second rebuttable presumption does not apply. (v) Because neither of the rebuttable presumptions in paragraph (c)(2)(v)(A)(1)(ii) of this section applies in this case, the taxpayer will not be treated as having a dealing purpose unless other facts and circumstances establish that the taxpayer acquired and held the apartments for the principal purpose of selling the apartments to customers in the ordinary course of a trade or business. Assume that none of the facts and circumstances suggest that the taxpayer had such a purpose. If that is the case, the taxpayer does not have a dealing purpose. (vi) The marketing of the property satisfies the holding period requirement, and the taxpayer does not have a dealing purpose. Thus, holding the apartments in the taxpayer's dealing activity is treated for purposes of this paragraph (c)(2) as the use of the apartments in a nondealing activity. In this case, the rental activity is the only nondealing activity in which the apartments were used prior to their disposition.

Thus, the apartments are treated under paragraph (c)(2)(v)(A)(2) of this section as interests in property that were used only in the rental activity for the entire period during which the taxpayer held such interests. Accordingly, the rules in paragraph (c)(2) (ii) and (iii) of this section do not apply, and all gain from the sale of the apartments is treated as passive activity gross income. Example (2). (i) The facts are the same as in example (1), except that the taxpayer converts the apartments into condominum units on July 1, 1987, and the first unit is sold on January 1, 1988. (ii) In this case, all of the apartments were simultaneously offered for sale to customers and used in a nondealing activity of the taxpayer for more than 25 percent of the period during which the apartments were used in nondealing activities. Thus, the taxpayer is rebuttably presumed to have acquired the apartments (including apartments that are used in the rental activity for at least 24 months) for the principal purpose of selling them to customers in the ordinary course of a trade or business. Assume that the facts and circumstances do not rebut this presumption. If that is the case, the taxpayer has a dealing purpose, and paragraph (c)(2)(v)(A) of this section does not apply to the disposition of the apartments. (iii) Paragraph (c)(2)(v)(B) of this section does not apply to the disposition of a taxpayer's interest in property that is held in a dealing activity of the taxpayer at the time of the disposition, the use of the interest in property in any nondealing activity of the taxpayer for any period during which the interest is also offered for sale to customers is treated as incidental to the use of the interest in the dealing activity. Accordingly, for purposes of applying the rules of this paragraph (c)(2) to the disposition of the apartments, the rental of the apartments after July 1, 1987, is treated as the use of the apartments in the taxpayer's dealing activity. Example (3). (i) The facts are the same as in example (1), except that the last unit is sold in 1991. (ii) The treatment of apartments sold in 1990 is the same as in example (1). The apartments sold in 1991, however, were simultaneously offered for sale to customers and used in a nondealing activity for more than 25 percent of the period during which such apartments were used in nondealing activities. (For example, an apartment that is sold on January 31, 1991, has been offered for sale for 13 months or 26.1 percent of the 49-month period during which it was used in nondealing activities.) Thus, the taxpayer is rebuttably presumed to have acquired the apartments sold in 1991 for the principal purpose of selling them to customers in the ordinary course of a trade or business. Assume that the facts and circumstances do not rebut this presumption. In that case, the marketing of the apartments sold in 1991 does not satisfy the principal purpose requirements, and paragraph (c)(2)(v)(A) of this section does not apply to the disposition of those apartments. Accordingly, for purposes of applying the rules of this paragraph (c)(2) to the disposition of the apartments sold in 1991, the rental of the apartments after January 1, 1990, is treated, under paragraph (c)(2)(v)(B) of this section, as the use of the apartments in the taxpayer's dealing activity. 4. Paragraph (c)(6) (i), (ii), and (iii) is revised to read as follows: (c)

(6) Gross income from certain oil or gas properties-(i) In general. Notwithstanding any other provision of the regulations under section 469, passive activity gross income for any taxable year does not include an amount of the taxpayer's gross passive income for such year from- (A) An oil or gas property that includes an oil or gas well if, for any prior taxpayer year beginning after December 31, 1986, any of the taxpayer's loss from the well was treated, solely by reason of §1.469-1T(e)(4) (relating to a special rule for losses from oil and gas working interests), and not by reason of the taxpayer's material participation in the activity, as a loss that is not from a passive activity; or (B) Any property the basis of which is determined in whole or in part by reference to the basis of property described in paragraph (c)(6)(i)(A) of this section; equal to the taxpayer's net passive income from such property for the taxable year. (ii) Gross and net passive income from the property. For purposes of this paragraph (c)(6)- (A) The taxpayers's gross passive income for any taxable year from any property described in paragraph (a)(6)(i) of this section is any passive activity gross income for such year (determined without regard to this paragraph (c)(6) and paragraph (f) of this section) from such property; (B) The taxpayer's net passive income for any taxable year from any property described in paragraph (c)(6)(i) of this section is the excess, if any, of- (1) The taxpayer's gross passive income for the taxable year from such property; over (2) Any passive activity deductions for the taxable year (including any deduction treated as a deduction for such year under §1.469-1T(f)(4)) that are reasonably allocable to such income; and (C) If any oil or gas well or other item of property (the item) is included in two or more properties described in paragraph (c)(6)(i) of this section (the properties), the taxpayer shall allocate the passive activity gross income (determined without regard to this paragraph (c)(6) and paragraph (f) of this section) from such item and the passive activity deductions reasonably allocable to such item among such properties. (iii) Property. For purposes of paragraph (c)(6)(i)(A) of this section, the term "property" does not have the meaning given such term by section 614(a) or the regulations thereunder, and an oil or gas property that includes an oil or gas well is- (A) The well; and (B) Any other item of property (including any oil or gas well) the value of which is directly enhanced by any drilling, logging, seismic testing, or other activities the costs of which were taken into account in determining the amount of the taxpayer's income or loss from the well.

5. Paragraph (c)(6)(iv) is amended by removing the phrase "net income" in the last sentences of examples (1) and (2), and adding the phrase "net passive income" in its place. 6. Paragraph (d)(1), Example, is amended by removing "sections 469 and 1211" and adding "sections 469, 613A(d), and 1211" each place the former occurs. 7. Paragraph (d)(2)(ix) is amended by adding "section 613A(d)," immediately before "section 1212(a)(1)(B)". 8. Paragraph (d)(5)(iii)(A) is revised to read as follows: (d) (5) (iii) (A) Applicability of rules in paragraph (c)(2). For purposes of this paragraph (d)(5), a taxpayer's interests in property used in an activity and the amounts allocated to such interests shall be determined under paragraph (c)(2)(i)(C) of this section. In addition, the rules contained in paragraph (c)(2) (iv) and (v) of this section shall apply in determining for purposes of this paragraph (d)(5) the activity (or activities) in which an interest in property is used at the time of its disposition and during the 12-month period ending on the date of its disposition. (9) Paragraph (d)(6)(v)(E) is revised to read as follows: (d) (6) (v) (E) Are taken into account under section 613A(d) (relating to limitations on certain depletion deductions), section 1211 (relating to the limitation on capital losses), or section 1231 (relating to property used in a trade or business and involuntary conversions); or 10. Paragraph (d)(8) is amended by removing the phrase "sections 469 and 1211" and adding the following in its place: "sections 469, 613A(d), and 1211". 11. Paragraphs (e)(2) (ii) and (iii) are revised to read as follows: (e) (2) (ii) Section 707(c). Except as provided in paragraph (e)(2)(iii)(B) of this section, any payment to a partner for services or the use of capital that is described in section

707(c) (including any payment described in section 736(a)(2)) (relating to guaranteed payments made in liquidation of the interest of a retiring or deceased partner) shall be characterized as a payment for services or as the payment of interest, respectively, and not as a distributive share of partnership income. (iii) Payments in liquidation of a partner's interest in partnership property-(A) In general. If any gain or loss is taken into account by a retiring partner (or any other person that owns (directly or indirectly) an interest in such partner if such partner is a passthrough entity) or a deceased partner's successor in interest as a result of a payment to which section 736(b) (relating to payments made in exchange for a retired or deceased partner's interest in partnership property) applies, such gain or loss shall be treated as passive activity gross income or a passive activity deduction only to the extent that such gain or loss would have been passive activity gross income or a passive activity deduction of such retiring or deceased partner (or such other person) if it had been recognized at the time the liquidation of such partner's interest commenced. (B) Payments in liquidation of a partner's interest in unrealized receivables and goodwill under section 736(a). (1) If a payment is made in liquidation of a retiring or deceased partner's interest, such payment is described in section 736(a), and any income- (i) Is taken into account by the retiring partner (or any other person that owns (directly or indirectly) an interest in such partner if such partner is a passthrough entity) or the deceased partner's successor in interest as a result of such payment; and (ii) Is attributable to the portion (if any of the payment that is allocable to the unrealized receivables (within the meaning of section 751(c)) and goodwill of the partnership; the percentage of such income that is treated as passive activity gross income shall not exceed the percentage of passive activity gross income that would be included in the gross income that such retiring or deceased partner (or such other person) would have recognized if such unrealized receivables and goodwill had been sold at the time that the liquidation of such partner's interest commenced. (2) For purposes of this paragraph (e)(2)(iii)(B), the portion (if any) of a payment under section 736(a) that si allocable to unrealized receivables and goodwill of a partnership shall be determined in accordance with the principles employed under §1.736-1(b) for determining the portion of a payment made under section 736 that is treated as a distribution under section 736(b). 12. Paragraph (e)(3)(iii)(B) is revised to read as follows: (e) (3) (iii)

(B) An amount of gain that would have been treated as gain that is not from a passive activity under paragraph (c)(2)(iii) (relating to substantially appreciated property formerly used in a nonpassive activity), (c)(6) (relating to certain oil or gas properties), (f)(5) (relating to certain property rented incidental to development), (f)(6) (relating to property rented to a nonpassive activity), or (f)(7) (relating to certain interests in a passthrough entity engaged in the trade or business of licensing intangible property) of this section would have been allocated to such holder (or such other person) with respect to such interest if all of the property used in such passive activity had been sold immediately prior to the disposition for its fair market value on the applicable valuation date (within the meaning of paragraph (e)(3)(ii)(D)(1) of this section; and 13. Paragraph (f)(5)(i) is amended by removing the phrase "used in a rental activity for such year", by removing "24" and adding "12" in its place, and by removing the phrase ", but without regard to paragraph (e) thereof" from the parenthetical immediately following the words "materially participated". 14. Paragraph (f)(5)(ii) is amended by adding the following phrase immediately after the word "when": "the performance of the services described in paragraph (f)(5)(i)(C) of this section is complete, and". 15. Paragraph (f)(5)(iii)(C) si amended by removing the parenthetical phrase and adding the following in its place: "(but only if, as of the time the taxpayer acquires an interest in the property, a substantial portion of the property is not leased)". 16. Paragraph (f)(5)(iv), Example, is revised to read as follows: (f) (5) (iv) Example. (i) A, a calendar year individual, is a partner in calendar year partnership P, which develops commercial real estate. In 1988, P acquires an interest in undeveloped land, and arranges for the financing and construction of an office building on the land. Construction is completed in February 1990, and substantially all of the building is held out for rent and is in a state of readiness for rental beginning on March 1, 1990. (ii) P holds the building for rent for the remainder of 1990 and all of 1991, and sells the building on January 15, 1992, pursuant to a contract entered into on January 15, 1991. P did not hold the building (or any other buildings) for sale to customers in the ordinary course of P's trade or business (see paragraph (c)(2)(v) of this section). A's distributive share of P's taxable losses from the rental of the building is $50,000 for 1990 and $30,000 for 1991. All of A's losses from the rental of the building are disallowed under §1.469-1T(a)(1)(i). A's distributive share of the gain recognized by P on the sale of the building is $150,000. A has no other gross income or deductions from the activity of renting the building.

(iii) For purposes of paragraph (f)(5)(i)(C) of this section, in 1988, 1989, and 1990, the real estate development activity that A holds through P involves the performance of services for the purpose of enhancing the value of the building. In 1992, the building is sold, and the date on which the use of the building in the rental activity commenced (March 1, 1990) was less than 12 months before the date on which a binding contract for such sale was entered into (January 15, 1991). Accordingly, if A materially participated in the real estate development activity in 1988, 1989, or 1990 (without regard to whether A materially participated in the activity in more than one of those years), an amount of A's gross rental activity income for 1992 from the building equal to A's net rental activity income for 1992 from such building ($150,000-$80,000 of previously disallowed deductions = $70,000) is treated under this paragraph (f)(5) as gross income that is not from a passive activity. 17. Paragraph (f)(6) is amended by removing the phrase "used in a rental activity for such year" and by removing the phrase ", but without regard to paragraph (e) thereof" from the parenthetical immediately following the words "materially participates". 18. Paragraph (f)(9)(iii) is revised to read as follows: (f) (9) (iii) The gross rental activity income for a taxable year from an item of property is any passive activity gross income (determined without regard to paragraph (f) (2) through (6) of this section) that- (A) Is income for such year from the rental or disposition of such item of property; and (B) In the case of income from the disposition of such item of property, is income from an activity that involved the rental of such item of property during the 12-month period ending on the date of the disposition (see paragraph (c)(2)(ii) of this section); and 19. Paragraph (f)(9)(iv)(B) is amended by removing the phrase "the use of such item of property in the rental activity" and adding in its place the words "such income". 20. Paragraph (f)(10) is revised to read as follows: (f) (10) Coordination with section 163(d). Gross income that is treated as not from a passive activity under paragraph (f) (3), (4), or (7) of this section shall be treated as income described in section 469(e)(1)(A) and paragraph (c)(3)(i) of this section except in determining whether-

(i) Any property is treated for purposes of section 469(e)(1)(A)(ii)(I) and paragraph (c)(3)(i)(C) of this section as property that produces income of a type described in paragraph (c)(3)(i)(A) of this section; (ii) Any property is treated for purposes of section 469(e)(1)(A)(ii)(II) and paragraph (c)(3)(i)(D) of this section as property held for investment; (iii) An expense (other than interest expense) is treated for purposes of section 469(e)(1)(A)(i)(II) and paragraph (d)(4) of this section as clearly and directly allocable to portfolio income (within the meaning of paragraph (c)(3)(i) of this section); and (iv) Interest expense is allocated under §1.163-8T to an investment expenditure (within the meaning of §1.163-8T(b)(3)) or to a passive activity expenditure (within the meaning of §1.163-8T(b)(4)). Par. 5. Section 1.469-3T is amended as follows: 1. Paragraph (e) is revised. 2. Paragraph (f) is redesignated as paragraph (g), and a new paragraph (f) is added. 3. The revised provisions read as follows:

§1.469-3T Passive activity credit (temporary).

(e) Coordination with section 38(b). Any credit described in section 38(b) (1) through (5) is taken into account in computing the current year business credit for the first taxable year in which such credit is subject to section 469 and is not disallowed by section 469 and the regulations thereunder. (f) Coordination with section 47. In the case of any cessation described in section 47(a) (1), (3), or (5) or any change in use described in section 47(a) (2) or (4), the credits allocable to the taxpayer's activities under §1.469-1T(f)(4) shall be adjusted by reason of such cessation (or change in use). Par. 6. The text of §1.469-4T is added to read as follows:

§1.469-4T Definition of activity (temporary).

(a) Overview-(1) Purpose and effect of overview. This paragraph (a) contains a general description of the rules contained in this section and is intended solely as an aid to readers. The provisions of this paragraph (a) are not a substitute for the more detailed rules contained in the remainder of this section and cannot be relied upon in cases in which those rules qualify the general description contained in this paragraph (a). (2) Scope and structure of §1.469-4T. This section provides rules under which a taxpayer's business and rental operations are treated as one or more activities for purposes of section 469 and the regulations thereunder. (See paragraph (b)(2)(ii) of

this section for the definition of business and rental operations.) In general, these rules are divided into three groups: (i) Rules that identify the business and rental operations that constitute an undertaking (the undertaking rules). (ii) Rules that identify the undertaking or undertakings that constitute an activity (the activity rules). (iii) Rules that apply only under certain special circumstances (the special rules). (3) Undertaking rules-(i) In general. The undertaking is generally the smallest unit that can constitute an activity. (See paragraph (b)(1) of this section for the general rule and paragraph (k)(2)(iii) of this section for a special rule that permits taxpayers to treat a single rental real estate undertaking as multiple activities.) An undertaking may include diverse business and rental operations. (ii) Basic undertaking rule. The basic undertaking rule identifies the business and rental operations that constitute an undertaking by reference to their location and ownership. Under this rule, business and rental operations that are conducted at the same location and are owned by the same person are generally treated as part of the same undertaking. Conversely, business and rental operations generally constitute separate undertakings to the extent that they are conducted at different locations or are not owned by the same person. (See paragraph (c)(2)(i) of this section.) (iii) Circumstances in which location is disregarded. In some circumstances, the undertaking in which business and rental operations are included does not depend on the location at which the operations are conducted. Operations that are not conducted at any fixed place of business or that are conducted at the customer's place of business are treated as part of the undertaking with which the operations are most closely associated (see paragraph (c)(2)(iii)(C) of this section). In addition, operations that are conducted at a location but do not relate to the production of property at that location or to the transaction of business with customers at that location are treated, in effect, as part of the undertaking or undertakings that the operations support (see paragraph (c)(2)(ii) of this section). (iv) Rental undertakings. The basic undertaking rule is also modified if the undertaking determined under that rule includes both rental and nonrental operations. In such cases, the rental operations and the nonrental operations generally must be treated as separate undertakings (see paragraph (d)(1) of this section). This rule does not apply if more than 80 percent of the income of the undertaking determined under the basic rule is attributable to one class of operations (i.e., rental or nonrental) or if the rental operations would not be treated as part of a rental activity because of the exceptions contained in §1.469-1T(e)(3)(ii) (see paragraph (d)(2) of this section). In applying the rental undertaking rules, short-term rentals of real property (e.g., hotel-room rentals) are generally treated as nonrental operations (see paragraph (d)(3)(ii) of this section). (v) Oil and gas wells. Another exception to the basic undertaking rule treats oil and gas wells that are subject to the working-interest exception in §1.469-1T(e)(4) as separate undertakings (see paragraph (e) of this section).

(4) Activity rules-(i) In general. The basic activity rule treats each undertaking ni which a taxpayer owns an interest as a separate activity of the taxpayer (see paragraph (b)(1) of this section). In the case of trade or business undertakings, professional service undertakings, and rental real estate undertakings, additional rules may either require or permit the aggregation of two or more undertakings into a single activity. (ii) Aggregation of trade or business undertakings-(A) Trade or business undertakings. Trade or business undertakings include all nonrental undertakings other than oil and gas undertakings described in paragraph (a)(3)(v) of this section and professional service undertakings described in paragraph (a)(4)(iii) of this section (see paragraph (f)(1)(ii) of this section). (B) Similar, commonly-controlled undertakings treated as a single activity. An aggregation rule treats trade or business undertakings that are both similar and controlled by the same interests as part of the same activity. This rule is, however, generally inapplicable to small interests held by passive investors in such undertakings, except to the extent such interests are held through the same passthrough entity. (See paragraph (f)(2) of this section.) Undertakings are similar for purposes of this rule if more than half (by value) of their operations are in the same line of business (as defined in a revenue procedure issued pursuant to paragraph (f)(4)(iv) of this section) or if the undertakings are vertically integrated (see paragraph (f)(4)(iii) of this section). All the facts and circumstances are taken into account in determining whether undertakings are controlled by the same interests for purposes of the aggregation rule (see paragraph (j)(1) of this section). If, however, each member of a group of five or fewer persons owns a substantial interest in each of the undertakings, the undertakings may be rebuttably presumed to be controlled by the same interests (see paragraph (j) (2) and (3) of this section). (C) Integrated businesses treated as a single activity. Trade or business undertakings (including undertakings that have been aggregated because of their similarity and common control) are subject to a second aggregation rule. Under this rule undertakings that constitute an integrated business and are controlled by the same interests must be treated as part of the same activity. (See paragraph (g) of this section.) (iii) Aggregation of professional service undertakings. Professional service undertakings are nonrental undertakings that predominantly involve the provision of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (see paragraph (h)(1)(ii) of this section). In general, professional service undertakings that are either similar, related, or controlled by the same interests must be treated as part of the same activity (see paragraph (h)(2) of this section). The rules for determining whether trade or business undertakings are controlled by the same interests also apply with respect to professional service undertakings. Professional service undertakings are similar, however, if more than 20 percent (by value) of their operations are in the same field, and two professional service undertakings are related if one of the undertakings derives more than 20 percent of its gross income from persons who are customers of the other undertaking (see paragraph (h)(3) of this section). (iv) Rules for rental real estate-(A) Taxpayers permitted to determine rental real estate activities. The rules for aggregating rental real estate undertakings are

generally elective. They permit taxpayers to treat any combination of rental real estate undertakings as a single activity. Taxpayers may also divide their rental real estate undertakings and then treat portions of the undertakings as separate activities or recombine the portions into activities that include parts of different undertakings. (See paragraph (k)(2) (i) and (iii) of this section.) (B) Limitations on fragmentation and aggregation of rental real estate. Taxpayers may not fragment their rental real estate in a manner that is inconsistent with their treatment of such property in prior taxable years or with the treatment of such property by the passthrough entity through which it is held (see paragraph (k) (2)(ii) and (3) of this section). There are no comparable limitations on the aggregation of rental real estate into a single activity. If however, the income or gain from a rental real estate undertaking is subject to recharacterization under §1.469-2T(f)(3) (relating to the rental of nondepreciable property), a coordination rule provides that the undertaking must be treated as a separate activity (see paragraph (k)(6) of this section.) (v) Election to treat nonrental undertakings as separate activities. Another elective rule permits taxpayers to treat a nonrental undertaking as a separate activity even if the undertaking would be treated as part of a larger activity under the aggregation rules applicable to the undertaking (see paragraph (o)(2) of this section). This elective rule is limited by consistency requirements similar to those that apply to rental real estate operations (see paragraph (o) (3) and (4) of this section). Moreover, in cases in which a taxpayer elects to treat a nonrental undertaking as a separate activity, the taxpayer's level of participation (i.e., material, significant, or otherwise) in the separate activity is the same as the taxpayer's level of participation in the larger activity in which the undertaking would be included but for the election (see paragraph (o)(6) of this section). (5) Special rules-(i) Consolidated groups and publicly traded partnerships. Special rules apply to the business and rental operations of consolidated groups of corporations and publicly traded partnerships. Under these rules, a consolidated group is treated as one taxpayer in determining its activities and those of its members (see paragraph (m) of this section), and business and rental operations owned through a publicly traded partnership cannot be aggregated with operations that are not owned through the partnership (see paragraph (n) of this section). (ii) Transitional rule. A special rule applies for taxable years ending before August 10, 1989. In those years, taxpayers may organize business and rental operations into activities under any reasonable method (see paragraph (p)(1) of this section). A taxpayer will also be permitted to use any reasonable method to allocate disallowed deductions and credits among activities for the first taxable year in which the taxpayer's activities are determined under the general rules of §1.469-4T (see paragraph (p)(3) of this section). (b) General rule and definitions of general application-(1) General rule. Except as otherwise provided in this section, each undertaking in which a taxpayer owns an interest shall be treated as a separate activity of the taxpayer. See paragraphs (f), (g), and (h) of this section for rules requiring certain nonrental undertakings to be treated as part of the same activity and paragraph (k) of this section for rules identifying the rental real estate undertakings (or portions thereof) that are included in an activity.

(2) Definitions of general application. The following definitions set forth the meaning of certain terms for purposes of this section: (i) Passthrough entity. The term "passthrough entity" means a partnership, S corporation, estate, or trust. (ii) Business and rental operations-(A) In general. Except as provided in paragraph (b)(2)(ii)(B) of this section, the term "business and rental operations" means all endeavors that are engaged in for profit or the production of income and satisfy one or more of the following conditions for the taxable year: (1) Such endeavors involve the conduct of a trade or business (within the meaning of section 162) or are conducted in anticipation of such endeavors becoming a trade or business; (2) Such endeavors involve making tangible property available for use by customers; or (3) Research or experimental expenditures paid or incurred with respect to such endeavors are deductible under section 174 (or would be deductible if the taxpayer adopted the method described in section 174(a)). (B) Operations conducted through nonpassthrough entities. For purposes of applying section 469 and the regulations thereunder, a taxpayer's activities do not include operations that a taxpayer conducts through one or more entities (other than passthrough entities). The following example illustrates the operation of this paragraph (b)(2)(ii)(B): Example. (i) A, an individual, owns stock of X, a closely held corporation (within the meaning of §1.469-1T(g)(2)(ii) that is directly engaged in the conduct of a real estate development business. A participates in X's real estate development business, but does not own any interest in the business other than through ownership of the stock of X. (ii) X is subject to section 469 (see §1.469-1T(b)(5)) and does not hold the real estate development business through another entity. Accordingly, for purposes of section 469 and the regulations thereunder, the operations of X's real estate development business are treated as part of X's activities. (iii) A is also subject to section 469 (see §1.469-1T(b)(1)), but A's only interest in the real estate development business is held through X. X is a C corporation and therefore is not a passthrough entity. Thus, for purposes of section 469 and the regulations thereunder, A's activities do not include the operations of X's real estate development business. Accordingly, A's participation in X's busines is not participation in an activity of A, and is not taken into account in determining whether A materially participates (within the meaning of §1.469-5T) or significantly participates (within the meaning of §1.469-1T(c)(2)) in any activity. (See, however, §1.469-1T(g)(3) for rules under which a shareholder's participation is taken into account for purposes of determining whether a corporation materially or significantly participates in an activity.

(c) Undertaking-(1) In general. Except as otherwise provided in paragraphs (d), (e), and (k)(2)(iii) of this section, business and rental operations that constitute a separate source of income production shall be treated as a single undertaking that is separate from other undertakings. (2) Operations treated as a separate source of income production-(i) In general. Except as otherwise provided in this paragraph (c)(2), business and rental operations shall be treated for purposes of this paragraph (c) as a separate source of income production if and only if- (A) Such operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (within the meaning of paragraph (c)(2)(v) of this section); and (B) Income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) owned by such person are conducted at such location. (ii) Treatment of support operations-(A) In general. For purposes of section 469 and the regulations thereunder- (1) The support operations conducted at a location shall not be treated as part of an undertaking under paragraph (c)(2)(i) of this section; and (2) The income and expenses that are attributable to such operations and are reasonably allocable to an undertaking conducted at a different location shall be taken into account in determining the income or loss from the activity or activities that include such undertaking. (B) Support operations. For purposes of this paragraph (c)(2), the business and rental operations conducted at a location are treated as support operations to the extent that- (1) Such operations and an undertaking that is conducted at a different location are owned by the same person (within the meaning of paragraph (c)(2)(v) of this section); (2) Such operations involve the provision of property or services to such undertaking; and (3) Such operations are not income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section). (iii) Location. For purposes of this paragraph (c)(2)- (A) The term "location" means, with respect to any business and rental operations, a fixed place of business at which such operations are regularly conducted; (B) Business and rental operations are conducted at the same location if they are conducted in the same physical structure or within close proximity of one another;

(C) Business and rental operations that are not conducted at a fixed place of business or that are conducted on the customer's premises shall be treated as operations that are conducted at the location (other than the customer's premises) with which they are most closely associated; (D) All the facts and circumstances (including, in particular, the factors listed in paragraph (c)(3) of this section) are taken into account in determining the location with which business and rental operations are most closely associated; and (E) Oil and gas operations that are conducted for the development of a common reservoir are conducted within close proximity of one another. (iv) Income-producing operations. For purposes of this paragraph (c)(2), the term "income-producing operations" means business and rental operations that are conducted at a location and relate to (or are conducted in reasonable anticipation of)- (A) The production of property at such location; (B) The sale of property to customers at such location; (C) The performance of services for customers at such location; (D) Transactions in which customers take physical possession at such location of property that is made available for their use; or (E) Any other transactions that involve the presence of customers at such location. (v) Ownership by the same person. For purposes of this paragraph (c)(2), business and rental operations are owned by the same person if and only if one person (within the meaning of section 7701(a)(1)) is the direct owner of such operations. (3) Facts and circumstances determinations. In determining whether a location is the location with which business and rental operations are most closely associated for purposes of paragraph (c)(2)(iii)(D) of this section, the following relationships between operations that are conducted at such location and other operations are generally the most significant: (i) The extent to which other persons conduct similar operations at one location; (ii) Whether such operations are treated as a unit in the primary accounting records reflecting the results of such operations; (iii) The extent to which other persons treat similar operations as a unit in the primary accounting records reflecting the results of such similar operations; (iv) The extent to which such operations involve products or services that are commonly provided together; (v) The extent to which such operations serve the same customers;

(vi) The extent to which the same personnel, facilities, or equipment are used to conduct such operations; (vii) The extent to which such operations are conducted in coordination with or reliance upon each other; (viii) The extent to which the conduct of any such operations is incidental to the conduct of the remainder of such operations; (ix) The extent to which such operations depend on each other for their economic success; and (x) Whether such operations are conducted under the same trade name. (4) Examples. The following examples illustrate the application of this paragraph (c). In each example that does not state otherwise, the taxpayer is an individual and the facts, analysis, and conclusion relate to a single taxable year. Example (1). The taxpayer is the sole owner of a department store and a restaurant and conducts both businesses in the same building. Thus, the department store and restaurant operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., property is sold to customers and services are performed for customers on the premises of the department store). Accordingly, the department store and restaurant operations are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). Example (2). (i) The facts are the same as in example (1), except that the taxpayer is also the sole owner of an automotive center that services automobiles and sells tires, batteries, motor oil, and accessories. The taxpayer operates the automotive center in a separate structure in the shopping mall in which the department store is located. Although the automotive center operations and the department store and restaurant operations are not conducted in the same physical structure, they are conducted within close proximity (within the meaning of paragraph (c)(2)(iii)(B) of this section) of one another. Thus, the department store, restaurant, and automotive center operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section). (ii) As in example (1), the operations conducted at the same location are owned by the same person, and the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location. Accordingly, the department store, restaurant, and automotive center operations are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). Example (3). (i) The facts are the same as in example (2), except that the automotive center is located several blocks from the shopping mall. As in example

(1), the department store and restaurant operations are treating as a single undertaking that is separate from other undertakings. Because, however, the automotive center operations are not conducted within close proximity (within the meaning of paragraph (c)(2)(iii)(B) of this section) of the department store and restaurant operations, all of the taxpayer's operations are not conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section). (ii) All of the automotive center operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the taxpayer conducts income producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., property is sold to customers and services are performed for customers on the premises of the automotive center). Accordingly, the automotive center operations are also treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). See, however, paragraph (g) of this section for rules under which certain trade or business activities are treated as a single activity. Example (4). The taxpayer is the sole owner of a building and rents residential, office, and retail space in the building to various tenants. The taxpayer manages these rental operations from an office located in the building. The rental operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., customers take physical possession in the building of property made available for their use). Accordingly, the rental operations are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). See paragraph (d) of this section for rules for determining whether this undertaking is a rental undertaking and paragraph (k) of this section for rules for identifying rental real estate activities. Example (5). (i) The facts are the same as in example (4), except that the taxpayer also uses the rental office in the building ("Building 1") to manage rental operations in another building ("Building 2") that the taxpayer owns. The rental operations conducted in Building 2 are treated as a separate source of income production under paragraph (c)(2) of this section and as a single undertaking that is separate from other undertakings (the "Building 2 undertaking") under paragraph (c)(1) of this section. (ii) The operations conducted at the rental office in Building 1 and the Building 2 undertaking are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the operations conducted at the rental office with respect to the Building 2 undertaking relate to transactions in which customers take physical possession at another location of property that is made available for their use (i.e., the operations are not income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section)). Thus, to the extent the operations conducted at the rental office involve the management of the Building 2 undertaking, they are support operations (within the meaning of paragraph (c)(2)(ii)(B) of this section) with respect to the Building 2 undertaking.

(iii) Paragraph (c)(2)(ii)(A)(1) of this section provides that support operations are not treated as part of an undertaking under paragraph (c)(2)(i) of this section. Therefore, the support operations conducted at the rental office are not treated as part of the undertaking that consists of the rental operations conducted in Building 1 (the "Building 1 undertaking"). Paragraph (c)(2)(ii)(A)(2) of this section provides that the income and expenses that are attributable to support operations and are reasonably allocable to an undertaking conducted at a different location shall be taken into account in determining the income or loss from the activity that includes such undertaking. Accordingly, the income and expenses of the rental office that are reasonably allocable to the Building 2 undertaking are taken into account in determining the income or loss from the activity or activities that include the Building 2 undertaking. See paragraph (k) of this section for rules for identifying rental real estate activities. (iv) Rental office operations that involve the management of rental operations conducted in Building 1 are not support operations (within the meaning of paragraph (c)(2)(ii)(B) of this section) because they relate to an undertaking that is conducted at the same location (the "Building 1 undertaking"). Thus, the rules for support operations in paragraph (c)(2)(ii)(A) of this section do not apply to such operations, and they are treated as part of the Building 1 undertaking. Example (6). (i) The taxpayer conducts business and rental operations at eleven different locations (within the meaning of paragraph (c)(2)(iii) of this section). At ten of the locations the taxpayer owns grocery stores, and at the eleventh location the taxpayer owns a warehouse that receives goods and supplies them to the taxpayer's stores. The operations of each store are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at each location (i.e., property is sold to customers on the store premises, and customers take physical possession on the store premises of property made available for their use). Accordingly, the operations of each of the ten grocery stores are treated as a separate source of income production (see paragraph (c)(2) of this section), and each store is treated as a single undertaking (a "grocery store undertaking") that is separate from other undertakings (see paragraph (c)(1) of this section). The operations conducted at the warehouse, however, do not include any income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section). Accordingly, the warehouse operations do not satisfy the requirements of paragraph (c)(2)(i) of this section and are not treated as a separate undertaking under paragraph (c)(1) of this section. (ii) The warehouse operations and the grocery store undertakings are owned by the same person (i.e., the taxpayer is the direct owner of the operations), the operations conducted at the warehouse involve the provision of property to the grocery store undertakings, and the warehouse operations are not income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section). Thus, the warehouse operations are support operations (within the meaning of paragraph (c)(2)(ii)(B) of this section) with respect to the grocery store undertakings. Paragraph (c)(2)(ii)(A)(2) of this section provides that the income and expenses that are attributable to support operations and are reasonably allocable to an undertaking conducted at a different location shall be taken into account in determining the income or loss from the activity or activities that include such undertaking.

Accordingly, the income and expenses of the warehouse operations that are reasonably allocable to a grocery store undertaking are taken into account in determining the income or loss from the activity or activities that include such undertaking. See paragraph (f) of this section for rules under which certain similar, commonly-controlled undertakings are treated as a single activity. Example (7). (i) The facts are the same as in example (6), except that the warehouse operations also include the sale of goods to grocery stores that the taxpayer does not own ("other grocery stores"). Because of these sales, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the warehouse. The warehouse operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). Accordingly, prior to the application of the rules for support operations in paragraph (c)(2)(ii) of this section, the warehouse operations are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking (the "separate warehouse undertaking") that is separate from other undertakings (see paragraph (c)(1) of this section). (ii) As in example (6), the warehouse operations that involve supplying goods to the taxpayer's grocery store undertakings are support operations with respect to those undertakings. Therefore, those operations are not treated as part of the separate warehouse undertaking (see paragraph (c)(2)(ii)(A)(1) of this section), and the income and expenses of such operations are taken into account, as in example (6), in determining the income or loss from the activity or activities that include the taxpayer's grocery store undertakings. Example (8). (i) A partnership is formed to acquire real property and construct a building on the property. The partnership hires brokers to locate a suitable parcel of land, lawyers to negotiate zoning variances, easements, and building permits, and architects and engineers to design the improvements. After the architects and engineers have designed the improvements and other preliminaries have been completed, the partnership hires a general contractor who hires subcontractors and oversees construction. During the construction process and after construction has been completed, the partnership leases out space in the building. The partnership then operates the building as a rental property. The operations of acquiring the real property, negotiating contracts, overseeing the designing and construction of the improvements, leasing up the building, and operating the building are conducted at an office (the "management office") that is not at the same location (within the meaning of paragraph (c)(2)(iii) of this section) as the building. (ii) The operations conducted at the building site (e.g., excavating the land, pouring the concrete for the foundation, erecting the frame of the building, completing the exterior of the building, and building out the interior of the building) are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the partnership is the direct owner of the operations). In addition, the partnership conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., during the construction period property (the building) is produced at the building site, and during the rental period customers take physical possession in the building of property made available for their use). Accordingly, the operations conducted at the building site are treated as a separate source of income production (see

paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). (iii) The operations conducted at the management office and the undertaking conducted at the building site are owned by the same person (i.e., the partnership is the direct owner of the operations). In addition, the operations conducted at the management office relate to transactions in which customers take physical possession at another location of property that is made available for their use (i.e., the operations are not income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section)). Thus, to the extent the operations conducted at the management office involve the provision of services to the undertaking conducted at the building site, they are support operations (within the meaning of paragraph (c)(2)(ii)(B) of this section) with respect to such undertaking. (iv) Paragraph (c)(2)(ii)(A)(2) of this section provides that the income and expenses of support operations that are reasonably allocable to an undertaking conducted at a different location shall be taken into account in determining the income or loss from the activity that includes such undertaking. Accordingly, the income and expenses of the management office that are reasonably allocable to the undertaking conducted at the building site are taken into account in determining the income or loss from the activity or activities that include such undertaking. (v) Until the building is first held out for rent and is in a state of readiness for rental, the undertaking conducted at the building site is a trade or business undertaking (within the meaning of paragraph (f)(1)(ii) of this section). See paragraph (d) of this section for rules for determining whether the undertaking is a rental undertaking for periods after the building is first held out for rent and is in a state or readiness for rental and paragraph (k) of this section for rules for identifying rental real estate activities. Example (9). The taxpayer owns 15 oil wells pursuant to a single working interest (within the meaning of §1.469-1T (e)(4)(iv). All of the wells are drilled and operated for the development of a common reservoir. Thus, all of the wells are at the same location (see paragraph (c)(2)(iii)(E) of this section). All of the wells are owned by the same person (i.e., the taxpayer is the direct owner of the operations), and the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., oil wells are drilled in reasonable anticipation of producing oil at the location). Accordingly, the operations of the wells are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). See paragraph (e) of this section for rules under which certain oil and gas operations are treated as multiple undertakings even if they would be part of the same undertaking under the rules of this paragraph (c). Example (10). (i) Partnership X owns an automobile dealership and partnership Y owns an automobile repair shop. The dealership and repair shop operations are conducted in the same physical structure. Individuals A, B, and C are the only partners in partnerships X and Y, and each of the partners owns a one-third interest in both partnerships. (ii) The dealership operations and the repair-shop operations are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section), but are

owned by different persons (i.e., X is the direct owner of the dealership operations, and Y is the direct owner of the repair-shop operations). Moreover, indirect ownership of the operations is not taken into account under paragraph (c)(2)(v) of this section. Thus, it is irrelevant that the two partnerships are owned by the same persons in identical proportions. Accordingly, the dealership and repair-shop operations are not treated as part of the same source of income production (see paragraph (c)(2) of this section) or as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). See, however, paragraph (g) of this section for rules under which certain trade or business activities are treated as a single activity. Example (11). (i) The taxpayer owns and operates a delivery service. The business consists of a central office, retail establishments, and messengers who transport packages from one place to another. Customers may bring their packages to a retail establishment for delivery elsewhere or, by calling the central office, may have packages picked up at their homes or offices. The central office dispatches messengers and coordinates all pickups and deliveries. Customers may pay for deliveries when they drop off or pick up packages at a retail establishment, or the central office will bill the customer for services rendered. In addition, many packages are routed through the central office. (ii) The operations conducted at the central office are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). The operations actually conducted at the central office, however, do not include any income-producting operations (within the meaning of paragraph (c)(2)(iv) of this section). (iii) Under paragraph (c)(2)(iii) (C) and (D) of this section, business and rental operations that are not conducted at a fixed place of business or that are conducted on the customer's premises are treated as operations that are conducted at the location (other than the customer's premises) with which they are most closely associated, and all the facts and circumstances are taken into account in determining the location with which business and rental operations are most closely associated. The facts and circumstances in this case (including the facts that the central office dispatches messengers, coordinates all pickups and deliveries, and is the transshipment point for many packages) establish that the operations of delivering packages from one location to another are most closely associated with the central office. Thus, the delivery operations are treated as operations that are conducted at the central office, and the deliveries are treated as income-producing operations (i.e., the performance of services for customers) that the taxpayer conducts at the central office. Accordingly, the operations conducted at the central office are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). (iv) The operations conducted at each retail establishment are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). At each retail establishment, the taxpayer's operations include transactions that involve the presence of customers at the establishment. Thus, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv)(E) of this

section) at the retail establishments. Accordingly, the operations of each retail establishment are treated as a separate source of income production (see paragraph (c)(2) of this section) and as a single undertaking that is separate from other undertakings (see paragraph (c)(1) of this section). See, however, paragraph (f) of this section for rules under which certain similar, commonly-controlled undertakings are treated as a single activity. Example (12). (i) The taxpayer is the sole owner of a saw mill and a lumber yard. The taxpayer's business operations consist of converting timber into lumber and other wood products and selling the resulting products. The timber is processed at the saw mill, and the resulting products are transported to the lumber yard where they are sold. The saw mill and the lumber yard are at different locations (within the meaning of paragraph (c)(2)(iii) of this section). The transportation operations are managed at the saw mill. (ii) The operations conducted at the saw mill are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., lumber is produced at the mill). Similarly, the selling operations at the lumber yard are conducted at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are owned by the same person (i.e., the taxpayer is the direct owner of the operations). In addition, the taxpayer conducts income-producing operations (within the meaning of paragraph (c)(2)(iv) of this section) at the location (i.e., lumber is sold to customers at the lumber yard). Thus, the milling operations and the selling operations are treated as separate sources of income production (see paragraph (c)(2) of this section) and as separate undertakings (see paragraph (c)(1) of this section). (iii) The operations conducted at the mill involve the provision of property to the lumber-yard undertaking. Nonetheless, the milling operations are income-producing operations because they relate to the production of property at the mill, and an undertaking's income-producing operations are not treated as support operations (see paragraph (c)(2)(ii)(B)(3) of this section). Accordingly, the milling operations are not support operations with respect to the lumber-yard undertaking. See, however, paragraph (f) of this section for rules under which certain vertically-integrated undertakings are treated as part of the same activity. (iv) The operations of transporting finished products from the saw mill to the lumber yard are not conducted at a fixed location. Under paragraphs (c)(2)(iii) (C) and (D) of this section, business and rental operations that are not conducted at a fixed place of business or that are conducted on the customer's premises are treated as operations that are conducted at the location (other than the customer's premises) with which they are most closely associated, and all the facts and circumstances are taken into account in determining the location with which business and rental operations are most closely associated. The facts and circumstances in this case (including the fact that the transportation operations are managed at the saw mill) establish that the transportation operations are most closely associated with the saw mill. Thus, the transportation operations are treated as operations that are conducted at the mill and as part of the undertaking that consists of the milling operations.

(d) Rental undertaking-(1) In general. This paragraph (d) applies to operations that are treated, under paragraph (c) of this section and before the application of paragraph (d)(1)(i) of this section, as a single undertaking that is separate from other undertakings (a "paragraph (c) undertaking"). For purposes of this section- (i) A paragraph (c) undertaking's rental operations and its operations other than rental operations shall be treated, except as otherwise provided in paragraph (d)(2) of this section, as two separate undertakings; (ii) The income and expenses that are reasonably allocable to an undertaking (determined after the application of paragraph (d)(1)(i) of this section) shall be taken into account in determining the income or loss from the activity or activities that include such undertaking; and (iii) An undertaking (determined after the application of paragraph (d)(1)(i) of this section) shall be treated as a rental undertaking if and only if such undertaking, considered as a separate activity, would constitute a rental activity (within the meaning of §1.469-1T(e)(3)). (2) Exceptions. Paragraph (d)(1)(i) of this section shall not apply to a paragraph (c) undertaking for any taxable year in which- (i) The rental operations of the paragraph (c) undertaking, considered as a separate activity, would not constitute a rental activity (within the meaning of §1.469- 1T(e)(3)); (ii) Less than 20 percent of the gross income of the paragraph (c) undertaking is attributable to rental operations; or (iii) Less than 20 percent of the gross income of the paragraph (c) undertaking is attributable to operations other than rental operations. (3) Rental operations. For purposes of this paragraph (d), a paragraph (c) undertaking's rental operations are determined under the following rules: (i) General rule. Except as otherwise provided in paragraph (d)(3) (ii) or (iii) of this section, a paragraph (c) undertaking's rental operations are all of the undertaking's business and rental operations that involve making tangible property available for use by customers and the provision of property and services in connection therewith. (ii) Real property provided for short-term use. A paragraph (c) undertaking's operations that involve making short-term real property available for use by customers and the provision of property and services in connection therewith shall not be treated as rental operations if such operations, considered as a separate activity, would not constitute a rental activity. An item of property is treated as short-term real property for this purpose if and only if such item is real property that the paragraph (c) undertaking makes available for use by customers and the average period of customer use (within the meaning of §1.469-1T(e)(3)(iii)) for all of the paragraph (c) undertaking's real property of the same type as such item is 30 days or less.

(iii) Property made available to licensees. A paragraph (c) undertaking's operations that involve making tangible property available during defined business hours for nonexclusive use by various customers shall not be treated as rental operations. (See §1.469-1T(e)(3)(ii)(E).) (4) Examples. The following examples illustrate the application of this paragraph (d). In each example that does not state otherwise, the taxpayer is an individual and the facts, analysis, and conclusions relate to a single taxable year. Example (1). The taxpayer owns a building in which the taxpayer rents office space to tenants and operates a parking garage that is used by tenants and other persons. (Assume that, under paragraph (c)(1) of this section, the operations conducted in the building are treated as a single paragraph (c) undertaking.) The taxpayer's tenants typically occupy an office for at least one year, and the services provided to tenants are those customarily provided in office buildings. Some persons (including tenants) rent spaces in the parking garage on a monthly or annual basis. In general, however, spaces are rented on an hourly or daily basis, and the average period for which all customers (including tenants) use the parking garage is less than 24 hours. The paragraph (c) undertaking derives 75 percent of its gross income from office-space rentals and 25 percent of its gross income from the parking garage. The operations conducted in the building are not incidental to any other activity of the taxpayer (within the meaning of §1.469-1T(e)(3)(vi)). (ii) The parking spaces are real property and the average period of customer use (within the meaning of §1.469-1T(e)(3)(iii)) for the parking spaces is 30 days or less. Thus, the parking spaces are short-term real properties (within the meaning of paragraph (d)(3)(ii) of this section). (For this purpose, individual parking spaces that are rented on a monthly or annual basis are, nevertheless, short-term real properties because all the parking spaces are property of the same type, and the average rental period taking all parking spaces into account is 30 days or less.) In addition, the parking-garage operations involve making short-term real properties available for use by customers and the provision of property and services in connection therewith. (iii) Paragraph (d)(3) (i) and (ii) of this section provides, in effect, that a paragraph (c) undertaking's operations that involve making short-term real properties available for use by customers and the provision of property and services in connection therewith are treated as rental operations if and only if the operations, considered as a separate activity, would constitute a rental activity (within the meaning of §1.469- 1T(e)(3)). In this case, the parking-garage operations, if considered as a separate activity, would not constitute a rental activity because the average period of customer use for the parking spaces is seven days or less (see §1.469- 1T(e)(3)(ii)(A)). Accordingly, the parking-garage operations are not treated as rental operations. (iv) The paragraph (c) undertaking's remaining operations involve the provision of tangible property (the office spaces) for use by customers and the provision of property and services in connection therewith. The average period of customer use for the office spaces exceeds 30 days. Thus, the office spaces are not short-term real properties, and the undertaking's operations involving the rental of office spaces are rental operations.

(v) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, at least 20 percent of the paragraph (c) undertaking's gross income is attributable to rental operations (the office-space operations) and at least 20 percent is attributable to operations other than rental operations (the parking-garage operations). Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of this section do not apply. In addition, the average period of customer use for the office spaces exceeds 30 days, extraordinary personal services (within the meaning of §1.469-1T(e)(3)(v)) are not provided, and the rental of the office spaces is not treated as incidental to a nonrental activity under §1.469-1T(e)(3)(vi) (relating to incidental rentals that are not treated as a rental activity). Thus, the rental operations, if considered as a separate activity, would constitute a rental activity, and the exception in paragraph (d)(2)(i) of this section does not apply. Accordingly, the rental operations and the parking-garage operations are treated as two separate undertakings (the "office-space undertaking" and the "parking-garage undertaking"). (vi) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking if and only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the office-space undertaking, if considered as a separate activity, would constitute a rental activity (see (v) above), and the parking-garage undertaking, if considered as a separate activity, would not constitute a rental activity (see (iii) above). Accordingly, the office-space undertaking is treated as a rental undertaking, and the parking-garage undertaking is not. Example (2). (i) The taxpayer owns a building in which the taxpayer rents apartments to tenants and operates a restaurant. (Assume that, under paragraph (c)(1) of this section, the operations conducted in the building are treated as a single paragraph (c) undertaking.) The taxpayer's tenants typically occupy an apartment for at least one year, and the services provided to tenants are those customarily provided in residential apartment buildings. The paragraph (c) undertaking derives 85 percent of its gross income from apartment rentals and 15 percent of its gross income from the restaurant. The operations conducted in the building are not incidental to any other activity of the taxpayer (within the meaning of §1.469- 1T(e)(3)(vi)). (ii) The operations with respect to apartments (the "apartment operations") involve the provision of tangible property (the apartments) for use by customers and the provision of property and services in connection therewith. In addition, the apartments are not short-term real properties (within the meaning of paragraph (d)(3)(ii) of this section) because the average period of customer use (within the meaning of §1.469-1T(e)(3)(iii)) for the apartments exceeds 30 days. Accordingly, the apartment operations are rental operations (within the meaning of paragraph (d)(3) of this section). The restaurant operations do not involve the provision of tangible property for use by customers or the provision of property or services in connection therewith. Thus, the restaurant operations are not rental operations. (iii) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, however, the exception in paragraph (d)(2)(iii) of this section applies because less than 20 percent

of the paragraph (c) undertaking's gross income is attributable to operations other than rental operations (the restaurant operations). Accordingly, the rental operations and the restaurant operations are not treated as two separate undertakings under paragraph (d)(1)(i) of this section. (iv) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking if and only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the undertaking (determined after the application of paragraph (d)(1)(i) of this section) includes both the apartment operations and the restaurant operations, and the gross income of this undertaking represents amounts paid principally for the use of tangible property (the apartments). Moreover, the average period of customer use for the apartments exceeds 30 days, extraordinary personal services (within the meaning of §1.469- 1T(e)(3)(v)) are not provided, and the rental of the apartments is not treated as incidental to a nonrental activity under §1.469-1T(e)(3)(vi) (relating to incidental rentals that are not treated as a rental activity). Thus, the undertaking, if considered as a separate activity, would constitute a rental activity. Accordingly, the undertaking is treated as a rental undertaking. Example (3). (i) The taxpayer owns a building in which the taxpayer rents hotel rooms, meeting rooms, and parking spaces to customers, rents space to various retailers, and operates a restaurant and health club. (Assume that, under paragraph (c)(1) of this section, the operations conducted in the building are treated as a single paragraph (c) undertaking.) Although some customers occupy hotel rooms for extended periods (including some customers who reside in the hotel), customers use hotel rooms for an average period of two days and meeting rooms for an average period of one day. The services provided to persons using the hotel rooms and meeting rooms are those customarily provided in hotels (including wake-up calls, valet services, and delivery of food and beverages to rooms). Some customers rent spaces in the parking garage on a monthly or annual basis. In general, however, parking spaces are rented on an hourly or daily basis, and the average period for which customers use the parking garage is less than 24 hours. Retail tenants typically occupy their space for at least one year, and the services provided to retail tenants are those customarily provided in commercial buildings. The paragraph (c) undertaking derives 45 percent of its gross income from renting hotel rooms, meeting rooms, and parking spaces, 35 percent of its gross income from renting retail space, and 20 percent of its gross income from the restaurant and health club. The operations conducted in the building are not incidental to any other activity of the taxpayer (within the meaning of §1.469-1T(e)(3)(vi)). (ii) The parking spaces, hotel rooms, and meeting rooms are real property of three different types, but the average period of customer use (within the meaning of §1.469-1T (e)(3)(iii)) for property of each type is 30 days or less. Thus, the parking spaces, hotel rooms, and meeting rooms are short-term real properties. (For this purpose, individual parking spaces or hotel rooms that are rented for extended periods are, nevertheless, short-term real properties if the average rental period for all parking spaces is 30 days or less and the average rental period for all hotel rooms is 30 days or less.) In addition, the parking garage operations, the operations with respect to hotel rooms (the "hotel-room operations"), and the operations with respect to meeting rooms (the "meeting-room operations") involve making short-

term real properties available for use by customers and the provision of property and services in connection therewith. (iii) Paragraph (d)(3) (i) and (ii) of this section provides, in effect, that a paragraph (c) undertaking's operations that involve making short-term real properties available for use by customers and the provision of property and services in connection therewith are treated as rental operations if and only if the operations, considered as a separate activity, would constitute a rental activity (within the meaning of §1.469- 1T (e)(3)). In this case the parking-garage, hotel-room and meeting-room operations, if considered as separate activities, would not constitute rental activities because the average period of customer use for parking spaces, hotel rooms, and meeting rooms does not exceed seven days (see §1.469-1T (e)(3)(ii)(A)). Accordingly, the parking-garage, hotel-room, and meeting-room operations are not treated as rental operations. (iv) The operations with respect to retail space in the building (the "retail-space operations") involve the provision of tangible property (the retail spaces) for use by customers and the provision of property and services in connection therewith. In addition, the retail spaces are not short-term real properties (within the meaning of paragraph (d)(3)(ii) of this section) because the average period of customer use (within the meaning of §1.469-1T (e)(3)(iii)) for the retail spaces exceeds 30 days. Accordingly, the retail-space operations are rental operations. (v) The health-club operations involve making tangible property available for use by customers, but the property is customarily made available during defined business hours for nonexclusive use by various customers. Accordingly, the health-club operations are not rental operations (see paragraph (d)(3)(iii) of this seciton). The restaurant operations do not involve the provision of tangible property for use by customers or the provision of property or services in connection therewith. Accordingly, the restaurant operations also are not rental operations. (vi) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, at least 20 percent of the paragraph (c) undertaking's gross income is attributable to rental operations (35 percent of the paragraph (c) undertaking's gross income is from the retail-space operations) and at least 20 percent is attributable to operations other than rental operations (45 percent from the hotel-room, meeting-room and parking-garage operations and 20 percent from the restaurant and health-club operations). Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of this section do not apply. In addition, the average period of customer use for the retail space exceeds 30 days, extraordinary personal services (within the meaning of §1.469-1T (e)(3)(v)) are not provided, and the rental of the retail space is not treated as incidental to a nonrental activity under §1.469-1T (e)(3)(vi) (relating to incidental rentals that are not treated as a rental activity). Thus, the retail-space operations, if considered as a separate activity, would constitute a rental activity, and the exception in paragraph (d)(2)(i) of this section does not apply. Accordingly, the retail-space operations are treated as an undertaking (the "retail-space undertaking") and all the other operations conducted in the building (i.e., renting hotel and meeting rooms and parking spaces and operating the restaurant and health club) are treated as a separate undertaking (the "hotel undertaking").

(vii) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking if and only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the retail-space undertaking, if considered as a separate activity, would constitute a rental activity (see (iv) above). Accordingly, the retail-space undertaking is treated as a rental undertaking. The hotel undertaking, if considered as a separate activity, would not constitute a rental activity because all tangible property provided for the use of customers in the hotel undertaking is either property for which the average period of customer use is seven days or less (see §1.469-1T (e)(3)(ii)(A)) or property customarily made available during defined business hours for nonexclusive use by various customers (see §1.469-1T (e)(3)(ii)(E)). Accordingly, the hotel undertaking is not treated as a rental undertaking. Example (4). (i) A law partnership owns a ten-story building. The partnership uses eight floors of the building in its law practice and leases two floors to one or more tenants. (Assume that, under paragraph (c)(1) of this section, the operations conducted in the building are treated as a single paragraph (c) undertaking.) Tenants typically occupy space on the two rented floors for at least one year, and the services provided to tenants are those customarily provided in office buildings. The paragraph (c) undertaking derives 90 percent of its gross income from rendering legal services and 10 percent of its gross income from renting space. The operations conducted in the building are not incidental to any other activity of the taxpayer (within the meaning of §1.469-1T (e)(3)(vi)). (ii) The operations with respect to the office space leased to tenants (the "office-space operations") involve the provision of tangible property (the office space) for use by customers and the provision of property and services in connection therewith. In addition, the office spaces are not short-term real properties (within the meaning of paragraph (d)(3)(ii) of this section) because the average period of customer use (within the meaning of §1.469-1T(e)(3)(iii)) for the office space exceeds 30 days. Accordingly, the office-space operations are rental operations (within the meaning of paragraph (d)(3) of this section). (iii) The operations that involve the performance of legal services (the "law-practice operations") do not involve the provision of tangible property for use by customers or the provision of property or services in connection therewith. Accordingly, the law-practice operations are not rental operations. (iv) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, however, the exception in paragraph (d)(2)(ii) of this section applies because less than 20 percent of the paragraph (c) undertaking's gross income is attributable to rental operations (the office-space operations). Accordingly, the law-practice operations and the office-space operations are not treated as two separate undertakings under paragraph (d)(1)(i) of this section. (v) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the undertaking (determined after the

application of paragraph (d)(1)(i) of this section) includes both the law-practice operations and the office-space operations, and the gross income of this undertaking does not represent amounts paid principally for the use of tangible property. Thus, the undertaking, if considered as a separate activity, would not constitute a rental activity. Accordingly, the undertaking is not treated as a rental undertaking. Example (5). (i) The facts are the same as in example (4), except that the building is owned by a separate partnership (the "real estate partnership"), which leases eight floors of the building to the law partnership for use in its law practice and two floors to one or more other tenants. The law partnership and real estate partnership are owned by the same individuals in identical proportions. (ii) The operations conducted in the building are owned by two different persons (i.e., the law partnership and the real estate partnership). (See paragraph (c)(2)(v) of this section.) Thus, the operations conducted in the building are not treated as a single undertaking under paragraph (c)(1) of this section. Instead, each partnership's share of such operations is treated as a separate paragraph (c) undertaking (the "law-practice undertaking" and the "office-space undertaking"). (iii) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking if and only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the office-space undertaking, if considered as a separate activity, would constitute a rental activity because all of the undertaking's gross income (including rents paid by the law partnership) represents amounts paid principally for the use of tangible property (the office space), the average period of customer use for the office space exceeds 30 days, extraordinary personal services (within the meaning of §1.469-1T(e)(3)(v)) are not provided, and the rental of the office space is not treated as incidental to a nonrental activity under §1.469-1T(e)(3)(vi) (relating to incidental rentals that are not treated as a rental activity). Accordingly, the office-space undertaking is treated as a rental undertaking. See, however, §1.469-2T(f)(6) (relating to certain rentals of property to a trade or business activity in which the taxpayer materially participates). (iv) The law-practice undertaking, if considered as a separate activity, would not constitute a rental activity because none of the undertaking's gross income represents amounts paid principally for the use of tangible property. Accordingly, the law-practice undertaking is not treated as a rental undertaking. Example (6). (i) The taxpayer owns a building in which the taxpayer operates a nursing home and a medical clinic. (Assume that, under paragraph (c)(1) of this section, the operations conducted in the building are treated as a single paragraph (c) undertaking.) The nursing-home operations consist of renting apartments in the nursing home to elderly and handicapped persons and providing medical care, meals, and social activities. (Assume that these services are extraordinary personal services (within the meaning of §1.469-1T(e)(3)(v)). The medical clinic provides medical care to nursing-home residents and other individuals. Nursing-home residents typically occupy an apartment for at least one year. The paragraph (c) undertaking derives 55 percent of its gross income from nursing-home operations (including the provision of medical services to nursing-home residents) and 45 percent of its gross income from medical-clinic operations. The operations conducted in the building are not incidental to any other activity of the taxpayer (within the meaning of §1.469-1T(e)(3)(vi)).

(ii) The paragraph (c) undertaking's nursing-home operations involve the provision of tangible property (the apartments) for use by customers and the provision of property and services in connection therewith. In addition, the apartments are not short-term real properties (within the meaning of paragraph (d)(3)(ii) of this section) because the average period of customer use (within the meaning of §1.469- 1T(e)(3)(iii)) for the apartments exceeds 30 days. Accordingly, the nursing-home operations are rental operations (within the meaning of paragraph (d)(3) of this section). The medical-clinic operations do not involve the provision of tangible property for use by customers or the provision of property or services in connection therewith. Thus, the medical-clinic operations are not rental operations. (iii) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, however, the nursing-home operations, if considered as a separate activity, would not constitute a rental activity because extraordinary personal services are provided in connection with making nursing-home apartments available for use by customers (see §1.469- T(e)(3)(ii)(C)). Thus, the exception in paragraph (d)(2)(i) of this section applies, and the nursing-home operations and the medical-clinic operations are not treated as two separate undertakings under paragraph (d)(1)(i) of this section. (iv) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the nursing-home operations, if considered as a separate activity, would not constitute a rental activity (see (iii) above). Thus, an undertaking that includes no rental operations other than the nursing-home operations would not, if considered as a separate activity, constitute a rental activity. Accordingly, the undertaking is not treated as a rental undertaking. Example (7). (i) The taxpayer rents and sells videocassettes. (Assumes that, under paragraph (c)(1) of this section, the videocassette operations are treated as a single paragraph (c) undertaking.) Renters of videocassettes typically keep the videocassettes for one or two days, and do not receive any other property or services in connection with videocassette rentals. The paragraph (c) undertaking derives 70 percent of its gross income from renting videocassettes and 30 percent of its gross income from selling videocassettes. The videocassette operations are not incidental to any other activity of the taxpayer (within the meaning of §1.469- 1T(e)(3)(vi)). (ii) The rental of videocassettes involves the provision of tangible property (the videocassettes) for use by customers. In addition, the special rules for short-term real properties contained in paragraph (d)(3)(ii) of this section do not apply in this case because the videocassettes are not real property. Thus, the operations that involve videocassette rentals are rental operations (within the meaning of paragraph (d)(3) of this section). The sale of videocassettes does not involve the provision of tangible property for use by customers or the provision of property or services in connection therewith. Thus, the operations that involve videocassette sales are not rental operations. (iii) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental

operations are treated as two separate undertakings. In this case, however, the rental operations, if considered as a separate activity, would not constitute a rental activity because the average period of customer use for rented videocassettes does not exceed seven days (see §1.469-1T(e)(3)(ii)(A)). Accordingly, the exception in paragraph (d)(2)(i) of this section applies, and the videocassette-rental operations and videocassette-sales operations are not treated as two separate undertakings under paragraph (d)(1)(i) of this section. (iv) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the videocassette-rental operations, if considered as a separate activity, would not constitute a rental activity (see (iii) above). Thus, an undertaking that includes no rental operations other than the videocassette-rental operations would not, if considered as a separate activity, constitute a rental activity. Accordingly, the undertaking is not treated as a rental undertaking. Example (8). (i) The taxpayer owns a building in which the taxpayer sells, leases, and services automobiles. (Assume that, under paragraph (c)(1) of this section, the operations conducted in the building are treated as a single paragraph (c) undertaking.) The minimum lease term for any leased automobile is 31 days, and the services provided to lessees (including periodic oil changes, lubrication, and routine services and repairs) are those customarily provided in long-term automobile leases. The paragraph (c) undertaking derives 75 percent of its gross income from selling automobiles, 15 percent of its gross income from servicing automobiles other than leased automobiles, and 10 percent of its gross income from leasing automobiles. The taxpayer's automobile operations are not incidental to any other activity of the taxpayer (within the meaning of §1.469-1T(e)(3)(vi)). (ii) The paragraph (c) undertaking's automobile-leasing operations involve the provision of tangible property (the automobiles) for use by customers and the provision of services in connection therewith. In addition, the special rules for short-term real properties contained in paragraph (d)(3)(ii) of this section do not apply in this case because the automobiles are not real property. Accordingly, the automobile-leasing operations are rental operations (within the meaning of paragraph (d)(3) of this section). The paragraph (c) undertaking's automobile-sales operations and servicing operations for automobiles other than leased automobiles (the "selling-and-servicing operations") do not involve the provision of tangible property for use by customers or the provision of property or services in connection therewith. Thus, the selling-and-servicing operations are not rental operations. (iii) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, however, the exception in paragraph (d)(2)(ii) of this section applies because less than 20 percent of the paragraph (c) undertaking's gross income is attributable to rental operations (the "automobile-leasing operations"). Accordingly, the rental operations and the selling-and-servicing operations are not treated as two separate undertakings under paragraph (d)(1)(i) of this section.

(iv) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the undertaking (determined after the application of paragraph (d)(1)(i) of this section) includes both the selling-and-servicing operations and the automobile-leasing operations, and the gross income of the undertaking does not represent amounts paid principally for the use of tangible property. Thus, the undertaking, if considered as a separate activity, would not constitute a rental activity. Accordingly, the undertaking is not treated as a rental undertaking. Example (9). (i) The facts are the same as in example (8), except that the paragraph (c) undertaking derives 60 percent of its gross income from selling automobiles, 15 percent of its gross income from servicing automobiles other than leased automobiles, and 25 percent of its gross income from leasing automobiles. (ii) Paragraph (d)(1)(i) of this section provides, with certain exceptions, that a paragraph (c) undertaking's rental operations and its operations other than rental operations are treated as two separate undertakings. In this case, more than 20 percent of the paragraph (c) undertaking's gross income is attributable to rental operations (the automobile-leasing operations), and more than 20 percent is attributable to operations other than rental operations (the selling-and-servicing operations). Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of this section do not apply. In addition, the average period of customer use for leased automobiles exceeds 30 days, extraordinary personal services (within the meaning of §1.469- 1T(e)(3)(v)) are not provided, and the leasing of the automobiles is not treated as incidental to a nonrental activity under §1.469-1T(e)(3)(vi) (relating to incidental rentals that are not treated as a rental activity). Thus, the leasing operations, if considered as a separate activity, would constitute a rental activity, and the exception in paragraph (d)(2)(i) of this section does not apply. Accordingly, the rental operations and the selling-and-servicing operations are treated as two separate undertakings (the "automobile-leasing undertaking" and the "automobile selling-and-servicing undertaking"). (iii) Paragraph (d)(1)(iii) of this section provides that an undertaking (determined after the application of paragraph (d)(1)(i) of this section) is treated as a rental undertaking if and only if the undertaking, considered as a separate activity, would constitute a rental activity. In this case, the automobile-leasing undertaking would, if considered as a separate activity, constitute a rental activity, and the automobile selling-and-servicing undertaking would not, if considered as a separate activity, constitute a rental activity (see example (8) and (ii) above). Accordingly, the automobile-leasing undertaking is treated as a rental undertaking, and the automobile selling-and-servicing undertaking is not. (e) Special rules for certain oil and gas operations-(1) Wells treated as nonpassive under §1.469-1T(e)(4)(i). An oil or gas well shall be treated as an undertaking that is separate from other undertakings in determining the activities of a taxpayer for a taxable year if the following conditions are satisfied: (i) The well is drilled or operated pursuant to a working interest (within the meaning of §1.469-1T(e)(4)(iv)) and at any time during such taxable year the taxpayer holds such working interest either-

(A) Directly; or (B) Through an entity that does not limit the liability of the taxpayer with respect to the drilling or operation of such well pursuant to such working interest; and (ii) The taxpayer would not be treated as materially participating (within the meaning of §1.469-5T) for the taxable year in the activity in which such well would be included if the taxpayer's activities were determined without regard to this paragraph (e). (2) Business and rental operations that constitute an undertaking. In any case in which an oil or gas well is treated under this paragraph (e) as an undertaking that is separate from other undertakings, the business and rental operations that constitute such undertaking are the business and rental operations that are attributable to such well. (3) Examples. The following examples illustrate the application of this paragraph (e). In each example, the taxpayer is an individual whose taxable year is the calendar year. Example (1). During 1989, A directly owns an undivided interest in a working interest (within the meaning of §1.469-1T(e)(4)(iv)) in two oil wells. A does not participate in the activity in which the wells would be included if A's activities were determined without regard to this paragraph (e). Under paragraph (e)(1) of this section, each well is treated as a separate undertaking in determining A's activities for 1989 because A holds the working interest directly and would not be treated as materially participating for 1989 in the activity in which the wells would be included if A's activities were determined without regard to this paragraph (e). The aggregation rules in paragraph (f) of this section do not apply to these undertakings (see paragraph (f)(1)(ii)(B) of this section). Thus, each of the undertakings is treated as a separate activity under paragraph (b)(1) of this section. The result is the same even if A has net income from one or both wells for 1989 and even if the wells would otherwise be treated as part of the same undertaking under paragraph (c) of this section. The result would also be the same if A held the working interest through an entity, such as a general partnership, that does not limit A's liability with respect to the drilling or operation of the wells pursuant to the working interest. Example (2). (i) During 1989, B is a general partner in a partnership that owns a working interest (within the meaning of §1.469-1T(e)(4)(iv)) in an oil well. B does not own any interest in the well other than through the partnership. At the end of 1989, however, B's partnership interest is converted into a limited partnership interest, and during 1990 B holds the working interest only as a limited partner. B does not participate in the activity in which the well would be included if B's activities were determined without regard to this paragraph (e). (ii) Under paragraph (e)(1) of this section, the well is treated as a separate undertaking in determining B's activities for 1989 because B holds the working interest during 1989 through an entity that does not limit B's liability with respect to the drilling or operation of the well pursuant to the working interest, and B would not be treated as materially participating for 1989 in the activity in which the well would be included if B's activities were determined without regard to this paragraph (e). Throughout 1990, however, B's liability with respect to the drilling and operation of

the well is limited by the entity through which B holds the working interest (i.e., the limited partnership). Accordingly, paragraph (e)(1) of this section does not apply to the well in 1990, and the well may be included under paragraph (c) of this section in an undertaking that includes other operations. Example (3). The facts are the same as in example (2), except that B's partnership interest is converted into a limited partnership interest at the end of November 1989. An oil or gas well may be treated as a separate undertaking under paragraph (e)(1) of this section if at any time during the taxable year the taxpayer holds a working interest in the well directly or through an entity that does not limit the taxpayer's liability with respect to the drilling or operation of the well pursuant to the working interest (see §1.469-1T(e)(4)(i)). Thus, although B's liability with respect to the drilling and operation of the well is limited during December 1989, the result in both 1989 and 1990 is the same as in example (2). In 1989, however, disqualified deductions and a ratable portion of the gross income from the well may be treated under §1.469-1T(e)(4)(ii) as passive activity deductions and passive activity gross income, respectively. (f) Certain trade or business undertakings treated as part of the same activity-(1) Applicability-(i) In general. This paragraph (f) applies to a taxpayer's interests in trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section). (ii) Trade or business undertaking. For purposes of this paragraph (f), the term "trade or business undertaking" means any undertaking in which a taxpayer has an interest, other than- (A) A rental undertaking (within the meaning of paragraph (d) of this section); (B) An oil or gas well treated as an undertaking that is separate from other undertakings under paragraph (e) of this section; or (C) A professional service undertaking (within the meaning of paragraph (h) of this section). (2) Treatment as part of the same activity. A taxpayer's interests in two or more trade or business undertakings that are similar (within the meaning of paragraph (f)(4) of this section) and controlled by the same interests (within the meaning of paragraph (j) of this section) shall be treated as part of the same activity of the taxpayer for any taxable year in which the taxpayer- (i) Owns interests in each such undertaking through the same passthrough entity; (ii) Owns a direct or substantial indirect interest (within the meaning of paragraph (f)(3) of this section) in each such undertaking; or (iii) Materially or significantly participates (within the meaning of §1.469-5T) in the activity that would result if such undertakings were treated as part of the same activity.

(3) Substantial indirect interest-(i) In general. For purposes of this paragraph (f), a taxpayer owns a substantial indirect interest in an undertaking for a taxable year if at any time during such taxable year the taxpayer's ownership percentage (determined in accordance with paragraph (j)(3) of this section) in a passthrough entity that directly owns such undertaking exceeds ten percent. (ii) Coordination rule. A taxpayer shall be treated for purposes of this paragraph (f) as owning a substantial indirect interest in each of two or more undertakings for any taxable year in which- (A) Such undertakings are treated as part of the same activity of the taxpayer under paragraph (f)(2)(i) of this section; and (B) The taxpayer owns a substantial indirect interest (within the meaning of paragraph (f)(3)(i) of this section) in any such undertaking. (4) Similar undertakings-(i) In general. Except as provided in paragraph (f)(4)(iii) of this section, two undertakings are similar for purposes of this paragraph (f) if and only if- (A) There are predominant operations in each such undertaking; and (B) The predominant operations of both undertakings are in the same line of business. (ii) Predominant operations. For purposes of paragraph (f)(4)(i)(A) of this section, there are predominant operations in an undertaking if more than 50 percent of the undertaking's gross income is attributable to operations in a single line of business. (iii) Vertically-integrated undertakings. If an undertaking (the "supplier undertaking") provides property or services to other undertakings (the "recipient undertakings"), the following rules apply for purposes of this paragraph (f): (A) Supplier undertaking similar to recipient undertaking. If the supplier undertaking predominantly involves the provision of property and services to a recipient undertaking that is controlled by the same interests (within the meaning of paragraph (j) of this section), the supplier undertaking shall be treated as similar to the recipient undertaking. For purposes of applying the preceding sentence- (1) If a supplier undertaking and two or more recipient undertakings that are similar (within the meaning of paragraph (f)(4)(i) of this section) are controlled by the same interests, such recipient undertakings shall be treated as a single undertaking; and (2) A supplier undertaking predominantly involves the provision of property and services to a recipient undertaking for any taxable year in which such recipient undertaking obtains more than 50 percent (by value) of all property and services provided by the supplier undertaking. (B) Recipient undertaking similar to supplier undertaking. If the supplier undertaking is the predominant provider of property and services to a recipient undertaking that is controlled by the same interests (within the meaning of paragraph (j) of this

section), the recipient undertaking shall be treated, except as otherwise provided in paragraph (f)(4)(iii)(C) of this section, as similar to the supplier undertaking. For purposes of the preceding sentence, a supplier undertaking is the predominant provider of property and services to a recipient undertaking for any taxable year in which the supplier undertaking provides more than 50 percent (by value) of all property and services obtained by the recipient undertaking. (C) Coordination rules. (1) Paragraph (f)(4)(iii)(B) of this section does not apply if, under paragraph (f)(4)(iii)(A) of this section- (i) The supplier undertaking is treated as an undertaking that is similar to any recipient undertaking; (ii) The recipient undertaking is treated as a supplier undertaking that is similar to another recipient undertaking; or (iii) Another supplier undertaking is treated as an undertaking that is similar to the recipient undertaking. (2) If paragraph (f)(4)(iii)(A) of this section applies to a supplier undertaking, the supplier undertaking shall be treated as similar to undertakings that are similar to the recipient undertaking and shall not otherwise be treated as similar to undertakings to which the supplier undertaking would be similar without regard to paragraph (f)(4)(iii) of this section. (3) If paragraph (f)(4)(iii)(B) of this section applies to a recipient undertaking, the recipient undertaking shall be treated as similar to undertakings that are similar to the supplier undertaking and shall not otherwise be treated as similar to undertakings to which the recipient undertaking would be similar without regard to paragraph (f)(4)(iii) of this section. (iv) Lines of business. The Commissioner shall establish, by revenue procedure, lines of business for purposes of this paragraph (f)(4). Business and rental operations that are not included in the lines of business established by the Commissioner shall nonetheless be included in a line of business for purposes of this paragraph (f)(4). Such operations shall be included in a single line of business or in multiple lines of business on a basis that reasonably reflects- (A) Similarities and differences in the property or services provided pursuant to such operations and in the markets to which such property or services are offered; and (B) The treatment within the lines of business established by the Commissioner of operations that are comparable in their similarities and differences. (5) Examples. The following examples illustrate the application of this paragraph (f). In each example that does not state otherwise, the taxpayer is an individual and the facts, analysis, and conclusions relate to a single taxable year. Example (1). (i) The taxpayer is a partner in partnerships A, B, C, and D and owns a five-percent interest in each partnership. Each partnership owns a single undertaking (undertakings A, B, C, and D), and the undertakings are trade or business

undertakings (within the meaning of paragraph (f)(1)(ii) of this section) that are controlled by the same interests (within the meaning of paragraph (j) of this section). In addition, undertakings A, B, and D are similar (within the meaning of paragraph (f)(4) of this section). The taxpayer is not related to any of the other partners, and does not participate in any of the undertakings. (ii) In general, each undertaking in which a taxpayer owns an interest is treated as a single activity that is separate from other activities of the taxpayer (see paragraph (b)(1) of this section). This paragraph (f) provides aggregation rules for trade or business undertakings that are similar and controlled by the same interests. These aggregation rules do not apply, however, unless the taxpayer owns interests in the undertakings through the same passthrough entity, owns direct or substantial indirect interests in the undertakings, or materially or significantly participates in the undertakings. In this case, the taxpayer does not satisfy any of these conditions, and the aggregation rules in this paragraph (f) do not apply. Accordingly, except as otherwise provided in paragraph (g) of this section (relating to an aggregation rule for integrated businesses), undertakings A, B, C, and D are treated as separate activities of the taxpayer under paragraph (b)(1) of this section. Example (2). (i) The facts are the same as in example (1), except that the taxpayer owns a 25-percent interest in partnership A, a 15-percent interest in partnership B, and a 40-percent interest in partnership C. (ii) Paragraph (f)(2)(ii) of this section provides that trade or business undertakings that are similar and controlled by the same interests are treated as part of the same activity of the taxpayer if the taxpayer owns a direct or substantial indirect interest in each such undertaking. In this case, the taxpayer owns more than ten percent of partnerships A, B, and C, and these partnerships directly own undertakings A, B, and C. Thus, the taxpayer owns a substantial indirect interest in undertakings A, B, and C (see paragraph (f)(3)(i) of this section). Of these undertakings, only undertakings A and B are both similar and controlled by the same interests. Accordingly, the taxpayer's interests in undertakings A and B are treated as part of the same activity. As in example (1), the aggregation rules in this paragraph (f) do not apply to undertakings C and D, and except as otherwise provided in paragraph (g) of this section, undertakings C and D are treated as separate activities. Example (3). (i) The facts are the same as in example (1), except that the taxpayer participates (within the meaning of §1.469-5T(f)) for 60 hours in undertaking A and for 60 hours in undertaking B. (ii) Paragraph (f)(2)(iii) of this section provides that trade or business undertakings that are similar and controlled by the same interests are treated as part of the same activity of the taxpayer if the taxpayer materially or significantly participates (within the meaning of §1.469-5T) in the activity that would result from the treatment of similar, commonly-controlled undertakings as part of the same activity. In this case, the activity that would result from treating the similar, commonly-controlled undertakings as part of the same activity consists of undertakings A, B, and D, and the taxpayer participates for 120 hours in the activity that results from this treatment. Accordingly, undertakings A, B, and D are treated as part of the same activity because the taxpayer significantly participates (within the meaning of §1.469-5T(c)(2)) in the activity that results from this treatment. The result is the same whether the taxpayer participates in one, two, or all three of the similar,

commonly-controlled undertakings, so long as the taxpayer's aggregate participation in undertakings A, B, and D exceeds 100 hours. As in example (1), the aggregation rules in this paragraph (f) do not apply to undertaking C, and except as otherwise provided in paragraph (g) of this section, undertaking C is treated as a separate activity. Example (4). (i) The taxpayer owns a 5-percent interest in partnership A. Partnership A owns interests in partnerships B and C, each of which owns a single undertaking (undertakings B and C). In addition, the taxpayer is a partner in partnerships C and D and directly owns a 15-percent interest in each partnership. Partnership D also owns a single undertaking (undertaking D). Undertakings B, C, and D are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section) that are similar (within the meaning of paragraph (f)(4) of this section) and controlled by the same interests (within the meaning of paragraph (j) of this section). The taxpayer does not participate in undertaking B, C, or D. (ii) Paragraph (f)(2)(i) of this section provides that trade or business undertakings that are similar and controlled by the same interests are treated as part of the same activity of the taxpayer if the taxpayer owns interests in the undertakings through the same passthrough entity. In this case, the taxpayer owns interests in undertakings B and C through partnership A. Thus, the taxpayer's interests in undertakings B and C are treated as part of the same activity. (iii) Paragraph (f)(2)(ii) of this section provides that trade or business undertakings that are similar and controlled by the same interests are treated as part of the same activity of the taxpayer if the taxpayer owns a direct or substantial indirect interest in each such undertaking. In this case, the taxpayer owns more than ten percent of partnerships C and D, and these partnerships directly own undertakings C and D. Thus, the taxpayer owns a substantial indirect interest in undertakings C and D (see paragraph (f)(3)(i) of this section). (iv) The coordination rule in paragraph (f)(3)(ii) of this section applies to undertakings B and C because they are treated as part of the same activity under paragraph (f)(2)(i) of this section, and the taxpayer owns a substantial indirect interest in undertaking C. Under the coordination rule, the taxpayer is treated as owning a substantial indirect interest in undertaking B as well as undertaking C. Accordingly, the taxpayer's interests in undertakings B, C, and D are treated as part of the same activity. Example (5). (i) Undertakings A, B, C, and D are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section), each of which involves the operation of a department store, restaurants, and movie theaters. The following table shows, for each undertaking, the percentages of gross income attributable to the various operations of the undertaking. ----------------------------------------------- ------------------------------ Department store Restaurants Movie Theaters ------------ ----------------------------------------------------------------- Undertaking A ........................ 70% 20% 10% Undertaking B ........................ 60% 20% 20% Undertaking C ........................ 35% 35% 30% Undertaking D ........................ 35% 10% 55% ----------------------------------------------------------------------------- (ii) Paragraph (f)(4)(i) of this section provides that two undertakings are similar for purposes of this paragraph (f) if and only if there are predominant operations in each

undertaking and the predominant operations of the two undertakings are in the same line of business. (Assume that the applicable revenue procedure provides that "general merchandise stores," "eating and drinking places," and "motion picture services" are three separate lines of business.) (iii) Undertaking A and undertaking B each derives more than 50 percent of its gross income from department-store operations, which are in the general-merchandise-store line of business. Thus, there are predominant operations in undertaking A and undertaking B, and the predominant operations of the two undertakings are in the same line of business. Accordingly, undertakings A and B are similar. (iv) Undertaking C does not derive more than 50 percent of its gross income from operations in any single line of business. Thus, there are no predominant operations in undertaking C, and undertaking C is not similar to any of the other undertakings. (v) Undertaking D derives more than 50 percent of its gross income from movie-theater operations, which are in the motion-picture-services line of business. Thus, there are predominant operations in undertaking D. The predominant operations of undertaking D, however, are not in the same line of business as those of undertakings A and B. Accordingly, undertaking D is not similar to undertakings A and B. Example (6). (i) Undertakings A and B are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section) that derive all of their gross income from the sale of automobiles. Undertakings C and D derive all of their gross income from the rental of automobiles. Undertaking C is not a rental undertaking (within the meaning of paragraph (d)(1)(iii) of this section) because the average period of customer use (within the meaning of §1.469-1T(e)(3)(iii)) for its automobiles does not exceed seven days (see §1.469-1T(e)(3)(ii)(A)). Undertaking D, on the other hand, leases automobiles for periods of one year or more and is a rental undertaking. (ii) Paragraph (f)(4)(i) of this section provides that two undertakings are similar for purposes of this paragraph (f) if and only if there are predominant operations in each undertaking and the predominant operations of the two undertakings are in the same line of business. (Assume that the applicable revenue procedure provides that (a) "automotive dealers and service stations" (automotive retail) and (b) "auto repair, services (including rentals), and parking" (automotive services) are two separate lines of business.) (iii) Undertakings A and B both derive more than 50 percent of their gross income from operations in the automotive-retail line of business (the automobile-sales operations). Similarly, undertakings C and D both derive more than 50 percent of their gross income from operations in the automotive-services line of business (the automobile-rental operations). Thus, there are predominant operations in each undertaking, the predominant operations of undertakings A and B are in the same line of business, and the predominant operations of undertakings C and D are in the same line of business. Accordingly, undertakings A and B are similar, undertakings C and D are similar, and undertakings A and B are not similar to undertakings C and D. (iv) Paragraph (f)(1) of this section provides that this paragraph (f) applies only to trade or business undertakings and that a rental undertaking is not a trade or

business undertaking. Accordingly, this paragraph (f) does not apply to undertaking D, and undertakings C and D, although similar, are not treated, under this paragraph (f), as part of the same activity. Example (7). (i) Undertakings A, B, and C are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section) that involve real estate operations. Undertaking A derives all of its gross income from the development of real property, undertaking B derives all of its gross income from the management of real property and the performance of services as a leasing agent with respect to real property, and undertaking C derives all of its gross income from buying, selling, or arranging purchases and sales of real property. Undertaking D derives all of its gross income from the rental of residential apartments and is a rental undertaking (within the meaning of paragraph (d)(1)(iii) of this section). (ii) Paragraph (f)(4)(i) of this section provides that two undertakings are similar for purposes of this paragraph (f) if there are predominant operations in each undertaking and the predominant operations of the two undertakings are in the same line of business. (Assume that the applicable revenue procedure provides that real estate development and services (including the development and management of real property, dealing in real property, and the performance of services as a leasing agent with respect to real property) is a single line of business (the "real-estate" line of business).) (iii) Undertakings A, B, and C all derive more than 50 percent of their gross income from operations in the real-estate line of business. Thus, there are predominant operations in undertakings A, B, and C, and the predominant operations of the three undertakings are in the same line of business. Accordingly, undertakings A, B, and C are similar. (iv) Undertaking D also derives more than 50 percent of its gross income from operations in the real-estate line of business. Thus, there are predominant operations in undertaking D, and the predominant operations of undertaking D are in the same line of business as those of undertakings A, B, and C. Paragraph (f)(1) of this section provides, however, that this paragraph (f) applies only to trade or business undertakings and that a rental undertaking is not a trade or business undertaking. Accordingly, this paragraph (f) does not apply to undertaking D, and undertaking D, although similar to undertakings A, B, and C, is not treated, under this paragraph (f), as part an activity that includes undertaking A, B, or C. Example (8). (i) Undertakings A and B are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section), both of which involve the provision of moving services. Undertaking A derives its gross income principally from local moves, and undertaking B derives its gross income principally from long-distance moves. (ii) Paragraph (f)(4)(i) of this section provides that two undertakings are similar for purposes of this paragraph (f) if there are predominant operations in each undertaking and the predominant operations of the two undertakings are in the same line of business. Under paragraph (f)(4)(iv) of this section, operations that are not in the lines of business established by the applicable revenue procedure are nonetheless included in a line of business. In addition, such operations are included in a single line of business or in multiple lines of business on a basis that reasonably

reflects (a) similarities and differences in the property or services provided pursuant to such operations and in the markets to which such property or services are offered, and (b) the treatment within the lines of business established by the Commissioner of operations that are comparable in their similarities and differences. (Assume that the provision of moving services is not in any line of business established by the Commissioner and that within the lines of business established by the Commissioner services that differ only in the distance over which they are performed (e.g., local and long-distance telephone services) are generally treated as part of the same line of business.) (iii) Undertakings A and B provide the same types of services to similar customers, and the only significant difference in the services provided is the distance over which they are performed. Thus, treating local and long-distance moving services as a single line of business (the "moving-services" line of business) reasonably reflects the treatment within the lines of business established by the Commissioner of operations that are comparable in their similarities and differences. (iv) Each undertaking derives more than 50 percent of its gross income from operations in the moving-services line of business. Thus, there are predominant operations in each undertaking, and the predominant operations of the two undertakings are in the same line of business. Accordingly, undertakings A and B are similar. Example (9). (i) Undertakings A, B, C, D, and E are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section) and are controlled by the same interests (within the meaning of paragraph (j) of this section). Undertakings A, B, and C derive all of their gross income from retail sales of dairy products, and undertakings D and E derive all of their gross income from the processing of dairy products. Undertakings D and E sell less than ten percent of their dairy products to undertakings A, B, and C, and sell the remainder to unrelated undertakings. Undertakings A, B, and C purchase less than ten percent of their inventory from undertakings D and E and purchase the remainder from unrelated undertakings. (ii) Paragraph (f)(4)(i) of this section provides that, except as provided in paragraph (f)(4)(iii) of this section, undertakings are similar for purposes of this paragraph (f) if and only if there are predominant operations in each undertaking and the predominant operations of the undertakings are in the same line of business. (Assume that the applicable revenue procedure provides that (a) "food stores" and (b) "manufacturing-food and kindred products" are two separate lines of business.) (iii) Undertakings A, B, and C all derive more than 50 percent of their gross income from operations in the food-store line of business (the dairy-sales operations). Thus, there are predominant operations in undertakings A, B, and C, and the predominant operations of the three undertakings are in the same line of business. Accordingly, undertakings A, B, and C are similar. (iv) Undertakings D and E both derive more than 50 percent of their gross income from operations in the food-manufacturing line of business (the dairy-processing operations). Thus, there are predominant operations in undertakings D and E, and the predominant operations of the two undertakings are in the same line of business. Accordingly, undertakings D and E are similar. The predominant operations of undertakings D and E are not in the same line of business as those of undertakings

A, B, and C. Accordingly, undertakings D and E are not similar to undertakings A, B, and C. (v) Paragraph (f)(4)(iii) of this section provides rules under which certain undertakings whose operations are not in the same line of business nevertheless are similar to one another if one of the undertakings (the "supplier undertaking") provides property or services to the other undertaking (the "recipient undertaking"), and the undertakings are controlled by the same interests. These rules apply, however, only if the supplier undertaking predominantly involves the provision of property and services to the recipient undertaking (see paragraph (f)(4)(iii)(A) of this section), or the supplier undertaking is the predominant provider of property and services to the recipient undertaking (see paragraph (f)(4)(iii)(B) of this section). In this case, undertakings D and E are supplier undertakings, and undertakings A, B, and C are recipient undertakings. Undertakings D and E, however, sell less than ten percent of their dairy products to undertakings A, B, and C and thus do not predominantly involve the provision of property and services to recipient undertakings. Similarly, undertakings D and E are not the predominant providers of property and services to undertakings A, B, and C. Thus, the rules for vertically-integrated undertakings in paragraph (f)(4)(iii) of this section do not apply in this case. Example (10). (i) The facts are the same as in example (9), except that undertaking D sells 75 percent of its dairy products to undertakings A, B, and C. (ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier undertaking predominantly involves the provision of property to a recipient undertaking that is controlled by the same interests. Paragraph (f)(4)(iii)(A)(2) of this section provides that a supplier undertaking predominantly involves the provision of property to a recipient undertaking if the supplier undertaking provides more than 50 percent of its property to such recipient undertaking. In addition, paragraph (f)(4)(iii)(A)(1) of this section provides that if a supplier undertaking and two or more similar recipient undertakings are controlled by the same interests, the recipient undertakings are treated as a single undertaking for purposes of applying paragraph (f)(4)(iii)(A) of this section. Undertakings D and E both provide dairy products to undertakings A, B, and C. Thus, for purposes of paragraph (f)(4)(iii) of this section, undertakings D and E are supplier undertakings and undertakings A, B, and C are recipient undertakings. Undertaking D predominantly involves the provision of property to undertakings A, B, and C. Moreover, undertakings A, B, and C are treated as a single undertaking under paragraph (f)(4)(iii)(A)(1) of this section because undertakings A, B, and C are similar to one another under paragraph (f)(4)(i) of this section, and undertakings A, B, C, and D are controlled by the same interests. Accordingly, paragraph (f)(4)(iii)(A) of this section applies to undertakings A, B, C, and D. (iii) If paragraph (f)(4)(iii)(A) of this section applies to supplier and recipient undertakings, the supplier undertaking is treated under paragraph (f)(4)(iii) (A) and (C)(2) of this section as an undertaking that is similar to the recipient undertakings and to undertakings to which the recipient undertakings are similar. Accordingly, undertaking D is similar, for purposes of this paragraph (f), to undertakings A, B, and C. (iv) Undertaking E does not predominantly involve the provision of property to undertakings A, B, and C, or to any other related undertakings. Thus, paragraph

(f)(4)(iii)(A) of this section does not apply to undertaking E, and undertaking E is not similar to undertakings A, B, and C. Moreover, undertakings D and E are not similar because, under paragraph (f)(4)(iii)(C)(2) of this section, undertaking D is not similar to any undertaking that is not similar to undertakings A, B, and C. Example (11). (i) The facts are the same as in example (10), except that 75 percent of undertaking D's dairy products are sold to undertakings A and B, and none are sold to undertaking C. (ii) In this case, undertaking D is a supplier undertaking only with respect to undertakings A and B. Accordingly, paragraph (f)(4)(iii)(A) applies only to undertakings A, B, and D. As in example (10), undertaking D is similar to undertakings A and B, and is not similar to undertaking E. In addition, if paragraph (f)(4)(iii)(A) of this section applies to supplier and recipient undertakings, the supplier undertaking is treated under paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that is similar to the recipient undertakings and undertakings to which the recipient undertakings are similar. Accordingly, even though undertaking D does not provide any property or services to undertaking C, undertaking D is similar to undertaking C because undertaking C is similar to undertakings A and B. Example (12). (i) The facts are the same as in example (9), except that undertakings A and B purchase 80 percent of their inventory from undertaking D. (ii) Paragraph (f)(4)(iii)(B) of this section applies, except as provided in paragraph (f)(4)(iii)(C) of this section, if a supplier undertaking is the predominant provider of property to a recipient undertaking that is controlled by the same interests. Undertakings D and E both provide dairy products to undertakings A, B, and C. Thus, for purposes of paragraph (f)(4)(iii) of this section, undertakings D and E are supplier undertakings, and undertakings A, B, and C are recipient undertakings. In addition, undertaking D is the predominant provider of property and services to undertakings A and B, and undertakings A, B and D are controlled by the same interests. Thus, except as provided in paragraph (f)(4)(iii)(C) of this section, paragraph (f)(4)(iii)(B) of this section applies to undertakings A, B, and D. (iii) The coordination rules in paragraph (f)(4)(iii)(C)(1) of this section provide that paragraph (f)(4)(iii)(B) of this section does not apply in certain cases to which paragraph (f)(4)(iii)(A) of this section applies. These coordination rules would apply if undertaking D or E (or any other undertaking that is controlled by the interests that control undertakings A, B, and C) predominantly involved the provision of property and services to undertakings A, B, and C. The coordination rules in paragraph (f)(4)(iii)(C)(1) of this section would also apply if undertaking A, B, or D predominantly involved the provision of property or services to a recipient undertaking that is controlled by the same interests. Assume that these coordination rules do not apply in this case. (iv) If paragraph (f)(4)(iii)(B) of this section applies to supplier and recipient undertakings, the recipient undertakings are treated under paragraph (f)(4)(iii) (B) and (C)(3) of this section as undertakings that are similar to the supplier undertaking and to undertakings to which the supplier undertaking is similar. Accordingly, undertakings A and B are similar, for purposes of this paragraph (f), to undertaking D and, because undertakings D and E are similar, to undertaking E.

(v) The principal providers of property and services to undertaking C are unrelated undertakings. Thus, paragraph (f)(4)(iii)(B) of this section does not apply to undertaking C, and undertaking C is not similar to undertakings D and E. Moreover, undertaking C is not similar to undertakings A and B because, under paragraph (f)(4)(iii)(C)(3) of this section, undertakings A and B are not similar to any undertaking that is not similar to undertaking D. Example (13). (i) Undertakings A through Z are trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section) and are controlled by the same interests (within the meaning of paragraph (j) of this section). Undertaking A derives all of its gross income from the manufacture and sale of men's and women's clothing, undertaking B derives all of its gross income from sales of men's and women's clothing to retail stores, and undertakings C through Z derive all of their gross income from retail sales of men's and women's clothing. Undertaking A sells clothing exclusively to undertaking B. Undertaking B sells 75 percent of its clothing to undertakings C through Z, and sells the remainder to unrelated retail stores. Undertaking B purchases 80 percent of its inventory from undertaking A, and undertakings C through Z purchase 60 to 90 percent of their inventory from undertaking B. (ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier undertaking predominantly involves the provision of property to a recipient undertaking that is controlled by the same interests. In addition, paragraph (f)(4)(iii)(A)(1) of this section provides that if a supplier undertaking and two or more similar recipient undertakings are controlled by the same interests, the recipient undertaking are treated as a single undertaking for this purpose. Undertaking B provides men's and women's clothing to undertaking C through Z. Thus, for purposes of paragraph (f)(4)(iii) of this section, undertaking B is a supplier undertaking and undertakings C through Z are recipient undertakings. In addition, undertaking B predominantly involves the provision of property to undertakings C through Z, and undertakings C through Z are treated as a single undertaking for purposes of paragraph (f)(4)(iii)(A) of this section. Accordingly, paragraph (f)(4)(iii)(A) of this section applies to undertakings B and C through Z. (iii) If paragraph (f)(4)(iii)(A) of this section applies to supplier and recipient undertakings, the supplier undertaking is treated under paragraph (f)(4)(iii)(A) of this section as an undertaking that is similar to the recipient undertakings. Accordingly, undertaking B is similar, for purposes of this paragraph (f), to undertakings C through Z. (iv) Undertaking A provides men's and women's clothing to undertaking B. Thus, for purposes of paragraph (f)(4)(iii) of this section, undertaking A is a supplier undertaking and undertaking B is a recipient undertaking. In addition, undertaking A predominantly involves the provision of property to undertaking B, and undertakings A and B are controlled by the same interests. Accordingly, paragraph (f)(4)(iii)(A) of this section applies to undertakings A and B, and undertaking A is similar to undertaking B. (v) If paragraph (f)(4)(iii)(A) of this section applies to supplier and recipient undertakings, the supplier undertaking is treated under paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that is similar to undertakings to which the recipient

undertakings are similar. Accordingly, undertaking A is also similar, for purposes of this paragraph (f), to undertakings C through Z. (vi) The coordination rule in paragraph (f)(4)(iii)(C)(1)(i) of this section provides that paragraph (f)(4)(iii)(B) of this section does not apply if, as described above, the supplier undertaking predominantly involves the provision of property to recipient undertakings and is treated under paragraph (f)(4)(iii)(A) of this section as an undertaking that is similar to such recipient undertakings. Accordingly, paragraph (f)(4)(iii)(B) of this section does not apply to undertakings B through Z, even though undertaking B is the predominant provider of property and services to undertakings C through Z, and undertakings B through Z are controlled by the same interests. For the same reason, paragraph (f)(4)(iii)(B) of this section does not apply to undertaking A and B. (Paragraph (f)(4)(iii)(B) of this section is also inapplicable to undertakings A and B because the coordination rule in paragraph (f)(4)(iii)(C)(1)(ii) of this section applies if the recipient undertaking (undertaking B) is itself a supplier undertaking that is treated under paragraph (f)(4)(iii)(A) of this section as an undertaking that is similar to its recipient undertakings (undertakings C through Z).) (g) Integrated businesses-(1) Applicability-(i) In general. This paragraph (g) applies to a taxpayer's interests in trade or business activities (within the meaning of paragraph (g)(1)(ii) of this section). (ii) Trade or business activity. For purposes of this paragraph (g), the term "trade or business activity" means any activity (determined without regard to this paragraph (g)) that consists of interests in one or more trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section). (2) Treatment as a single activity. A taxpayer's interests in two or more trade or business activities shall be treated as a single activity if and only if- (i) The operations of such trade or business activities constitute a single integrated business, activities constitute a single integrated business; and (ii) Such activities are controlled by the same interests (within the meaning of paragraph (j) of this section). (3) Facts and circumstances test. In determining whether the operations of two or more trade or business activities constitute a single integrated business for purposes of this paragraph (g), all the facts and circumstances are taken into account, and the following factors are generally the most significant: (i) Whether such operations are conducted at the same location; (ii) The extent to which other persons conduct similar operations at one location; (iii) Whether such operations are treated as a unit in the primary accounting records reflecting the results of such operations; (iv) The extent to which other persons treat similar operations as a unit in the primary accounting records reflecting the results of such similar operations;

(v) Whether such operations are owned by the same person (within the meaning of paragraph (c)(2)(v) of this section); (vi) The extent to which such operations involve products or services that are commonly provided together; (vii) The extent to which such operations serve the same customers; (viii) The extent to which the same personnel, facilities, or equipment are used to conduct such operations; (ix) The extent to which such operations are conducted in coordination with or reliance upon each other; (x) The extent to which the conduct of any such operations is incidental to the conduct of the remainder of such operations; (xi) The extent to which such operations depend on each other for their economic success; and (xii) Whether such operations are conducted under the same trade name. (4) Examples. The following examples illustrate the application of this paragraph (g). The facts, analysis, and conclusion in each example relate to a single taxable year, and the trade or business activities described in each example are controlled by the same interests (within the meaning of paragraph (j) of this section). Example (1). (i) The taxpayer owns a number of department stores and auto-supply stores. Some of the taxpayer's department stores include auto-supply departments. In other cases, the taxpayer operates a department store and an auto-supply store at the same location (within the meaning of paragraph (c)(2)(iii) of this section), or at different locations from which the same group of customers can be served. In cases in which a department store and an auto-supply store are operated at the same location, the department-store operations are the predominant operations (within the meaning of paragraph (f)(4)(ii) of this section), and the undertaking that includes the stores is treated as a department-store undertaking for purposes of paragraph (f) of this section. Under paragraph (f) of this section, the department-store undertakings are all treated as part of the same activity of the taxpayer (the "department-store activity"). Similarly, the auto-supply undertakings (i.e., the auto-supply stores that are not operated at a department-store location) are all treated as part of the same activity (the "auto-supply activity"). (Assume that department-store undertakings and auto-supply undertakings are not similar and are not treated as part of the same activity under paragraph (f) of this section.) (ii) The department stores and auto-supply stores use a common trade name and coordinate their marketing activities (e.g., the stores advertise in the same catalog and the same newspaper supplements, honor the same credit cards (including credit cards issued by the department stores), and jointly conduct sales and other promotional activities). Although sales personnel generally work only in a particular store or in a particular department within a store, other employees (e.g., cashiers, janitorial and maintenance workers, and clerical staff) may work in or perform

services for various stores, including both department and auto-supply stores. In addition, the management of store operations is organized on a geographical basis, and managers above the level of the individual store generally supervise operations in both types of store. A central office provides payroll, financial, and other support services to all stores and establishes pricing and other business policies. Most inventory for both types of stores is acquired through a central purchasing department and inventory for all stores in an area is stored in a common warehouse. (iii) Based on the foregoing facts and circumstances, the operations of the department-store activity and the auto-supply activity constitute an integrated business. Paragraph (g)(3) of this section provides that the factors relevant to this determination include the conduct of department-store and auto-supply operations at the same location, the location of department and auto-supply stores at sites where the same group of customers can be served, the treatment of all such operations as a unit in the taxpayer's financial statements, the taxpayer's ownership and the common management of all such operations, the use of the same personnel, facilities, and equipment to conduct and support the operations, the use of a common trade name, and the coordination (as evidenced by the coordinated marketing activities) of department-store and auto-supply operations. (iv) Paragraph (g)(2) of this section provides that a taxpayer's interests in two or more trade or business activities (within the meaning of paragraph (g)(1)(ii) of this section) are treated as a single activity of the taxpayer if the operations of such activities constitute an integrated business and the activities are controlled by the same interests. The department-store activity and the auto-supply activity consist of trade or business undertakings and, thus, are trade or business activities. In addition, the activities are controlled by the same interests (the taxpayer), and the operations of the activities constitute an integrated business. Accordingly, the department-store activity and the auto-supply activity are treated as a single activity of the taxpayer. Example (2). (i) The taxpayer owns a number of stores that sell stereo equipment and a repair shop that services stereo equipment. Under paragraph (f) of this section, the stores are all treated as part of the same activity of the taxpayer (the "store activity"). The repair shop does not sell stereo equipment, does not predominantly involve the provision of services to the taxpayer's stores, and is treated as a separate activity (the "repair-shop activity"). (Assume that stereo-sales undertakings and stereo-repair undertakings are not similar and are not treated as part of the same activity under paragraph (f) of this section.) (ii) The stores sell stereo equipment produced by manufacturers for which the stores are an authorized distributor. The repair shop's operations principally involve the servicing of stereo equipment produced by the same manufacturers. These operations include repairs on equipment under warranty for which reimbursement is received from the manufacturer and reconditioning of equipment taken as trade-ins by the taxpayer's stores. The majority of the operations, however, involve repairs that are performed for customers and are not covered by a warranty. The taxpayer's distribution agreements with manufacturers generally require the taxpayer to repair and service equipment produced by the manufacturer both during and after the warranty period. In some cases, the distribution agreements require that the taxpayer's repair facility meet the manufacturer's standards and provide for periodic inspections to ensure that these standards are met.

(iii) The stores and the repair shop use a common trade name. Sales personnel generally work only in a particular store and stereo technicians work only in the repair shop. The stores and the repair shop are, however, managed from a central office, which supervises both store and repair-shop operations, provides payroll, financial, and other support services to the stores and the repair shop, and establishes pricing and other business policies. In addition, inventory for the stores and supplies for the repair shop are acquired through a central purchasing department and are stored in a single warehouse. (iv) Based on the foregoing facts and circumstances, the operations of the store activity and the repair-shop activity constitute an integrated business. Paragraph (g)(3) of this section provides that the factors relevant to this determination include the treatment of all such operations as a unit in the taxpayer's financial statements, the taxpayer's ownership and the common management of all such operations, the use of the same personnel and facilities to support the operations, the use of a common trade name, the extent to which the same customers patronize both the stores and the repair shop, the similarity of the products (i.e., stereo equipment) involved in both store and repair-shop operations, and the extent to which the provision of repair services contributes to the taxpayer's ability to obtain the stereo equipment sold in store operations. (v) Paragraph (g)(2) of this section provides that a taxpayer's interests in two or more trade or business activities (within the meaning of paragraph (g)(1)(ii) of this section) are treated as a single activity of the taxpayer if the operations of such activities constitute an integrated business and the activities are controlled by the same interests. The store activity and repair-shop activity consist of trade or business undertakings and thus are trade or business activities. In addition, the activities are controlled by the same interests (the taxpayer), and the operations of the activities constitute an integrated business. Accordingly, the store activity and the repair-shop activity are treated as a single activity of the taxpayer. Example (3). (i) The taxpayer owns interests in three partnerships. One partnership owns a television station, the second owns a professional sports franchise, and the third owns a motion-picture production company. The operations of the partnerships are treated as three separate undertakings. Although other persons own interests in the partnerships, all three undertakings are controlled (within the meaning of paragraph (j) of this section) by the taxpayer. The operations of the partnerships are treated as three separate activities (the "television activity," the "sports activity," and the "motion-picture activity"). (Assume that the undertakings are not similar and are not treated as part of the same activity under paragraph (f) of this section.) (ii) Each partnership prepares financial statements that reflect only the results of that partnership's operations, and each of the activities is conducted under its own trade name. The taxpayer participates extensively in the management of each partnership and makes the major business decisions for all three partnerships. Each partnership, however, employs separate management and other personnel who conduct its operations on a day-to-day basis. The taxpayer generally arranges the partnerships' financing and often obtains loans for two, or all three, partnerships from the same source. Although the assets of one partnership are not used as security for loans to another partnership, the taxpayer's interest in a partnership may secure loans to the other partnerships. The television station broadcasts the sports franchise's games, and the motion-picture production company occasionally

prepares programming for the television station. In addition, support staff of one partnership may, during periods of peak activity or in the case of emergency, be made available to another partnership on a temporary basis. There are no other significant transactions between the partnerships. Moreover, all transactions between the partnerships involve essentially the same terms as would be provided in transactions between unrelated persons. (iii) Based on the foregoing facts and circumstances, the television activity, the sports activity, and the motion-picture activity constitute three separate businesses. Paragraph (g)(3) of this section provides that the factors relevant to this determination include the treatment of the activities as separate units in the partnerships' financial statements, the use of a different trade name for each activity, the separate day-to-day management of the activities, and the limited extent to which the activities contribute to or depend on each other (as evidenced by the small number of significant transactions between the partnerships and the arm's length nature of those transactions). The taxpayer's participation in management and financing are taken into account in this determination, as are the transactions between the partnerships, but these factors do not of themselves support a determination that the activities constitute an integrated business. (iv) Paragraph (g)(2) of this section provides that a taxpayer's interests in two or more trade or business activities (within the meaning of paragraph (g)(1)(ii) of this section) are treated as a single activity of the taxpayer only if the operations of such activities constitute an integrated business and the activities are controlled by the same interests. In this case, the taxpayer's activities do not constitute an integrated business, and the aggregation rule in paragraph (g)(2) of this section does not apply. Accordingly, the television activity, the sports activity, and the motion-picture activity are treated as three separate activities of the taxpayer. (h) Certain professional service undertakings treated as a single activity-(1) Applicability-(i) In general. This paragraph (h) applies to a taxpayer's interests in professional service undertakings (within the meaning of paragraph (h)(1)(ii) of this section). (ii) Professional service undertaking. For purposes of this paragraph (h), an undertaking is treated as a professional service undertaking for any taxable year in which the undertaking derives more than 50 percent of its gross income from the provision of services that are treated, for purposes of section 448 (d)(2)(A) and the regulations thereunder, as services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. (2) Treatment as a single activity-(i) Undertakings controlled by the same interest. A taxpayer's interests in two or more professional service undertakings that are controlled by the same interests (within the meaning of paragraph (j) of this section) shall be treated as part of the same activity of the taxpayer. (ii) Undertakings involving significant similar or significant related services. A taxpayer's interests in two or more professional service undertakings that involve the provision of significant similar services or significant related services shall be treated as part of the same activity of the taxpayer.

(iii) Coordination rule. (A) Except as provided in paragraph (h)(2)(iii)(B) of this section, a taxpayer's interests in two or more undertakings (the "original undertakings") that are treated as part of the same activity of the taxpayer under the provisions of paragraph (h)(2) (i) or (ii) of this section shall be treated as interests in a single professional service undertaking (the "aggregated undertaking") for purposes of reapplying such provisions. (B) If any original undertaking included in an aggregated undertaking and any other undertaking that is not included in such aggregated undertaking involve the provision of significant similar or related services, the aggregated undertaking and such other undertaking shall be treated as undertakings that involve the provision of significant similar or related services for purposes of reapplying the provisions of paragraph (h)(2)(ii) of this section. (3) Significant similar or significant related services. For purposes of this paragraph (h)- (i) Services (other than consulting services) in any field described in paragraph (h)(1)(ii) of this section are similar to all other services in the same field; (ii) All the facts and circumstances are taken into account in determining whether consulting services are similar; (iii) Two professional service undertakings involve the provision of significant similar services if and only if- (A) Each such undertaking provides significant professional services; and (B) Significant professional services provided by one such undertaking are similar to significant professional services provided by the other such undertaking; (iv) Services are significant professional services if and only if such services are in a field described in paragraph (h)(1)(ii) of this section and more than 20 percent of the undertaking's gross income is attributable to services in such field (or, in the case of consulting services, to similar services in such field); and (v) Two professional service undertakings involve the provision of significant related services if and only if more than 20 percent of the gross income of one such undertaking is derived from customers that are also customers of the other such undertaking. (4) Examples. The following examples illustrate the application of this paragraph (h). In each example that does not state otherwise, the taxpayer is an individual, and the facts, analysis, and conclusions relate to a single taxable year. Example (1). (i) The taxpayer is a partner in a law partnership that has offices in various cities. Some of the partnership's offices provide a full range of legal services. Other offices, however, specialize in a particular area or areas of the law (e.g., litigation, tax law, corporate law, etc.). In either case, substantially all of the office's gross income is derived from the provision of legal services. Under paragraph (c)(1)

of this section, each of the law partnership's offices is treated as a single undertaking that is separate from other undertakings (a "law-office undertaking"). (ii) Each law-office undertaking derives more than 50 percent of its gross income from the provision of services in the field law. Thus, each such undertaking is treated as a professional service undertaking (within the meaning of paragraph (h)(1)(ii) of this section). (iii) Each law-office undertaking derives more than 20 percent of its gross income from services in the field of law. Thus, each such undertaking involves significant professional services (within the meaning of paragraph (h)(3)(iv) of this section) in the field of law. In addition, all services in the field of law are treated as similar services under paragraph (h)(3)(i) of this section. Thus, the law-office undertakings involve the provision of significant similar services (within the meaning of paragraph (h)(3)(iii) of this section). (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's interest in professional service undertakings that involve the provision of significant similar services are treated as part of the same activity of the taxpayer. Accordingly, the taxpayer's interests in the law-office undertakings are treated as part of the same activity of the taxpayer under paragraph (h)(2)(ii) of this section even if the undertakings are not controlled by the same interests (within the meaning of paragraph (j) of this section). Example (2). (i) The taxpayer is a partner in medical partnerships A and B. Both partnerships derive all of their gross income from the provision of medical services, but partnership A specializes in internal medicine and partnership B operates a radiology laboratory. Under paragraph (c)(1) of this section, the medical-service business of each partnership is treated as a single undertaking that is separate from other undertakings (a "medical-service undertaking"). Partnerships A and B are not controlled by the same interests (within the meaning of paragraph (j) of this section). (ii) Each partnership's medical-service undertaking derives more than 50 percent of its gross income from the provision of services in the field of health. Thus, each partnership's medical-service undertaking is treated as a professional service undertaking (within the meaning of paragraph (h)(1)(ii) of this section). (iii) Each partnership's medical-service undertaking derives more than 20 percent of its gross income from services in the field of health. Thus, each such undertaking involves significant professional services (within the meaning of paragraph (h)(3)(iv) of this section) in the field of health. In addition, all services in the field of health are treated as similar services under paragraph (h)(3)(i) of this section. Thus, the medical-services undertakings of partnerships A and B involve the provision of significant similar services (within the meaning of paragraph (h)(3)(iii) of this section). (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's interests in professional service undertakings that involve the provision of significant similar services are treated as part of the same activity of the taxpayer. Accordingly, the taxpayer's interests in the medical-service undertakings of partnerships A and B are

treated as part of the same activity of the taxpayer under paragraph (h)(2)(ii) of this section even though the undertakings are not controlled by the same interests. Example (3). (i) The facts are the same as in example (2), except that the taxpayer withdraws from partnership A in 1989 and becomes a partner in partnership B in 1990. In addition, the taxpayer was a full-time participant in the operations of partnership A from 1970 through 1989, but does not participate in the operations of partnership B. (ii) Paragraph (h)(2)(ii) of this section provides that a taxpayer's interests in professional service undertakings that involve the provision of significant similar services are treated as part of the same activity of the taxpayer. This rule is not limited to cases in which the taxpayer holds such interests simultaneously. Thus, as in example (2), the taxpayer's interests in the medical-service undertakings of partnerships A and B are treated as part of the same activity of the taxpayer. (iii) The activity that includes the taxpayer's interests in the medical-service undertakings of partnerships A and B is a personal service activity (within the meaning of §1.469-5T(d)) because it involves the performance of personal services in the field of health. In addition, the taxpayer materially participated in the activity for three or more taxable years preceding 1990 (see §1.469-5T(j)(1)). Thus, even if the taxpayer does not work in the activity after 1989, the taxpayer is treated, under

§1.469-5T(a)(6), as materially participating in the activity for 1990 and subsequent

taxable years. Example (4). (i) The taxpayer is a partner in an accounting partnership that has offices in various cities (partnership A) and in a management-consulting partnership that has a single office (partnership B). Each of partnership A's offices derives substantially all of its gross income from services in the field of accounting, and partnership B derives substantially all of its gross income from services in the field of consulting. Under paragraph (c)(1) of this section, partnership B's consulting business is treated as a single undertaking that is separate from other undertakings (the "consulting undertaking") and each of partnership A's offices is similarly treated (the "accounting undertakings"). The accounting undertakings are controlled by the same interests, but partnerships A and B are not controlled by the same interests (within the meaning of paragraph (j) of this section). Partnership B's consulting business derives 50 percent of its gross income from customers of partnership A's accounting undertakings, but does not derive more than 20 percent of its gross income from the customers of any single accounting undertaking. (ii) Each accounting undertaking derives more than 50 percent of its gross income from the provision of services in the field of accounting, and the consulting undertaking derives more than 50 percent of its gross income from the provision of services in the field of consulting. Thus, each accounting undertaking is treated as a professional service undertaking (within the meaning of paragraph (h)(1)(ii) of this section), and the consulting undertaking is also treated as a professional service undertaking. (iii) Each accounting undertaking derives more than 20 percent of its gross income from services in the field of accounting. Thus, each such undertaking involves significant professional services (within the meaning of paragraph (h)(3)(iv) of this section) in the field of accounting. In addition, all services in the field of accounting

are treated as similar services under paragraph (h)(3)(i) of this section. Thus, the accounting undertakings involve the provision of significant similar services (within the meaning of paragraph (h)(3)(iii) of this section). (iv) Paragraph (h)(2) (i) and (ii) of this section provides that a taxpayer's interests in professional service undertakings that are controlled by the same interests or that involve the provision of significant similar services are treated as part of the same activity of the taxpayer. The accounting undertakings are controlled by the same interests (see (i) above) and involve the provision of significant similar services (see (iii) above). Accordingly, the taxpayer's interests in the accounting undertakings are treated as part of the same activity under paragraph (h)(2) (i) and (ii) of this section. (v) The consulting undertaking derives more than 20 percent of its gross income from services in the field of consulting. If, based on all the facts and circumstances, these services are determined to be similar consulting services under paragraph (h)(3)(ii) of this section, the consulting undertaking involves significant professional services (within the meaning of paragraph (h)(3)(iv) of this section). In this case, however, the consulting undertaking and the accounting undertakings do not involve the provision of significant similar services (within the meaning of paragraph (h)(3)(iii) of this section) because consulting services and accounting services are not treated as similar services under paragraph (h)(3)(i) of this section. (vi) The consulting undertaking does not derive more than 20 percent of its gross income from the customers of any single accounting undertaking of partnership A. If, however, partnership A's accounting undertakings are aggregated, the consulting undertaking derives more than 20 percent of its gross income from customers of the aggregated undertakings. Paragraph (h)(3)(v) of this section provides that two professional service undertakings involve the provision of significant related services if more than 20 percent of the gross income of one undertaking is derived from customers of the other undertaking. For purposes of applying this rule, partnership A's accounting undertakings are treated as a single undertaking under paragraph (h)(2)(iii) of this section because the accounting undertakings are treated as part of the same activity under paragraph (h)(2)(i) and (ii) of this section. Thus, the consulting undertaking and the accounting undertakings involve the provision of significant related services. (vii) Paragraph (h)(2)(ii) of this section provides that a taxpayer's interests in professional service undertakings that involve the provision of significant related services are treated as part of the same activity of the taxpayer. Accordingly, the taxpayer's interests in the consulting undertaking and the accounting undertakings are treated as part of the same activity of the taxpayer under paragraph (h)(2)(ii) of this section. Example (5). (i) The facts are the same as in example (4), except that partnership B's consulting business derives only 15 percent of its gross income from customers of partnership A's accounting undertakings. (ii) As in example (4), the taxpayer's interests in the accounting undertakings are treated as part of the same activity under paragraph (h)(2)(i) and (ii) of this section and are treated under paragraph (h)(2)(iii) of this section as a single undertaking for purposes of reapplying those provisions. In this case, however, the consulting

undertaking does not derive more than 20 percent of tis gross income from the customers of partnership A's accounting undertakings. Thus, the consulting undertaking and the accounting undertakings do not involve the provision of significant related services. Accordingly, the accounting undertakings and the consulting undertaking are not treated as part of the same activity under paragraph (h)(2)(i) or (ii) of this section because they are not controlled by the same interests and do not involve the provision of significant similar or related services. Example (6). (i) The taxpayer is a partner in partnerships A, B, and C. Partnership A derives substantially all of its gross income from the provision of engineering services, partnership B derives substantially all of its gross income from the provision of architectural services, and partnership C derives 40 percent of its gross income from the provision of engineering services and the remainder from the provision of architectural services. Under paragraph (c)(1) of this section, each partnership's service business is treated as a single undertaking that is separate from other undertakings. Partnerships A, B, and C are not controlled by the same interests (within the meaning of paragraph (j) of this section). (ii) Each partnership's undertaking derives more than 50 percent of its gross income from the provision of services in the fields of architecture and engineering. Thus, each such undertaking is treated as a professional service undertaking (within the meaning of paragraph (h)(1)(ii) of this section). (iii) Partnership A's undertaking ("undertaking A") derives more than 20 percent of its gross income from services in the field of engineering, partnership B's undertaking ("undertaking B") derives more than 20 percent of its gross income from services in the field of architecture, and partnership C's undertaking ("undertaking C") derives more than 20 percent of its gross income from services in the field of engineering and more than 20 percent of its gross income from services in the field of architecture. Thus, undertaking A involves significant services in the field of engineering, undertaking B involves significant services in the field of architecture, and undertaking C involves significant services in both fields. Under paragraph (h)(3)(i) of this section, all services within each field are treated as similar services, but engineering services and architectural services are not treated as similar services. Thus, undertakings A and C, and undertakings B and C, involve the provision of significant similar services (within the meaning of paragraph (h)(3)(iii) of this section). (iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's interests in professional service undertakings that involve the provision of significant similar services are treated as part of the same activity of the taxpayer. Accordingly, the taxpayer's interests in undertakings A and C are treated as part of the same activity of the taxpayer. (v) Under paragraph (h)(2)(iii)(A) of this section, undertakings A and C are also treated as a single undertaking for purposes of determining whether undertaking B involves the provision of significant similar services. Paragraph (h)(2)(iii)(B) of this section in effect provides that treating undertakings A and C as a single undertaking does not affect the conclusion that the architectural services provided by undertakings B and C are significant similar services. Thus, undertaking B and the single undertaking in which undertakings A and C are included under paragraph (h)(3)(iii) of this section involve the provision of significant similar services, and the

taxpayer's interests in undertakings A, B, and C are treated as part of the same activity of the taxpayer under paragraph (h)(2)(ii) of this section. (i) [Reserved] (j) Control by the same interests and ownership percentage-(1) In general. Except as otherwise provided in paragraph (j)(2) of this section, all the facts and circumstances are taken into account in determining, for purposes of this section, whether undertakings are controlled by the same interests. For this purpose, control includes any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised. It is the reality of control that is determinative, and not its form or mode of exercise. (2) Presumption-(i) In general. Undertakings are rebuttably presumed to be controlled by the same interests if such undertakings are part of the same common-ownership group. (ii) Common-ownership group. Except as provided in paragraph (j)(2)(iii) of this section, two or more undertakings of a taxpayer are part of the same common-ownership group for purposes of this paragraph (j)(2) if and only if the sum of the common-ownership percentages of any five or fewer persons (within the meaning of section 7701(a)(1), but not including passthrough entities) with respect to such undertakings exceeds 50 percent. For this purpose, the common-ownership percentage of a person with respect to such undertakings is the person's smallest ownership percentage (determined in accordance with paragraph (j)(3) of this section) in any such undertaking. (iii) Special aggregation rule. If, without regard to this paragraph (j)(2)(iii), an undertaking of a taxpayer is part of two or more common-ownership groups, any undertakings of the taxpayer that are part of any such common-ownership group shall be treated for purposes of this paragraph (j)(2) as part of a single common-ownership group in determining the activities of such taxpayer. (3) Ownership percentage-(i) In general. For purposes of this section, a person's ownership percentage in an undertaking or in a passthrough entity shall include any interest in such undertaking or passthrough entity that the person holds directly and the person's share of any interest in such undertaking or passthrough entity that is held through one or more passthrough entities. (ii) Passthrough entities. The following rules apply for purposes of applying paragraph (j)(3)(i) of this section: (A) A partner's interest in a partnership and share of any interest in a passthrough entity or undertaking held through a partnership shall be determined on the basis of the greater of such partner's percentage interest in the capital (by value) of such partnership or such partner's largest distributive share of any item of income or gain (disregarding guaranteed payments under section 707(c)) of such partnership. (B) A shareholder's interest in an S corporation and share of any interest in a passthrough entity or undertaking held through an S corporation shall be determined on the basis of such shareholder's stock ownership.

(C) A beneficiary's interest in a trust or estate and share of any interest in a passthrough entity or undertaking held through a trust or estate shall not be taken into account. (iii) Attribution rules-(A) In general. Except as otherwise provided in paragraph (j)(3)(iii)(B) of this section, a person's ownership percentage in a passthrough entity or in an undertaking shall be determined by treating such person as the owner of any interest that a person related to such person owns (determined without regard to this paragraph (j)(3)(iii)) in such passthrough entity or in such undertaking. (B) Determination of common-ownership percentage. The common-ownership percentage of five or fewer persons with respect to two or more undertakings shall be determined, in any case in which, after the application of paragraph (j)(3)(iii)(A) of this section, two or more such persons own the same interest in any such undertaking (the "related-party owners") by treating as the only owner of such interest (or portion thereof) the related-party owner whose ownership of such interest (or a portion thereof) would result in the highest common-ownership percentage. (C) Related person. A person is related to another person for purposes of this paragraph (j)(3)(iii) if the relationship of such persons is described in section 267(b) or 707(b)(1). (4) Special rule for trade or business activities. In determining whether two or more trade or business activities are controlled by the same interests for purposes of paragraph (g) of this section, each such activity shall be treated as a separate undertaking in applying this paragraph (j). (5) Examples. The following examples illustrate the application of this paragraph (j): Example (1). (i) Partnership X is the sole owner of an undertaking (undertaking X), and partnership Y is the sole owner of another undertaking (undertaking Y). Individuals A, B, C, D, and E are the only partners in partnerships X and Y, and the partnership agreements of both X and Y provide that no action may be taken or decision made on behalf of the partnership without the unanimous consent of the partners. Moreover, each partner actually participates in, and agrees to, all major decisions that affect the operations of either partnership. The ownership percentages (within the meaning of paragraph (j)(3) of this section) of A, B, C, D, and E in each partnership (and in the undertaking owned by the partnership) are as follows: ------- ----------------------------------- Partner Partnership/Undertaking ---------------------- -------------------- X (percent) Y (percent) ------------------------------------------ A ..................... 15 5 B ..................... 10 60 C ..................... 10 20 D ..................... 77 12 E ...................... 8 20 ------------------------------ 120 117 --- --------------------------------------- The sum of the ownership percentages exceeds 100 percent for both X and Y because, under paragraph (j)(3)(ii)(A) of this section, each partner's ownership percentage is determined on the basis of the greater of the partner's percentage interest in the capital of the partnership or the partner's largest distributive share of any item of income or gain of the partnership.

(ii) Paragraph (j)(2)(ii) of this section provides that a person's common-ownership percentage with respect to any two or more undertakings is the person's smallest ownership percentage in any such undertaking. Thus, the common-ownership percentages of A, B, C, D, and E with respect to undertakings X and Y are as follows: ------------------------------------------ Partner Common-ownership percentage ------- ----------------------------------- A ...................................... 5 B ..................................... 10 C ..................................... 10 D ..................................... 12 E ...................................... 8 ------------------------- ----- 45 ------------------------------------------ (iii) Paragraph (j)(2)(i) of this section provides that undertakings are rebuttably presumed to be controlled by the same interests if the undertakings are part of the same common-ownership group. In general, undertakings are part of a common-ownership group only if the sum of the common-ownership percentages of any five or fewer persons with respect to such undertakings exceeds 50 percent. In this case, the sum of the partners' common-ownership percentages with respect to undertakings X and Y is only 45 percent. Thus, undertakings X and Y are not part of the same common-ownership group. (iv) If the presumption in paragraph (j)(2)(i) of this section does not apply, all the facts and circumstances are taken into account in determining whether undertakings are controlled by the same interests (see paragraph (j)(1) of this section). In this case, all actions and decisions in both undertakings require the unanimous consent of the same persons and each of those persons actually participates in, and agrees to, all major decisions. Accordingly, undertakings X and Y are controlled by the same interests (i.e., A, B, C, D, and E). Example (2). (i) Partnerships W, X, Y, and Z are each the sole owner of an undertaking (undertakings W, X, Y, and Z). Individuals A, B, and C are partners in each of the four partnerships, and the remaining interests in each partnership are owned by a number of unrelated individuals, none of whom owns more than a one-percent interest in any of the partnerships. The ownership percentages (within the meaning of paragraph (j)(3) of this section) of A, B, and C in each partnership (and in the undertaking owned by the partnership) are as follows: -------------------------- ------------------------- Partnership/Undertaking Partner -------------------------------- ------------------- A B C --------------------------------------------------- W ............................ 23% 21% 40%% X ............................ 19% 30% 22%% Y ............................ 25% 25% 20%% Z ............................. 8% 4% 2% ----------- ---------------------------------------- (ii) Paragraph (j)(2)(ii) of this section provides that a person's common-ownership percentage with respect to any two or more undertakings is the person's smallest ownership percentage in any such undertaking. Thus, the common-ownership percentages of A, B, and C in undertakings W, X, Y, and Z are as follows: ------------ ------------------------------ Partner Common-ownership percentage ------------------- ----------------------- A ...................................... 8 B ...................................... 4 C ...................................... 2 ------------------------------ 14 ------------------------- ----------------- (iii) The sum of the common-ownership percentages of A, B, and C with respect to undertakings W, X, Y, and Z is 14 percent, and no other person owns more than a one-percent interest in any of the undertakings. Thus, the sum of the common-

ownership percentages of any five or fewer persons with respect to all four undertakings cannot exceed 50 percent. Accordingly, undertakings W, X, Y, and Z are not part of the same common-ownership group (see paragraph (j)(2)(ii) of this section) and are not rebuttably presumed to be controlled by the same interests (see paragraph (j)(2)(i) of this section). (iv) The common-ownership percentages of A, B, and C in undertakings W, X, and Y are as follows: ------------------------------------------ Partner Common ownership percentage ------------------------------------------ A ..................................... 19 B ..................................... 21 C ..................................... 20 ------------------------ ------ 60 ------------------------------------------ (v) The sum of the common-ownership percentages of A, B, and C, taking into account only undertakings W, X, and Y, is 60 percent. Because the sum of the common-ownership percentages exceeds 50 percent, undertakings W, X, and Y are part of the same common-ownership group (see paragraph (j)(2)(ii) of this section and are rebuttably presumed to be controlled by the same interests (see paragraph (j)(2)(i) of this section). Example (3). (i) Corporation X, an S corporation, is the sole owner of an undertaking (undertaking X), and corporation Y, another S corporation, is the sole owner of another undertaking (undertaking Y). Individuals A, B, and C are shareholders in corporations X and Y. Both A and B are related (within the meaning of paragraph (j)(3)(iii)(C) of this section) to C, but not to each other. A, B, and C are not related to any other person that owns an interest in either corporation X or corporation Y. The ownership percentages (determined without regard to the attribution rules of paragraph (j)(3)(iii) of this section) of A, B, and C in each corporation (and in the undertaking owned by the corporation) are as follows: Corporation/Undertaking ----- ----------------------------------------- Shareholder X (percent) Y (percent) ------------ ---------------------------------- A ......................... 20 -------------- B ............. ----- --------- 20 C .......................... 5 5 ---------------------------------------------- (ii) In general, a person's ownership percentage is determined by treating the person as the owner of interests that are actually owned by related persons (see paragraph (j)(3)(iii)(A) of this section). If A, B, and C are treated as owning interests that are actually owned by related persons, their ownership percentages are as follows: Corporation/Undertaking ---------------------------------------------- Shareholder X (percent) Y (percent) ---------------------------------------------- A ......................... 25 5 B .......................... 5 25 C ......................... 25 25 ----------------------------- ----------------- (iii) Paragraph (j)(3)(iii)(B) of this section provides that, in determining the sum of the common-ownership percentages of any five or fewer persons with respect to any undertakings, each interest in such undertakings is counted only once. If two or more persons are treated as owners of the same interest under paragraph (j)(3)(iii)(A) of this section, the person whose ownership would result in the highest sum is treated as the only owner of the interest. In this case, C's common-ownership percentage with respect to undertakings X and Y, determined by treating C as the owner of the interests actually owned by A and B, is 25 percent. If, however, A and B are treated as the owners of the interests actually owned by C, each has a common-ownership percentage of only five percent. Thus, in determining the sum of common- ownership percentages with respect to undertakings X and Y, C is treated as the

owner of the interests actually owned by A and B because this treatment results in the highest sum of common-ownership percentages with respect to such undertakings. Example (4). (i) The ownership percentages of individuals A, B, and C in undertakings X, Y, and Z are as follows: Undertaking ----------------------------------- ---- Individual X Y Z --------------------------------------- A ................. 30% 30% 30% B ................. 30% 30% 30% C ............ -------- 30% 30% --------------------- ------------------ No other person owns an interest in more than one of the undertakings. (ii) Paragraph (j)(2)(ii) of this section provides that a person's common ownership percentage with respect to any two or more undertakings is the person's smallest ownership percentage in any such undertaking. Thus, A's common-ownership percentage with respect to undertakings X, Y, and Z is 30 percent, and the common-ownership percentages of B and C (and all other persons owning interests in such undertakings) with respect to such undertakings is zero. Accordingly, the sum of the common ownership percentages with respect to undertakings X, Y, and Z is only 30 percent, and undertakings X, Y, and Z are not treated as part of the same common-ownership group under paragraph (j)(2)(ii) of this section. (iii) B's common-ownership percentage with respect to undertakings X and Y is 30 percent, and the sum of A's and B's common-ownership percentages with respect to such undertakings is 60 percent. Thus, undertakings X and Y are treated as part of the same common-ownership group under paragraph (j)(2)(ii) of this section. Similarly, C's common-ownership percentage with respect to undertakings Y and Z is 30 percent, and the sum of A's and C's common-ownership percentages with respect to such undertakings is 60 percent. Thus, undertakings Y and Z are also treated as part of the same common-ownership group under paragraph (j)(2)(ii) of this section. (iv) Paragraph (j)(2)(iii) of this section requires the aggregation of common-ownership groups that include the same undertaking. In this case, undertaking Y is treated as part of the common-ownership group XY and as part of the common-ownership group YZ. Accordingly, undertakings X, Y, and Z are treated as part of a single common-ownership group and are rebuttably presumed to be controlled by the same interests (see paragraph (j)(2)(i) of this section) even though B does not own an interest in undertaking Z and C does not own an interest in undertaking X. The fact that B and C are not common owners with respect to undertakings X and Z is taken into account, however, in determining whether this presumption is rebutted. (k) Identification of rental real estate activities-(1) Applicability-(i) In general. Except as otherwise provided in paragraph (k)(6) of this section, this paragraph (k) applies to a taxpayer's interests in rental real estate undertakings (within the meaning of paragraph (k)(1)(ii) of this section). (ii) Rental real estate undertaking. For purposes of this paragraph (k), a rental real estate undertaking is a rental undertaking (within the meaning of paragraph (d) of this section) in which at least 85 percent of the unadjusted basis (within the meaning of §1.469-2T(f)(3)) of the property made available for use by customers is real property. For this purpose the term "real property" means any tangible property other than tangible personal property (within the meaning of §1.48-1(c)).

(2) Identification of activities-(i) Multiple undertakings treated as a single activity or multiple activities by taxpayer. Except as otherwise provided in this paragraph (k), a taxpayer may treat two or more rental real estate undertakings (determined after the application of paragraph (k)(2) (ii) and (iii) of this section) as a single activity or may treat such undertakings as separate activities. (ii) Multiple undertakings treated as a single activity by passthrough entity. A taxpayer must treat two or more rental real estate undertakings as a single rental real estate undertaking for a taxable year if any passthrough entity through which the taxpayer holds such undertakings treats such undertakings as a single activity on the applicable return of the passthrough entity for the taxable year of the taxpayer. (iii) Single undertaking treated as multiple undertakings. Notwithstanding that a taxpayer's interest in leased property would, but for the application of this paragraph (k)(2)(iii), be treated as used in a single rental real estate undertaking, the taxpayer may, except as otherwise provided in paragraph (k)(3) of this section, treat a portion of the leased property (including a ratable portion of any common areas or facilities) as a rental real estate undertaking that is separate from the undertaking or undertakings in which the remaining portion of the property is treated as used. This paragraph (k)(2)(iii) shall apply for a taxable year if and only if- (A) Such portion of the leased property can be separately conveyed under applicable State and local law (taking into account the limitations, if any, imposed by any special rules or procedures, such as condominium conversion laws, restricting the separate conveyance of parts of the same structure); and (B) The taxpayer holds such leased property directly or through one or more passthrough entities, each of which treats such portion of the leased property as a separate activity on the applicable return of the passthrough entity for the taxable year of the taxpayer. (3) Treatment in succeeding taxable years. All rental real estate undertakings or portions of such undertakings that are treated, under this paragraph (k), as part of the same activity for a taxable year ending after August 9, 1989 must be treated as part of the same activity in each succeeding taxable year. (4) Applicable return of passthrough entity. For purposes of this paragraph (k), the applicable return of a passthrough entity for a taxable year of a taxpayer is the return reporting the passthrough entity's income, gain, loss, deductions, and credits taken into account by the taxpayer for such taxable year. (5) Evidence of treatment required. For purposes of this paragraph (k), a person (including a passthrough entity) does not treat a rental real estate undertaking as multiple undertakings for a taxable year or, except as otherwise provided in paragraph (k) (2)(ii) or (3) of this section, treat multiple rental real estate undertakings as a single undertaking for a taxable year unless such treatment is reflected on a schedule attached to the person's return for the taxable year. (6) Coordination rule for rental of nondepreciable property. This paragraph (k) shall not apply to a rental real estate undertaking if less than 30 percent of the unadjusted basis (within the meaning of §1.469-2T(f)(3)) of property used or held

for use by customers in such undertaking during the taxable year is subject to the allowance for depreciation under section 167. (7) Coordination rule for rental of dwelling unit. For any taxable year in which section 280A(c)(5) applies to a taxpayer's use of a dwelling unit- (i) Paragraph (k) (2) and (3) of this section shall not apply to the taxpayer's interest in such dwelling unit; and (ii) The taxpayer's interest in such dwelling unit shall be treated as a separate activity of the taxpayer. (8) Examples. The following examples illustrate the application of this paragraph (k). In each example, the taxpayer is an individual whose taxable year is the calendar year. Example (1). (i) In 1989, the taxpayer directly owns five condominium units (units A, B, C, D, and E) in three different buildings. Units A, B, and C are in one of the buildings and constitute a single rental real estate undertaking (within the meaning of paragraph (k)(1)(ii) of this section). Units D and E are in the other two buildings, and each of these units constitutes a separate rental real estate undertaking. Each of the units can be separately conveyed under applicable State and local law. (ii) Paragraph (k)(2)(iii) of this section permits a taxpayer to treat a portion of the property included in a rental real estate undertaking as a separate rental real estate undertaking if the property can be separately conveyed under applicable State and local law and the taxpayer owns the property directly. Thus, the taxpayer can treat units A, B, and C as three separate undertakings. Alternatively, the taxpayer could treat two of those units (e.g., units A and C) as an undertaking and the remaining unit as a separate undertaking, or could treat units A, B, and C as a single undertaking. (iii) Paragraph (k)(2)(i) of this section permits a taxpayer to treat two or more rental real estate undertakings as a single activity, or to treat such undertakings as separate activities. Thus, the taxpayer, by combining undertakings, can treat all five units as a single activity. Alternatively, the taxpayer could treat each undertaking as a separate activity, or could combine some, but not all, undertakings. Thus, for example, the taxpayer could treat units A, B, C, and D as an activity and unit E as a separate activity. (iv) For purposes of paragraph (k)(2)(i) of this section, a taxpayer's rental real estate undertakings are determined after the application of paragraph (k)(2)(iii) of this section. Thus, the taxpayer, by treating units as separate undertakings under paragraph (k)(2)(iii) of this section and combining them with other units under paragraph (k)(2)(i) of this section, can treat any combination of units as a single activity. For example, the taxpayer could treat units A and B as a separate rental real estate undertaking, and then treat units A, B, and D as a single activity. In that case, the taxpayer could treat units C and E either as a single activity or as two separate activities.

Example (2). (i) The facts are the same as in example (1). In addition, the taxpayer treats all five units as a single activity for 1989 and sells unit E in 1990. (See paragraph (k)(5) of this section for a rule providing that the units are treated as a single activity only if such treatment is reflected on a schedule attached to the taxpayer's return.) (ii) Under paragraph (k)(3) of this section, rental real estate undertakings that are treated as part of the same activity for a taxable year must be treated as part of the same activity in each succeeding year. In this case, all five units were treated as part of the same activity for 1989 and must therefore be treated as part of the same activity for 1990. Accordingly, the taxpayer's sale of unit E in 1990 cannot be treated as a disposition of the taxpayer's entire interest in an activity for purposes of section 469(g) and the rules to be contained in §1.469-6T (relating to the treatment of losses upon certain dispositions of passive and former passive activities). Example (3). (i) The facts are the same as in example (1), except that the taxpayer is a partner in a partnership that is the direct owner of the five condominium units. In its return for its taxable year ending on November 30, 1989, the partnership treats the five units as a single activity. (See paragraph (k)(5) of this section for a rule providing that the units are treated as a single activity only if such treatment is reflected on a schedule attached to the partnership's return.) The partnership sells unit E on November 1, 1990. (ii) Paragraph (k)(2)(ii) of this section provides that a taxpayer who holds rental real estate undertakings through a passthrough entity must treat those undertakings as a single rental real estate undertaking if they are treated as a single activity on the applicable return of the passthrough entity. Under paragraph (k)(4) of this section, the applicable return of the partnership for the taxpayer's 1989 taxable year is the partnership's return for its taxable year ending on November 30, 1989. Accordingly, the taxpayer must treat the five condominium units as a single rental real estate undertaking (and thus as part of the same activity) for 1989 because they are treated as a single activity on the partnership's return for its taxable year ending in 1989. (iii) Under paragraph (k)(3) of this section, the taxpayer must continue treating the condominium units as part of the same activity for taxable years after 1989. Accordingly, as in example (2), the five condominium units are treated as part of the same activity for 1990, and the sale of unit E in 1990 cannot be treated as a disposition of the taxpayer's interest in an activity for purposes of section 469(g) and the rules to be contained in §1.469-6T. Example (4). (i) The taxpayer owns a shopping center and a vacant lot that are separate rental real estate undertakings (within the meaning of paragraph (k)(1)(ii) of this section). The taxpayer rents space in the shopping center to various tenants and rents the vacant lot to a parking lot operator. Most of the unadjusted basis of the property used in the shopping-center undertaking (taking into account the land on which the shopping center is built) is subject to the allowance for depreciation, but no depreciable property is used in the parking-lot undertaking. (ii) This paragraph (k) provides rules for identifying rental real estate activities (including the rule in paragraph (k)(2)(i) of this section that permits a taxpayer to treat two or more rental real estate undertakings as a single activity). Paragraph

(k)(6) of this section provides, however, that these rules do not apply to a rental real estate undertaking if less than 30 percent of the unadjusted basis of the property used in the undertaking is subject to the allowance for depreciation. Thus, the taxpayer may not combine the parking-lot undertaking, which includes no depreciable property, with the shopping-center undertaking or any other rental real estate undertaking under paragraph (k)(2)(i) of this section. Accordingly, the parking lot undertaking is treated as a separate activity under paragraph (b)(1) of this section. Example (5). (i) The facts are the same as in example (4), except that the shopping center and the vacant lot are at the same location (within the meaning of paragraph (c)(2)(iii) of this section) and are part of the same rental real estate undertaking (within the meaning of paragraph (k)(1)(ii) of this section). Taking into account the property used in the shopping center operations (including the land on which the shopping center is built) and the vacant lot, 50 percent of the unadjusted basis of the property used in the undertaking is subject to the allowance for depreciation. (ii) In this case, the vacant lot is used in a rental real estate undertaking in which depreciable property is also used. Moreover, the exception in paragraph (k)(6) of this section does not apply to the undertaking consisting of the shopping center and the parking lot because at least 30 percent of unadjusted basis of the property used in the undertaking is subject to the allowance for depreciation. Accordingly, the taxpayer may combine the undertaking with other rental real estate undertakings and treat the combined undertakings as a single activity under paragraph (k)(2)(i) of this section. (l) [Reserved.] (m) Consolidated groups-(1) In general. The activities of a consolidated group (within the meaning of §1.469-1T(h)(2)(ii)) and of each member of such group shall be determined under this section as if the consolidated group were one taxpayer. (2) Examples. The following examples illustrate the application of this paragraph (m). In each example, the facts, analysis, and conclusions relate to a single taxable year. Example (1). (i) Corporations M, N, and O are the members of a consolidated group (within the meaning of §1.469-1T(h)(2)(ii)). Under §1.469-1T(h)(4)(i)(A) and (ii), the consolidated group and its members are treated as closely held corporations (within the meaning of §1.469-1T(g)(2)(ii)). Each member of the consolidated group owns a two-percent interest in partnership X and a two-percent interest in partnership Y, and owns interests in a number of trade or business undertakings (within the meaning of paragraph (f)(1)(ii) of this section) through the partnerships. Each of these undertakings is directly owned by partnership X or Y, and all the undertakings of partnerships X and Y are controlled by the same interests (within the meaning of paragraph (j) of this section) and are similar (within the meaning of paragraph (f)(4) of this section). The employees of the consolidated group and the shareholders of its common parent do not participate in the undertakings that the member corporations own through the partnerships. (ii) Paragraph (f)(2)(i) of this section provides that trade or business undertakings that are similar and controlled by the same interests are treated as part of the same

activity of the taxpayer if the taxpayer owns interests in the undertakings through the same passthrough entity. In this case, the member corporations own interests in similar, commonly-controlled undertakings through both partnerships, and such interests are treated under this paragraph (m) as interests owned by one taxpayer (the consolidated group). Accordingly, the member corporations' interests in the undertakings owned through partnership X are treated as part of the same activity of the consolidated group, and their interests in the undertakings owned through partnership Y are treated similarly. Example (2). (i) The facts are the same as in example (1), except that each member of the consolidated group owns a five-percent interest in partnership X and a five-percent interest in partnership Y. (ii) Paragraph (f)(2)(ii) of this section provides that trade or business undertakings that are similar and controlled by the same interests are treated as part of the same activity of the taxpayer if the taxpayer owns a direct or substantial indirect interest in each such undertaking. In this case, the member corporations own, in the aggregate, a 15-percent interest in partnership X and a 15-percent interest in partnership Y, and such interests are treated under this paragraph (m) as interests owned by one taxpayer (the consolidated group). Thus, the consolidated group owns a substantial indirect interest in the similar, commonly-controlled undertakings owned by partnerships X and Y (see paragraph (f)(3)(i) of this section). Accordingly, the member corporations' interests in the undertakings owned through partnerships X and Y are treated as part of the same activity of the consolidated group. (n) Publicly traded partnerships. The rules of this section shall apply to a taxpayer's interest in business and rental operations held through a publicly traded partnership (within the meaning of section 469(k)(2)) as if the taxpayer had no interest in any other business and rental operations. The following example illustrates the application of this paragraph (n): Example. (i) The taxpayer, an individual, owns a 20-percent interest in partnership X and a 15-percent interest in partnership Y. Partnership X directly owns a hotel ("hotel 1") and a commercial office building ("building 1"). Partnership Y directly owns two hotels ("hotels 2 and 3") and two commercial office buildings ("buildings 2 and 3"). Each of the three hotels is a separate trade or business undertaking (within the meaning of paragraph (f)(1)(ii) of this section), and each of the three office buildings is a separate rental real estate undertaking (within the meaning of paragraph (k)(1)(ii) of this section). The three hotel undertakings are similar (within the meaning of paragraph (f)(4) of this section) and are controlled by the same interests (within the meaning of paragraph (j) of this section). Partnership X is not a publicly traded partnership (within the meaning of section 469(k)(2)). Partnership Y, however, is a publicly traded partnership and is not treated as a corporation under section 7704. (ii) This paragraph (n) provides that the rules of this section apply to a taxpayer's interest in business and rental operations held through a publicly traded partnership as if the taxpayer had no interest in any other business and rental operations. Thus, undertakings owned through partnership Y may be treated as part of the same activity under the rules of this section, but an undertaking owned through partnership Y and an undertaking that is not owned through partnership Y may not be treated as part of the same activity.

(iii) Paragraph (f)(2)(i) of this section provides that a taxpayer's interests in two or more trade or business undertakings that are similar and controlled by the same interests are treated as part of the same activity if the taxpayer owns interests in each undertaking through the same passthrough entity. Partnership Y's hotel undertakings (i.e., hotels 2 and 3) are similar and are controlled by the same interests. In addition, the taxpayer owns interests in both undertakings through the same partnership. Accordingly, the taxpayer's interests in partnership Y's hotel undertakings are treated as part of the same activity. (iv) The hotel undertaking owned through partnership X (i.e., hotel 1) and the hotel undertakings owned through partnership Y are similar and controlled by the same interests, and the taxpayer owns a substantial indirect interest in each of the undertakings (see paragraph (f)(3)(i) of this section). Thus, the three undertakings would ordinarily be treated as part of the same activity under paragraph (f)(2)(ii) of this section. Under this paragraph (n), however, undertakings that are owned through a publicly traded partnership cannot be treated as part of the same activity as any undertaking not owned through that partnership. Accordingly, the hotel undertaking that the taxpayer owns through partnership X and the hotel undertakings that the taxpayer owns through partnership Y are treated as two separate activities. (v) Paragraph (k)(2)(i) of this section provides that, with certain exceptions, a taxpayer may treat two or more rental real estate undertakings as a single activity or as separate activities. Thus, the taxpayer's interests in the rental real estate undertakings owned through partnership Y (i.e., buildings 2 and 3) may be treated as a single activity or as separate activities. Under this paragraph (n), however, undertakings that are owned through a publicly traded partnership cannot be treated as part of the same activity as any undertaking not owned through that partnership. Accordingly, the taxpayer's interest in the rental real estate undertaking owned through partnership X (building 1) cannot be treated as part of an activity that includes any rental real estate undertaking owned through partnership Y. (o) Elective treatment of undertakings as separate activities-(1) Applicability. This paragraph applies to a taxpayer's interest in any undertaking (other than a rental real estate undertaking (within the meaning of paragraph (k)(1)(ii) of this section)) that would otherwise be treated under this section as part of an activity that includes the taxpayer's interest in any other undertaking. (2) Undertakings treated as separate activities. Except as otherwise provided in this paragraph (o), a person (including a passthrough entity) shall treat an undertaking to which this paragraph (o) applies as an activity separate from the remainder of the activity in which such undertaking would otherwise be included for a taxable year if and only if, for such taxable year or any preceding taxable year, such person made an election with respect to such undertaking under this paragraph (o). (3) Multiple undertakings treated as a single activity by passthrough entity. A person (including a passthrough entity) must treat interests in two or more undertakings as part of the same activity for a taxable year if any passthrough entity through which the person holds such undertakings treats such undertakings as part of the same activity on the applicable return of the passthrough entity for the taxable year of such person.

(4) Multiple undertakings treated as a single activity for a preceding taxable year. If a person (including a passthrough entity) treats undertakings as part of the same activity on such person's return for a taxable year ending after August 9, 1989, such person may not treat such undertakings as part of different activities under this paragraph (o) for any subsequent taxable year. (5) Applicable return of passthrough entity. For purposes of this paragraph (o), the applicable return of a passthrough entity for a taxable year of a taxpayer is the return reporting the passthrough entity's income, gain, loss, deductions, and credits taken into account by the taxpayer for such taxable year. (6) Participation. The following rules apply to multiple activities (the "separate activities") that would be treated as a single activity (the "original activity") if the taxpayer's activities were determined without regard to this paragraph (o): (i) The taxpayer shall be treated as materially participating (within the meaning of

§1.469-5T) for the taxable year in the separate activities if and only if the taxpayer

would, but for the application of this paragraph (o), be treated as materially participating for the taxable year in the original activity. (ii) The taxpayer shall be treated as significantly participating (within the meaning of

§1.469-5T(c)(2)) for the taxable year in the separate activities if and only if the

taxpayer would, but for the application of this paragraph (o), be treated as significantly participating for the taxable year in the original activity. (7) Election-(i) In general. A person makes an election with respect to an undertaking under this paragraph (o) by attaching the written statement described in paragraph (o)(7)(ii) of this section to such person's return for the taxable year for which the election is made (see paragraph (o)(2) of this section). (ii) Written statement. The written statement required by paragraph (o)(7)(i) of this section must- (A) State the name, address, and taxpayer identification number of the person making the election; (B) Contain a declaration that an election is being made under §1.469-4T(o); (C) Identify the undertaking with respect to which such election is being made; and (D) Identify the remainder of the activity in which such undertaking would otherwise be included. (8) Examples. The following examples illustrate the application of this paragraph (o): Example (1). (i) During 1989, the taxpayer, an individual whose taxable year is the calendar year, acquires and is the direct owner of ten grocery stores. The operations of each grocery store are treated under paragraph (c)(1) of this section as a single undertaking that is separate from other undertakings (a "grocery-store undertaking"), and the taxpayer's interests in the grocery-store undertakings would

be treated as part of the same activity of the taxpayer under paragraph (f)(2) of this section. (ii) Paragraph (o)(2) of this section provides that, with certain exceptions, undertakings that would be treated as part of the same activity under other rules in this section may, at the election of the taxpayer, be treated as separate activities. Thus, the taxpayer may elect to treat each grocery-store undertaking as a separate activity for 1989. Alternatively, the taxpayer may combine grocery-store undertakings in any manner and treat each combination of undertakings (and each uncombined undertaking) as a separate activity for 1989. In either case, the election must be made by attaching the written statement described in paragraph (o)(7)(ii) of this section to the taxpayer's 1989 return. Example (2). (i) The facts are the same as in example (1). In addition, the taxpayer, in 1989, elects to treat each grocery-store undertaking as a separate activity and participates for 15 hours in each of the grocery-store undertakings. (ii) The taxpayer's interest in each grocery-store undertaking is treated, under paragraph (o)(2) of this section, as a separate activity of the taxpayer for 1989 (a "grocery-store activity"). In 1989, however, the taxpayer participates for more than 100 hours in the activity in which the undertakings would be included (but for the election to treat the grocery-store undertakings as separate activities) and would be treated under §1.469-5T(c)(2) as significantly participating in such activity. Accordingly, the taxpayer is treated under paragraph (o)(6)(ii) of this section as significantly participating in each of the grocery-store activities for 1989. Example (3). (i) The facts are the same as in example (1). In addition, the taxpayer, in 1989, elects to treat each grocery-store undertaking as a separate activity. The taxpayer does not participate in any of the grocery-store undertakings in 1989 or 1990, and sells one of the grocery stores in 1990. (ii) As in example (2), the taxpayer's interests in each grocery-store undertaking is treated, under paragraph (o)(2) of this section, as a separate activity of the taxpayer for 1989. Because the taxpayer elected to treat the undertakings as separate activities for a preceding taxable year (1989), each grocery-store undertaking is also treated, under paragraph (o)(2) of this section, as a separate activity of the taxpayer for 1990. In addition, each of the taxpayer's grocery-store activities is a passive activity for 1989 and 1990 because the taxpayer does not participate in any of the grocery store undertakings for 1989 and 1990. Accordingly, the taxpayer's sale of the grocery store will generally be treated as a disposition of the taxpayer's entire interest in a passive activity for purposes of section 469(g) and the rules to be contained in §1.469-6T (relating to the treatment of losses upon certain dispositions of passive and former passive activities). Example (4). (i) The facts are the same as in example (3), except that the taxpayer elects to treat the grocery-store undertakings as two separate activities. One of the activities includes three grocery-store undertakings, and the store sold in 1990 is part of this activity. The other activity includes the seven remaining grocery-store undertakings. (ii) Paragraph (o)(4) of this section provides that a person who treats undertakings as part of the same activity for a taxable year ending after August 9, 1989, may not

elect to treat those undertakings as separate activities for a subsequent taxable year. The grocery store sold in 1990 was treated for 1989 as part of an activity that includes two other grocery stores. Thus, those three stores must be treated as part of the same activity for 1990. Accordingly, the taxpayer's sale of the grocery store cannot be treated as a disposition of the taxpayer's entire interest in a passive activity for purposes of section 469(g) and the rules to be contained in §1.469-6T. Example (5). (i) The facts are the same as in example (1), except that the taxpayer is a partner in a partnership that acquires and is the direct owner of the ten grocery stores. The taxable year of the partnership ends on November 30, and the partnership acquires the grocery stores in its taxable year ending on November 30, 1989. In its return for that taxable year, the partnership treats the grocery-store undertakings as a single activity. (ii) Paragraph (o)(3) of this section provides that a person who holds undertakings through a passthrough entity may not elect to treat those undertakings as separate activities if they are treated as part of the same activity on the applicable return of the passthrough entity. Under paragraph (o)(5) of this section, the applicable return of the partnership for the taxpayer's 1989 taxable year is the partnership's return for its taxable year ending on November 30, 1989. Accordingly, the taxpayer must treat the grocery-store undertakings as a single activity for 1989 because those undertakings are treated as a single activity on the partnership's return for its taxable year ending in 1989. (iii) Under paragraph (o)(4) of this section, the taxpayer must continue treating the grocery-store undertakings as part of the same activity for taxable years after 1989. This rule applies even if the partnership subsequently distributes its interest in the grocery stores to the taxpayer, and the taxpayer becomes the direct owner of the grocery-store undertakings. (p) Special rule for taxable years ending before August 10, 1989-(1) In general. For purposes of applying section 469 and the regulations thereunder for a taxable year ending before August 10, 1989, a taxpayer's business and rental operations may be organized into activities under the rules or paragraphs (b) through (n) of this section or under any other reasonable method. For example, for such taxable years a taxpayer may treat each of the taxpayer's undertakings as a separate activity, or a taxpayer may treat undertakings that involve the provision of similar goods or services as a single activity. (2) Unreasonable methods. A method of organizing business and rental operations into activities is not reasonable if such method- (i) Treats rental operations (within the meaning of paragraph (d)(3) of this section) that are not ancillary to a trade or business activity (within the meaning of §1.469- 1T(e)(2)) as part of a trade or business activity; (ii) Treats operations that are not rental operations and are not ancillary to a rental activity (within the meaning of §1.469-1T(e)(3)) as part of a rental activity; (iii) Includes in a passive activity of a taxpayer any oil or gas well that would be treated, under paragraph (e)(1) of this section, as a separate undertaking in determining the taxpayer's activities;

(iv) Includes in a passive activity of a taxpayer any interest in a dwelling unit that would be treated, under paragraph (K)(7) of this section, as a separate activity of the taxpayer; or (v) Is inconsistent with the taxpayer's method of organizing business and rental operations into activities for the taxpayer's first taxable year beginning after December 31, 1986. (3) Allocation of dissallowed deductions in succeeding taxable year. If any of the taxpayer's passive activity deductions or the taxpayer's credits from passive activities are disallowed under §1.469-1T for the last taxable year of the taxpayer ending before August 10, 1989, such disallowed deductions or credits shall be allocated among the taxpayer's activities for the first taxable year of the taxpayer ending after August 9, 1989, using any reasonable method. See §1.469-1T(f)(4).

§1.469-5T [Amended]

Par. 7. Section 1.469-5T is amended as follows: 1. Paragraph (f)(1) is amended by removing the parenthetical phrase "(directly or indirectly, other than through a C corporation)". 2. Paragraph (h) is amended by adding the following new paragraph (h)(3): (h) (3) Coordination with rules governing the treatment of passthrough entities. If a taxpayer takes into account for a taxable year of such taxpayer any item of gross income or deduction from a partnership or S corporation that is characterized as an item of gross income or deduction from an activity in which the taxpayer materially participated under §1.469-2T(e)(1), such taxpayer shall be treated as materially participating in such activity for such taxable year for purposes of applying paragraph (a)(5) and (6) of this section to any succeeding taxable year of such taxpayer. 3. Paragraph (j) is amended by redesignating paragraph (j) (including its heading) as paragraph (j)(2) and adding the following new heading and paragraph (j)(1): (j) Material participation for preceding taxable years-(1) In general. For purposes of paragraph (a)(5) and (6) of this section, a taxpayer has materially participated in an activity for a preceding taxable year if such activity includes an undertaking that involves substantially the same business and rental operations as an undertaking that was included in an activity in which the taxpayer materially participated (determined without regard to paragraph (a)(5) of this section) for such preceding taxable year 4. Paragraph (k), Example (5), is amended by removing "1999" and adding in its place "2000" wherever the former occurs. Par. 8. Section 1.469-11T is amended as follows:

1. Paragraph (c)(2)(i) is revised. 2. Paragraph (c)(3)(i)(A) is revised. 3. Paragraph (c)(3)(ii) is revised. 4. The examples in paragraph (c)(4) are revised. 5. In paragraph (c)(5)(i), the introductory text is revised. 6. The first four examples in paragraph (c)(5)(iii) are revised. 7. The revised provisions read as follows:

§1.469-11T Effective date and transition rules (temporary).

(c) (2) Qualified interest-(1) In general. For purposes of this paragraph (c), a taxpayer's interest in an undertaking (the "current-year undertaking") shall be treated as a qualified interest in the activity in which such undertaking is included for the taxable year if and only if the current-year undertaking continues business and rental operations of an undertaking that was- (A) Held by the taxpayer on October 22, 1986, and at all times thereafter; or (B) Acquired by the taxpayer after October 22, 1986, directly or indirectly, pursuant to one or more written binding contracts to which the taxpayer was a party (see paragraph (c)(7) of this section) on October 22, 1986, and held by the taxpayer at all times after such acquisition. (3) (1) (A) Any of the business and rental operations that are part of such activity continue business and rental operations that were being conducted by any person on October 22, 1986; or (ii) Character before 1987 irrelevant. For purposes of this paragraph (c), an activity may be treated as a pre-enactment activity without regard to whether such activity continues business and rental operations that would have been part of a passive activity of the taxpayer for any taxable year beginning before January 1, 1987, had section 469 and the regulations been in effect for such year. (4) Example (1). On October 22, 1986, the taxpayer owned an interest in property used as a personal residence. After October 22, 1986, the taxpayer ceased to use the property as a personal residence and began to use it in a rental activity (within the

meaning of §1.469-1T(e)(3)). The rental activity is a pre-enactment activity (within the meaning of paragraph (c)(3) of this section) because the property used in the rental activity was in existence on August 16, 1986. The rental activity does not continue business and rental operations of any undertaking in which the taxpayer held an interest on October 22, 1986, because the taxpayer did not hold the property in an activity on that date. In addition, the taxpayer did not acquire an interest in an undertaking involving such operations pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986. Accordingly, the taxpayer's interest in the rental activity is not a qualified interest (within the meaning of paragraph (c)(2) of this section), and the taxpayer does not have a preenactment interest in the rental activity. Example (2). The taxpayer owns an interest in a partnership, which owns property used in a rental activity (within the meaning of §1.469-1T(e)(3)). The taxpayer acquired the partnership interest pursuant to a written bidding contract to which the taxpayer was a party on October 22, 1986. The partnership acquired its interest in the rental property pursuant to written binding contracts to which the partnership was a party on October 22, 1986. Construction of the property used in the rental activity commenced prior to August 16, 1986. Under paragraph (c)(7)(ii) of this section, the taxpayer is treated as a party to the contracts to which the partnership was a party on October 22, 1986. Therefore, the taxpayer's interest in the rental activity is a qualified interest (within the meaning of paragraph (c)(2) of this section) because the taxpayer's interest in the rental property (i.e., in undertakings involving business and rental operations that are continued in the rental activity) was acquired after October 22, 1986, pursuant to written binding contracts to which the taxpayer was a party on that date. Because the property used in the rental activity was under construction on August 16, 1986, the rental activity is a pre-enactment activity (within the meaning of paragraph (c)(3) of this section). Accordingly, the taxpayer's interest in the rental activity is a pre-enactment interest. Example (3). The facts are the same as in example (2), except that the partnership acquired the property after October 22, 1986, pursuant to a contract entered into after October 22, 1986. The taxpayer's interest in the rental activity is not a pre-enactment interest because the taxpayer's interest in the rental property was not acquired pursuant to written binding contracts to which the taxpayer was a party on October 22, 1986. Example (4). The taxpayer owned a pre-enactment interest in an activity that continues business and rental operations that were conducted by the taxpayer on October 22, 1986. After that date, the taxpayer died, and the decedent's interest in the activity passed to the decedent's estate. Because a decedent and the decedent's estate are not the same taxpayer, the estate must independently satisfy the requirements for a pre-enactment interest regardless of the fact that the decedent had a pre-enactment interest in the activity. Since the activity was being conducted by the decedent on October 22, 1986, the activity is a pre-enactment activity (within the meaning of paragraph (c)(3) of this section). Because, however, the activity does not continue the business and rental operations of an undertaking that the estate held on October 22, 1986, or acquired pursuant to a written binding contract, the estate does not have a qualified interest in the activity (within the meaning of paragraph (c)(2) of this section).

(5) Effect of changes in a taxpayer's interest in a pre-enactment activity-(i) In general. If the taxpayer's share for a taxable year of an item of income, gain, loss, deduction, or credit from an interest in a pre-enactment activity was increased or decreased at any time after October 22, 1986, and prior to the end of such taxable year (other than pursuant to a written binding contract to which the taxpayer was a party on October 22, 1986), the share of such item that is attributable to a pre-enactment interest in such activity shall be determined by taking into account- (iii) Example (1). A taxpayer owns interests in a pre-enactment activity through an S corporation. On October 22, 1986, the taxpayer owned a 10-percent interest in the S corporation. After October 22, 1986, the taxpayer acquires an additional 5-percent interest in the S corporation pursuant to a contract entered into after October 22, 1986. Under this paragraph (c)(5), only items from the 10-percent interest that the taxpayer owned on October 22, 1986, are attributable to the taxpayer's pre-enactment interest in the activity. Example (2). On October 22, 1986, individuals A and B each owned a rental property. After October 22, 1986, A and B contribute their rental properties to a partnership in exchange for which each receives a 50-percent interest in all items of income, gain, loss, deduction, and credit of the partnership. Under paragraph (c)(5)(i) of this section, A's 50-percent share of each partnership item attributable to the rental property contributed by A is attributable to a pre-enactment interest. None of A's share of the partnership items attributable to the rental property contributed by B is attributable to a pre-enactment interest. Example (3). The facts are the same as in example (2), except that under the partnership agreement the items of income, gain, loss, deduction, and credit attributable to the rental property A contributed to the partnership are allocated 80 percent to A and 20 percent to B. Under paragraph (c)(5)(i) of this section, A's 80-percent share of each partnership item attributable to the rental property contributed by A is attributable to a pre-enactment interest. Example (4). The facts are the same as in example (3) except that on January 1, 1988, the partnership liquidates, distributing to A the rental property contributed by A to the partnership. Under paragraph (c)(5)(i) of this section, only 80 percent of A's income, gain, loss, deductions, and credits from the property for 1988 and subsequent years is attributable to a pre-enactment interest.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

ACT Par. 9. The authority for Part 602 continues to read as follows:

Authority

26 U.S.C. 7805.

§602.101 [Amended]

Par. 10. Section 602.101(c) is amended by inserting in the appropriate places in the table "§1.469-4T(k) 1545-1037" and "§1.469-4T(o) 1545-1037". There is need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason, it is found impracticable to issue this Treasury decision with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection (d) of that section. Lawrence B. Gibbs, Commissioner of Internal Revenue. March 20, 1989. Dennis Earl Ross, Acting Assistant Secretary of the Treasury.

AGENCY

Internal Revenue Service, Treasury.

ACTION

Temporary regulations.

SUMMARY

This document contains temporary regulations relating to the requirements that must be met for an investment to qualify under section 936(d)(4) as an investment in qualified Caribbean Basin Countries. Subject to such conditions as are prescribed by regulation, funds of possessions corporations that are invested by financial institutions in active business assets or development projects in a qualified Caribbean Basin country are to be treated as used in Puerto Rico for purposes of section 936(d)(2). The regulations prescribe the conditions for such an investment to qualify as for use in Puerto Rico under section 936(d)(4). The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

EFFECTIVE DATE

This temporary regulation is to be effective for investments made by a possessions corporation in a financial institution that are used by a financial institution for investments in accordance with a specific authorization granted by the Commissioner of Financial Institutions of Puerto Rico after September 22, 1989.

FOR FURTHER INFORMATION CONTACT

Christine Halphen (202-377-9493, not a toll-free call) or W. Edward Williams (202- 287-4851, not a toll-free call) of the Office of Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224 (Attention: CC:CORP:T:R (INTL-955-86)), (202-287-4851, not a toll-free call).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

These regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under control number 1545-1138. The estimated

average annual burden per respondent/recordkeeper is 30 hours depending on individual circumstances. These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances. For further information concerning this collection of information, where to submit comments on this collection of information, the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble to the cross-reference notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

Background

This document contains temporary Income Tax Regulations (26 CFR part 1) under section 936(d)(4) of the Internal Revenue Code of 1986, which section was enacted by section 1231(c) of the Tax Reform Act of 1986 (100 Stat. 2085). Need for Temporary Regulations Guidance as to the requirements that must be met for an investment by a possessions corporation to qualify under section 936(d)(4) is needed as soon as possible in order to assist the making of loans under the Caribbean Basin initiative program. Therefore, good cause is found to dispense with the notice and public procedure requirements of 5 U.S.C. 553(b) and the delayed effective date requirement of 5U.S.C.553(d). Explanation of Provision Section 1231(c) of the Tax Reform Act of 1986, Public Law 99-514 (Oct. 22, 1986), expands the definition of qualified possessions source investment income ("QPSII") by adding section 936(d)(4) to the Internal Revenue Code, effective for taxable years beginning after December 31, 1986. The purpose of the amendment is primarily to help promote economic development in qualified countries in the Caribbean region by allowing funds of possessions corporations to be invested not only in the U.S. possession where the possessions corporation conducts its business, but also, after 1986, in business and development projects in those Caribbean countries. The provision is essentially targeted to possessions corporations operating in Puerto Rico with the anticipation that it will help make new funds available for qualified Caribbean projects at reasonable rates of interest, reflecting the quasi-tax exemption granted to QPSII (by reason of the U.S. possessions tax credit under section 936 of the Code and substantial tax exemptions in Puerto Rico). The provision originated in the House Ways and Means Committee, and the Committee's Report indicates that the Government of Puerto Rico will make a good faith effort to commit $100 million annually of new funds for private direct investment in qualified Caribbean countries. Furthermore, the Committee's Report, as well as the Report of the Conference Committee, anticipates that the funds for investment are to be made available, without additional cost to the United States, from a variety of sources including possessions corporations (in exchange for future Puerto Rican tax concessions), Government Development Bank funds, and grants by the Government

of Puerto Rico. See H. Rep. No. 99-426, 99th Cong., 1st Sess. 413, 420 (Dec. 7, 1985); and H. Rep. No. 99-841, Vol. II, 99th Cong., 2d Sess. 631, 632 (Sept. 18, 1986). Section 936(d) of the Internal Revenue Code defines QPSII generally as gross income that a possessions corporation derives from sources within the U.S. possession in which it conducts an active trade or business and that is attributable to the investment in such possession, for use therein, of the possessions corporation's funds. Thus, the passive investment income of a possessions corporation that conducts an active trade or business in Puerto Rico would qualify as QPSII only if the income is from sources within Puerto Rico and the funds invested by the possessions corporation are for use in Puerto Rico. New section 936(d)(4), enacted by the Tax Reform Act of 1986, expands the definition of QPSII by providing, in substance, that an investment in a financial institution will, subject to such conditions as the Secretary of the Treasury prescribes pursuant to regulations, be treated as used in Puerto Rico to the extent used by such financial institution for investment in accordance with the goals and purposes of the Caribbean Basin Economic Recovery Act (Pub. L. 98-67 (Aug. 5, 1983), 97 Stat. 384, 19 U.S.C. 2701 et seq.), in active business assets or development projects in a qualified Caribbean Basin country. Regulations will be issued under section 936(d)(2) regarding the applicable rules for determining the source of income from investments made by a possessions corporation. It is anticipated that such regulations will reflect the previously stated position that income from section 936 funds made available for a qualified CBI investment through loans from a possessions corporation to a Puerto Rican financial institution which would then loan the funds on substantially identical terms to certain CBI obligors will be treated as Puerto Rican source income for purposes of determining whether such income qualifies as QPSII. See letter from the Assistant Secretary for Tax Policy of the Treasury Department to Congressma n Charles Rangel, dated August 24, 1988. Section 1.936-10T(c) of the temporary regulation provides guidance with respect to section 936(d)(4), principally in terms of the requirements for investments to qualify under section 936(d)(4) and certain certification and due diligence requirements. Paragraph (c)(1) outlines the general requirements for an investment to be a qualified investment for purposes of section 936(d)(4): (1) The investment is a loan made out of the possessions corporation's qualified funds; (2) the loan is made by a qualified financial institution; (3) the loan is made to a qualified recipient for investment in active business assets or a development project in a qualified Caribbean Basin country; (4) the investment is authorized by the Commissioner of Financial Institutions of Puerto Rico under regulations issued by such Commissioner; and (5) the qualified recipient and the qualified financial institution comply with certain certification, agreement, and due diligence requirements. Paragraph (c)(2) makes clear that an investment that qualifies for purposes of section 936(d)(4) when made must continue to meet the qualification requirements in order to retain its qualified status. However, substantial compliance rules are provided that allow correction of a failure to comply within a reasonable period of time after such failure is, or should have been, discovered. Also, failure to comply with due diligence requirements does not automatically disqualify an investment if the failure is due to reasonable cause and the financial institution or the qualified recipient can establish that the funds were properly invested.

Paragraph (c)(3) defines "qualified financial institution" as any entity that both qualifies as a banking, financing or similar business under §1.864-4(c)(5)(i) of the Treasury Regulations and is an "eligible institution", as defined in section 4.2.13 of Regulation No. 3582 promulgated by the Office of the Commissioner of Financial Institutions in Puerto Rico to regulate those institutions that are eligible to pay tax-exempt interest under the Puerto Rico Industrial and Tax Incentive Acts. Generally, an eligible institution is a depositary institution that is regulated by the Office of the Commissioner of Financial Institutions and other banking authorities in Puerto Rico and is authorized by the Commissioner of Financial Institutions to receive certain funds from exempted businesses (including from possessions corporations) pursuant to regulation No. 3582. The term "qualified financial institution" also includes the Government Development Bank for Puerto Rico, the Puerto Rico Economic Development Bank, as well as any other entity which the Internal Revenue Service may determine to be a qualified financial institution. A qualified financial institution does not include a branch that a Puerto Rican bank or other financial institution may maintain outside of Puerto Rico. Paragraph (c)(4) defines an investment in active business assets generally as a loan to a qualified recipient for the acquisition, construction, rehabilitation, improvement, upgrading or expansion by the qualified recipient of qualified assets for use by the recipient in a qualified business activity and for the financing of expenditures incidental to such acquisition. The qualified recipient must own the qualified assets rather than lease or license them. Qualified assets are: (1) Newly constructed or improved real property; (2) tangible personal property (including capital expenditures for the reconditioning, upgrading, transformation or improvement of any tangible personal property), provided such tangible personal property is either new property or used property that at no time during the preceding 5-year period was used in a business activity in the qualified Caribbean Basin country in which the property is to be used; (3) intangible property rights (not including U.S. rights or rights acquired from a related person), provided the rights were at no time during the preceding 5-year period used in a business activity in the qualified Caribbean Basin country in which the property is to be used; and (4) exploration and development expenditures relating to oil, gas or mineral deposits. The regulations leave open the possibility for the Service to qualify other assets either by way of published rulings or private letter rulings. Paragraph (c)(4)(iii) defines incidental expenditures as expenditures associated with placing qualified assets in service, including reasonable costs associated with arranging the financing of the investment and de minimis amounts for working capital requirements and the refinancing of existing debt. Paragraph (c)(4)(iv) defines a qualified business activity as a lawful industrial or commercial activity that is conducted as an active trade or business (using standards similar to those described in §1.367-2T(b) (2) and (3)) in a qualified Caribbean Ba sin country. A trade or business is generally defined in reference to various business classifications used in the 1987 Standard Industrial Classification Manual. Paragraph (c)(5) defines an investment in a development project generally as an investment in qualified assets for use in either a facility in a qualified Caribbean Basin country that either supports local economic development and satisfies a public use requirement or supports the performance in a qualified Caribbean Basin country of a non-commercial governmental function (other than military activities).

Paragraph (c)(6) contains temporary period rules that specify the time limits within which loan or bond proceeds disbursed to a qualified recipient must be used to pay for the costs of the investment in qualified business assets or the development project. Generally, loan or bond proceeds must be invested within six months of disbursement or date of issue. A longer temporary period is allowed under paragraph (c)(6)(ii) in the case of a construction project or a long-term contract that is financed out of bond proceeds. In that case, the temporary period is as long as is reasonably required to complete the project or contract, based upon a plan filed with, and approved by, the Commissioner of Financial Institutions of Puerto Rico prior to the date of issue. Rules are also provided in paragraph (c)(6)(iv) concerning the investment of loan or bond proceeds during a temporary period. Generally, the loan or bond proceeds may be held in unrestricted yield investments during the six-month period beginning with the date of disbursement of loan proceeds to the borrower or the date of issue, but the investments must give rise to income sourced in Puerto Rico or in the Caribbean Basin country in which the investment is made. Any bond proceeds allowed to be held beyond the six-month period must be invested in eligible activities in Puerto Rico, as defined under Puerto Rican Regulation No. 3582. Paragraph (c)(7) contains rules regarding the replacement of temporary financing with permanent financing that qualifies for QPSII treatment and the refunding of existing QPSII-qualified bond issues or loan arrangements. Paragraph (c)(8) contains miscellaneous operating rules, including rules concerning the use of a financial intermediary other than a qualified financial institution to loan funds to a qualified recipient for an investment in active business assets or in a development project. Paragraph (c)(9) defines a qualified recipient as a person described in section 7701(a)(1) of the Code that is engaged in a qualified business activity or a government of a qualified Caribbean Basin country, provided such person or government complies with the agreement and representation requirements of paragraph (c)(11). Paragraph (c)(10) defines an investment in a qualified Caribbean Basin country generally as an investment in an active business asset or a development project located or used in the qualified Caribbean Basin country. A qualified Caribbean Basin country is defined as the U.S. Virgin Islands and any beneficiary country that meets the requirements of section 274(h)(6)(A) (i) and (ii), and includes the territorial waters and continental shelf thereof. The balance of the temporary regulation deals with the agreements and representations required of qualified recipients and qualified financial institutions, including the certification requirement in section 936(d)(4)(C)(i) and the due diligence requirements imposed upon qualified financial institutions. The due diligence requirements in the temporary regulation are based on requirements in regulations promulgated by the Puerto Rican government. The temporary regulations contain no special provisions regarding the funding of privatization transactions. Comments are solicited as to the circumstances in which

funding of a privatization should qualify as an investment in active business assets as opposed to a mere refinancing of existing investments.

Special Analyses

It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required.

Drafting Information

The principal authors of these regulations are Christine Halphen and W. Edward Williams of the Office of the Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service. Other personnel from offices of the Internal Revenue Service and the Treasury Department participated in developing these regulations. List of Subjects in 26 CFR 1.861-1 Through 1.997-1 Income taxes, Corporate deductions, Aliens, Exports, DISC, Foreign investment in U.S., Foreign tax credit, FSC, Sources of income, U.S. investments abroad. 26 CFR Part 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows: Income Tax Regulations

PART 1-[AMENDED]

Paragraph 1. The authority for part 1 continues to read in part:

Authority

26 U.S.C. 7805. Par. 2. New §§1.936-8T and 1.936-9T are added and reserved immediately following §1.936-7 to read as follows. New §1.936-10T is added immediately following those sections to read as set forth below.

§1.936-8T. Qualified possession source investment income (Temporary

regulations). [Reserved]

§1.936-9T. Source of qualified possession source investment income

(Temporary regulations). [Reserved]

§1.936-10T. Qualified investments (Temporary regulations).

(a) In general. [Reserved] (b) Qualified investments in Puerto Rico. [Reserved] (c) Qualified investment in certain Caribbean Basin countries-(1) General rule. An investment of qualified funds described in §1.936-10T shall be treated as a qualified investment of funds for use in Puerto Rico if the funds are used for a qualified investment in a qualified Caribbean Basin country. A qualified investment in a qualified Caribbean Basin country is a loan of qualified funds by a qualified financial institution (described in paragraph (c)(3) of this section) to a qualified recipient (described in paragraph (c)(9) of this section) for investment in active business assets (as defined in paragraph (c)(4) of this section) in a qualified Caribbean Basin country (described in paragraph (c)(10)(ii) of this section) or for investment in development projects (as defined in paragraph (c)(5) of this section) in a qualified Caribbean Basin country, provided- (i) The investment is authorized, prior to disbursement of the funds, by the Commissioner of Financial Institutions of Puerto Rico pursuant to regulations issued by such Commissioner; and (ii) The agreement, representation, certification, and due diligence requirements under paragraphs (c)(11), (c)(12), and (c)(13) of this section are complied with. (2) Termination of qualification-(i) In general. An investment that, at any time after having met the requirements for a qualified investment in a qualified Caribbean Basin country under the terms of this paragraph (c), fails to meet any of the conditions enumerated in this paragraph (c) shall no longer be considered a qualified investment in a qualified Caribbean Basin country from the time of such failure, unless the investment satisfies the requirements for substantial compliance described in paragraph (c)(2)(ii) of this section. Such a failure includes, but is not limited to, the occurrence of any of the following events: (A) Active business assets ceasing to qualify as such; (B) Proceeds from the investment being diverted for the financing of assets, projects, or operations that are not active business assets or development projects or are not the assets or the project of the qualified recipient; (C) The qualified recipient's qualified business activity ceasing to qualify as such; or (D) The qualified Caribbean Basin country ceasing to be a country described in paragraph (c)(10)(ii) of this section. (ii) Substantial compliance-(A) In general. Substantial compliance with the requirements of this paragraph (c) shall be satisfied if the event or events that cause disqualification of the investment are corrected within a reasonable period of time.

For purposes of this section, a reasonable period of time shall not exceed 60 days after such event or events come to the attention of the qualified recipient or the qualified financial institution or should have come to their attention by the exercise of reasonable diligence. (B) Due diligence requirements. Substantial compliance with the due diligence requirements of paragraphs (c)(11), (c)(12), and (13) of this section shall be satisfied if the failure to comply is due to reasonable cause and, upon request of the Commissioner of Financial Institutions of Puerto Rico or of the Assistant Commissioner (International) (or his authorized representative), the qualified financial institution, the financial intermediary, or the qualified recipient establishes to the satisfaction of the Commissioner of Financial Institutions of Puerto Rico or of the Assistant Commissioner (International) (or his authorized representative) that it has exercised due diligence in ensuring that the funds were properly disbursed to a qualified recipient and applied by or on behalf of such qualified recipient to uses that qualify the investment as an investment in qualified business assets or a development project under the provisions of this paragraph (c). (iii) Assumption. An investment shall not cease to qualify merely because the qualified recipient's obligation to the qualified financial institution (or to a financial intermediary, if any) is assumed by another person provided such other person assumes the qualified recipient's agreement and representation requirements under paragraph (c)(11)(i) of this section and is either- (A) A qualified recipient on the date of assumption, in which case such person shall be treated for purposes of this section as the original qualified recipient and shall be subject to all the requirements of this section for continued qualification of the loan as a qualified investment in a qualified Caribbean Basin country; or (B) An international organization, the principal purpose of which is to foster economic development in developing countries and which is described in section 1 of the International Organizations Immunities Act (22 U.S.C. 288), if the assumption of the obligation is pursuant to a bona fide guarantee agreement. (3) Qualified financial institution-(i) General rule. For purposes of section 936(d)(4)(A) and this section, a qualified financial institution includes only- (A) A banking, financing, or similar business defined in §1.864-4(c)(5)(i) that is an eligible institution described in subdivision (ii) of this paragraph (c)(3), but not including branches of such institution outside of Puerto Rico; (B) The Government Development Bank for Puerto Rico; (C) The Puerto Rico Economic Development Bank; and (D) Such other entity as may be determined by the Commissioner by notice or other guidance published in the Internal Revenue Bulletin or by ruling issued to an entity which establishes its eligibility. A ruling request from an entity pursuant to this paragraph (c)(3) must set forth sufficient information to establish that the entity is in substance,

purpose, and operation a financial institution of the type referred to in paragraph (c)(3)(i) (A), (B), or (C) of this section. (ii) Eligible institution. An eligible institution means an institution- (A) That is organized under the laws of the Commonwealth of Puerto Rico or is the Puerto Rican branch of an institution organized under the laws of another jurisdiction if such branch is engaged in a banking, financing, or similar business defined in §1.864-4(c)(5)(i), and (B) That qualifies as an eligible institution under section 4.2.13 of Regulation No. 3582 issued by the Commissioner of Financial Institutions of Puerto Rico (hereinafter "Puerto Rican Regulation No. 3582") or any successor thereof. (4) Investments in active business assets-(i) In general. For purposes of section 936(d)(4)(A)(i)(I) and this section and subject to the provisions of paragraph (c)(8) of this section, a loan qualifies as an investment in active business assets if- (A) The amounts disbursed under the loan to a qualified recipient are promptly applied by (or on behalf of) the qualified recipient solely for capital expenditures for the construction, rehabilitation, improvement, upgrading or expansion of qualified assets described in paragraph (c)(4)(ii) (A), (B) and (E) of this section, for the acquisition of qualified assets described in paragraph (c)(4)(ii) (B), (C) and (E) of this section, for the expenditures described in paragraph (c)(4)(ii)(D) of this section, and, if applicable, for the financing of expenditures incidental to an investment described in paragraph (c)(4)(iii)(A) of this section; (B) The qualified recipient owns the assets for United States income tax purposes and uses them in a qualified business activity; and (C) The requirements of paragraph (c)(6) and (c)(7) of this section (regarding temporary periods, financing of previous incurred costs, and the timing of disbursement of the loan or the issuance of obligations to finance an investment) are satisfied. (ii) Definition of qualified assets. For purposes of this section, qualified assets mean- (A) Real property; (B) Tangible personal property (such as raw materials, furniture, machinery, or equipment) that is not property described in section 1221(1) and that is either new property or property which at no time during the five-year period preceding the date of acquisition with the loan proceeds was used in a business activity in the qualified Caribbean Basin country in which the property is to be used; (C) Rights to intangible property that is a patent, invention, formula, process, design, pattern, know-how, or similar item, or rights under a franchise agreement, provided that such rights

(1) Were not at any time during the five-year period preceding the date of acquisition with the loan proceeds used in a business activity in the qualified Caribbean Basin country in which the rights are to be used, (2) Do not include United States rights, and (3) The qualified recipient acquiring the rights and the person from whom acquired are not related (within the meaning of section 267(b), using "10 percent" instead of "50 percent" in the places where it appears). (D) Exploration and development expenditures incurred by a qualified recipient for the purpose of ascertaining the existence, location, extent or quality of any deposit of ore, oil, gas, or other mineral in a qualified Caribbean Basin country, as well as for purposes of developing such deposit (within the meaning of section 616 of the Code and the regulations thereunder); and (E) Other assets that are not described in paragraph (c)(4)(ii) (A) through (D) of this section and that the Commissioner may, by notice or other guidance published in the Internal Revenue Bulletin or by ruling issued to a qualified financial institution or qualified recipient upon its request, determine to be qualified assets. (iii) Incidental expenditures. An amount in addition to the loan proceeds borrowed to make an investment in active business assets shall be considered an investment in active business assets if such amount is applied to finance expenditures that are incidental to making the investment in active business assets, provided such amount is disbursed at or about the same time the proceeds for making the investment in active business assets are disbursed. For purposes of this section, expenditures that are incidental to an investment in active business assets mean- (A) A reasonable amount of costs associated with arranging the financing of an investment in active business assets, not to exceed an amount described in section 147(g)(1); (B) A reasonable amount of installation costs and other reasonable costs associated with placing an active business asset in service in the qualified business activity; (C) An amount not in excess of 10 percent of the sum of the investment in active business assets and the costs described in paragraph (c)(4)(iii) (A) and (B) of this section to finance reasonable working capital requirements of the recipient's qualified business activity; and (D) An amount not in excess of 5 percent of the sum of the investment in active business assets and the costs described in paragraph (c)(4)(iii) (A) and (B) of this section for the refinancing of an existing debt of the qualified recipient if such refinancing is incidental to an investment in active business assets. (iv) Qualified business activity. A qualified business activity is a lawful industrial or commercial activity that is conducted as an active trade or business (under principles similar to those described in §1.367(a)-2T(b) (2) and (3)) in a qualified Caribbean Basin country. A trade or business for purposes of this paragraph (c)(4)(iv) is any business activity meeting the principles of section 367 of the Code and described in

Divisions A through I (excluding group 43 in Division E (relating to the United States Postal Service) and groups 84 (relating to museums, art galleries, and botanical and zoological gardens), 86 (relating to membership organizations), and 88 (relating to private households) in Division I) of the 1987 Standard Industrial Classification Manual issued by the Executive Office of the President, Office of Management and Budget, or in the comparable provisions of any successor Standard Industrial Classification Manual that is adopted by the Commissioner of Internal Revenue in a notice, regulation, or other document published in the Internal Revenue Cumulative Bulletin. (5) Investments in development projects-(i) In general. For purposes of section 936(d)(4)(A)(i)(II) and this section, and subject to the provisions of paragraph (c)(8) of this section, a loan by a qualified financial institution qualifies as an investment in a development project if- (A) The amounts disbursed under the loan are promptly applied by (or on behalf of) the qualified recipient solely for investment in qualified assets described in paragraph (c)(4)(i)(A) and in any land, buildings, or other property functionally related and subordinate to a facility described in paragraph (c)(5)(ii) of this section, determined under principles similar to those described in §1.103-8(a)(3), for use (under principles similar to those described in §1.367(a)-2T(b)(5)) in either- (1) A development project described in subdivision (ii) of this paragraph (c)(5) in a qualified Caribbean Basin country; or (2) The performance in a qualified Caribbean Basin country of a non-commercial governmental function described in paragraph (c)(5)(iv) of this section; and (B) The requirements of paragraph (c)(6) and (c)(7) of this section (regarding temporary periods, financing of previous incurred costs, and the timing of disbursement of the loan or issuance of obligations to finance a development project) are satisfied. (ii) Development project. For purposes of this paragraph (c), a development project is one or more facilities in a qualified Caribbean Basin country that support economic development in that country and that satisfy the public use requirement of paragraph (c)(5)(iii) of this section. Examples of facilities that may meet the public use requirement include but are not limited to- (A) Transportation systems and equipment, including sea, surface, and air, such as roads, railways, air terminals, runways, harbor facilities, and ships and aircraft; (B) Communications facilities; (C) Training and education facilities related to qualified business activities; (D) Industrial parks, including necessary support facilities such as roads; transmission lines for water, gas, electricity, and sewage; docks; plant sites preparations; power generation; sewage disposal; and water treatment; (E) Sports facilities;

(F) Convention or trade show facilities; (G) Sewage, solid waste, water, and electric facilities; (H) Low-income housing projects intended for occupancy by families and individuals of low or moderate income; and (I) Hydroelectric generating facilities. (iii) Public use requirement. To satisfy the public use requirement in paragraph (c)(5)(ii) of this section, a facility must serve or be available on a regular basis for general public use, as contrasted with similar types of facilities which are constructed for the exclusive use of a limited number of persons as determined under principles similar to those described in §1.103-8(a)(2). (iv) Non-commercial governmental functions. For purposes of paragraph (c)(5)(i)(B) of this section, the term "non-commercial governmental functions" refers to activities that, under U.S. standards, are not customarily attributable to or carried on by private enterprises for profit and are performed for the general public with respect to the common welfare or which relate to the administration of some phase of government. For example, the operation of libraries, toll bridges, or local transportation services, and activities substantially equivalent to those carried out by the Federal Aviation Authority, Interstate Commerce Commission, or United States Postal Service, are considered non-commercial governmental functions. For purposes of this section, non-commercial government functions shall not include military activities. (6) Rules regarding temporary period. This paragraph (c)(6) provides rules for determining whether amounts disbursed to a qualified recipient by a qualified financial institution shall be considered to have been promptly applied for the purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section. (i) Prompt application of borrowed proceeds. Except as otherwise provided in paragraphs (c)(6)(ii) and (c)(7)(iii) of this section, amounts disbursed to a qualified recipient by a financial institution shall be considered to have been promptly applied for the purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section if the requirements of this paragraph (c)(6)(i) are satisfied. (A) The amounts are fully expended by, or on behalf of, the qualified recipient for any of the purposes described in paragraph (c)(4)(i)(A) or (c)(5)(i)(A) of this section no later than 6 months from the date of such disbursement. Where the amounts disbursed to the qualified recipient are bond proceeds, the six-month period shall begin on the date of issuance of the bonds. (B) In the event the qualified financial institution invests any part of the bond proceeds during the temporary period, any proceeds from any such investment shall be paid to the qualified recipient or applied for its benefit. (ii) Special rules for construction projects or ol ng-term contracts financed out of bond proceeds. In the case of a construction project or a long-term contract described in §1.451-3(b) (1) and (2) that is financed out of bond proceeds, the six-

month period described in paragraph (c)(6)(i) of this section shall be extended with respect to the portion of such bond proceeds used to fund the construction project or the long-term contract for such reasonable period of time as shall be necessary for completion. For purposes of this paragraph (c)(6)(ii), the period of time shall be considered reasonable only if- (A) The period does not exceed three years from the date of issuance of the bonds; (B) The construction project or the long-term contract that is financed out of bond proceeds was identified as of the date of issue; (C) A construction and expenditure plan certified by an independent engineer or architect is filed with, and approved by, the Commissioner of Financial Institutions of Puerto Rico prior to the date of issue, which makes a reasonable estimate, as of the date of filing of the plan, of the amounts and uses of the bond proceeds and the time of completion, and includes a schedule of progress payments until completion; and (D) The terms of the construction and expenditure plan are disclosed in the public offering memorandum, private placement memorandum, or similar document prepared for information or disclosure purposes in relation to the issuance of bonds. (iii) Bond proceeds. For purposes of this paragraph (c), bond proceeds shall mean the proceeds from the issuance of obligations by a qualified financial institution by way of a public offering or a private placement, all or part of which are to be made available directly by the qualified financial institution to the qualified recipient for the financing of an investment in active business assets or a development project that has been identified at the time of issue and is described in a public offering memorandum, private placement memorandum, or similar document prepared for information or disclosure purposes in relation to the issuance of bonds. (iv) Temporary investments-(A) During six-month temporary period. During the six-month temporary period described in paragraph (c)(6)(i) of this section, and during the 30-day temporary period described in paragraph (c)(7)(iii)(A) of this section, loan proceeds disbursed to a qualified recipient, bond proceeds, and proceeds from the investment thereof, may be held in unrestricted yield investments provided that the income from such investments, if any, is or would be sourced either in Puerto Rico or in a country in which the investment in active business assets or development project is to be made. (B) During other temporary periods. After the expiration of the six-month or 30-day temporary period described in paragraph (c)(6)(iv)(A) of this section, any investment of bond proceeds or investment proceeds within the remainder of the period described in paragraph (c)(6)(ii) or (c)(7)(iii)(B) of this section shall be limited to investments in eligible activities. For purposes of this paragraph (c)(6)(iv)(B), the term "eligible activities" shall mean those investments described in section 6.2.4 of Puerto Rican Regulation No. 3582, as in effect on September 22, 1989. (7) Financing of previously incurred costs. This paragraph (c)(7) provides rules for determining whether loan proceeds which are disbursed after a qualified recipient has paid or incurred part or all of the costs of acquiring active business assets or

investing in a development project shall be considered to have been applied for such purposes. (i) Replacement of temporary non-qualified financing. This paragraph (c)(7)(i) prescribes the maximum time limits within which temporary nonqualified financing must be replaced. (A) In the case of the acquisition of an asset or a facility, the loan proceeds must be disbursed, or the obligations must be issued, no later than six months after the date on which the qualified recipient takes possession of the asset or the facility or, if earlier, places the asset or the facility in service. (B) In the case of a construction project or a long-term contract, the loan proceeds must be disbursed, or the obligations must be issued, no later than three years after the date on which the first payment is made toward the financeable costs of the construction project or the long-term contract, provided the authorization described in paragraph (c)(1)(i) of this section is issued by the Commissioner of Financial Institutions of Puerto Rico prior to the time of such first payment. The amount of the authorized loan or bond issue may not exceed the sum of- (1) The costs described in paragraph (c)(4)(i)(A) in the case of an investment in active business assets, or the costs described in paragraph (c)(5)(i) of this section in the case of a development project, and (2) The portion of unpaid interest accrued on prior temporary non-qualified financing through the date the qualified loan proceeds are disbursed or the qualified obligations are issued that would be required to be capitalized under U.S. tax rules. (ii) Refunding of qualified financing. A loan or bond issue used to finance a qualified investment in active business assets or in a development project described in paragraph (c)(1) of this section may be refinanced with a qualified new loan or bond issue to the extent of the remaining principal balance on such existing qualified financing, increased by the amount of unpaid interest accrued through the date the new loan proceeds are disbursed or the new obligations are issued that would be required to be capitalized under U.S. tax rules. (iii) Temporary periods-(A) In general. In the case of a loan or bond issue described in paragraph (c)(7) (i) or (ii) of this section, the temporary period described in paragraph (c)(6)(i)(A) of this section shall apply but shall be limited to 30 days from the date of disbursement of loan proceeds to the qualified recipient or from the date of issue in the case of a bond issue. (B) Special rules for construction projects or long-term contracts financed out of bond proceeds. In the case of a construction project or a long-term contract financed out of bond proceeds, the 30-day period described in paragraph (c)(7)(iii)(A) of this section shall be extended with respect to the portion of such bond proceeds used for the permanent financing of the construction project or the long-term contract for such reasonable period of time as shall be necessary for completion. For purposes of this paragraph (c)(7)(iii)(B), the period of time shall be considered reasonable only if-

(1) The period does not exceed three years from the date of issuance of the bonds; (2) A construction and expenditure plan certified by an independent engineer or architect is filed with, and approved by, the Commissioner of Financial Institutions of Puerto Rico prior to the date of issue, which makes a reasonable estimate, as of the date of issue, of the amounts and uses of the bond proceeds and the time of completion, and includes a schedule of progress payments until completion; and (3) The terms of the construction and expenditure plan are disclosed in the public offering memorandum, private placement memorandum, or similar document prepared for information or disclosure purposes in relation to the bond issue. (8) Miscellaneous operating rules-(i) Sale and leaseback. An asset that is acquired and leased back to the person from whom acquired does not constitute an investment in an active business asset. (ii) Use of asset in qualified business activity. For purposes of paragraph (c)(4)(i)(B), an asset shall be considered used or for use in a qualified business activity if it is used or for use in such activity under principles similar to those described in §1.367(a)-2T(b)(5), or a successor provision. (iii) Definition of capital expenditures. For purposes of this paragraph (c), capital expenditures mean those expenditures described in section 263(a) of the Code (without regard to paragraphs (A) through (G) of section 263(a)(1)). (iv) Loans through certain financial intermediaries. A loan by a qualified financial institution shall not be disqualified as an investment in active business assets or in a development project merely because the proceeds are first lent to a financial intermediary (as defined in paragraph (c)(8)(iv)(H) of this section) which, in turn, on-lends the proceeds directly to a qualified recipient, provided the requirements of this paragraph (c)(8)(iv) are satisfied. Similarly, a loan by a qualified financial institution shall not be disqualified as an investment in active business assets or in a development project merely because the loan transaction is processed by the central bank of issue of the country into which the loan is made pursuant to, and solely for purposes of complying with, the exchange control laws or regulations of such country. (A) The loan to the qualified recipient satisfies the requirements of paragraph (c)(4)(i) of this section in the case of an investment in active business assets, or of paragraph (c)(5)(i) of this section in the case of an investment in a development project. (B) The qualified recipient and the active business assets or development project in which the proceeds are to be invested have been identified prior to disbursement of any part of the proceeds by the qualified financial institution to the financial intermediary. (C) The effective interest rate charged by the qualified financial institution to the financial intermediary does not exceed the average interest rate paid by the qualified financial institution with respect to its eligible funds, increased by such number of basis points as is required to provide reasonable compensation to the qualified

financial institution for services performed and risks assumed with respect to the loan to the financial intermediary that are not ordinarily required to be performed or assumed with respect to a deposit, loan, repurchase agreement or other transfer of eligible funds with another qualified financial institution. The average interest rate shall be the average rate, determined on a daily basis, paid by the qualified financial institution on its eligible funds over the most recent quarter preceding the date on which the rate on the loan to the financial intermediary is committed. (D) The effective interest rate charged by the financial intermediary to the qualified recipient does not exceed the effective interest rate charged to the financial intermediary by the qualified financial institution, increased by such number of basis points as is required to provide reasonable compensation to the financial intermediary as determined by the Commissioner of Financial Institutions of Puerto Rico. (E) The financial intermediary borrows from the qualified financial institution under substantially the same terms as it lends to the qualified recipient. In particular, both loans must have disbursement terms, repayment schedules and maturity dates for interest and principal amounts such that the financial intermediary does not retain for more than 48 hours any of the funds disbursed by the qualified financial institution nor any of the funds paid by the qualified recipient in repayment of principal or interest on the loan. (F) The financial institution and the financial intermediary agree to comply with the due diligence requirements described in paragraphs (c)(11), (c)(12), and (c)(13) of this section; (G) The time periods and temporary investments rules in paragraphs (c) (6) and (7) of this section are complied with; and (H) For purposes of this paragraph (c), the financial intermediary is an active trade or business which a person maintains in a qualified Caribbean Basin country and which consists of a banking, financing or similar business as defined in §1.864- 4(c)(5)(i) (other than a central bank of issue) or is a public international organization, the principal purpose of which is to foster economic development in the Caribbean Basin beneficiary countries described in section 212(a)(1)(A) of the Caribbean Basin Economic Recovery Act, Public Law 98-67 (Aug. 5, 1983), 97 Stat. 384, 19 U.S.C. 2702(a)(1)(A) . For purposes of paragraph (c)(8)(iv) (C) and (D) of this section, the determination of whether compensation is reasonable shall be made in relation to normal commercial practices for comparable transactions carrying a similar degree of commercial, currency and political risk. Reasonable credit enhancement fees and other reasonable fees and amounts charged to the financial intermediary or the qualified recipient with respect to the loan transaction in addition to interest shall be added to the interest cost in determining the effective interest rate. (v) Privatization. [Reserved] (9) Qualified recipient. For purposes of this section, a qualified recipient is any person described in subdivision (i) or (ii) of this paragraph (c)(9). The term "person"

means a person described in section 7701(a)(1) or a government (within the meaning of §1.892-2T(a)(1)) of a qualified Caribbean Basin country. (i) In the case of an investment described in paragraph (c)(4) of this section (relating to investments in active business assets), a qualified recipient is a person that carries on a qualified business activity in a qualified Caribbean Basin country, and complies with the agreement and representation requirements described in paragraph (c)(11)(i) of this section at all times during the period in which the investment remains outstanding. (ii) In the case of an investment described in paragraph (c)(5) of this section (relating to investments in development projects), a qualified recipient is the borrower (including a person empowered by the borrower to authorize expenditures for the investment in the development project) that has authority to comply with the agreement and representation requirements described in paragraph (c)(11)(i) of this section at all times during the period in which the investment remains outstanding. (10) Investments in a qualified Caribbean Basin country-(i) Rules for determining the place of an investment. The rules of this paragraph (c)(10)(i) shall apply to determine the extent to which an investment in an active business asset or a development project will be considered made in a qualified Caribbean Basin country. (A) An investment in real property is considered made in the qualified Caribbean Basin country in which the real property is located. (B) Except as otherwise provided in this paragraph (c)(10)(i)(B), an investment in tangible personal property is considered made in a qualified Caribbean Basin country so long as the tangible personal property is predominantly used in that country. Whether property is used predominantly in a qualified Caribbean Basin country shall be determined under principles similar to those described in §1.48-1 (g)(1), (g)(2)(ii), (g)(2)(iv), (g)(2)(vi), (g)(2)(viii), and (g)(2)(x) (relating to investment tax credits for property used outside the United States) as in effect on December 31, 1986. A vessel, container, or aircraft shall be considered for use predominantly in a qualified Caribbean Basin country in any year if it is used for transport to and from such country with some degree of frequency during that year and at least 50 percent of the income from the use of such vessel, container or aircraft for that year is sourced in such country under principles similar to those described in section 863(c) (1) and (2) (relating to source rules for certain transportation income). Cables and pipelines which are permanently installed as part of a communication or transportation system between a qualified Caribbean Basin country and another country or among several countries which include a qualified Caribbean Basin country shall be considered used in a qualified Caribbean Basin country to the extent of 50 percent of the portion of the facility that directly links the qualified country to another country or to a hub, unless it is established by notice or other guidance published in the Internal Revenue Bulletin or by ruling issued to a qualified institution or qualified recipient upon request that it is appropriate to attribute a greater portion of the cost of the facility to the qualified Caribbean Basin country. (C) An investment in rights to intangible property is considered made in a qualified Caribbean Basin country to the extent such rights are used in that country. Where rights to intangible property are used shall be determined under principles similar to those described in §1.954-2T(b)(3)(vii) or a successor provision.

(ii) Qualified Caribbean Basin country. For purposes of this section, the term "qualified Caribbean Basin country" means any beneficiary country (within the meaning of section 212(a)(1)(A) of the Caribbean Basin Economic Recovery Act, Public Law 98-67 (Aug. 5, 1983), 97 Stat. 384, 19 U.S.C. 2702(a)(1)(A) ), which meets the requirements of subdivisions (i) and (ii) of section 274(h)(6)(A) and the U.S. Virgin Islands, and includes the territorial waters and continental shelf thereof. (11) Agreements and representations by qualified recipients and financial intermediaries-(i) In general. In order for an investment to be considered a qualified investment under section 936(d)(4) and paragraph (c)(1) of this section, a qualified recipient must certify to the qualified financial institution (or to the financial intermediary, if the loan is made through a financial intermediary) on the date of closing of the loan agreement and on each anniversary date thereof, that it is a qualified recipient described in paragraph (c)(9) of this section. In addition, the qualified recipient must agree in the loan agreement with the qualified financial institution (or with the financial intermediary, if the loan is made through a financial intermediary): (A) To use the funds at all times during the period the loan is outstanding solely for the purposes and in the manner described in paragraph (c)(4) of this section (regarding investment in active business assets) or in paragraph (c)(5) of this section (regarding investment in development projects); (B) To comply with the requirements of paragraph (c)(6) of this section (regarding time periods within which the funds must be invested and temporary investments) and paragraph (c)(7) of this section (regarding the time periods within which funding for investments must be secured and the refinancing of existing funding); (C) To notify the Assistant Commissioner (International), the qualified financial institution (or the financial intermediary, if the loan is made through a financial intermediary), and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to paragraph (c)(14) of this section if it no longer is a qualified recipient or if, for any other reason, the investment has ceased to qualify as a qualified investment described in paragraph (c)(1) of this section, promptly upon the occurrence of such disqualifying event; and (D) To permit examination by the office of the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all necessary books and records that are sufficient to verify that the funds were used for investments in active business assets or development projects in conformity with the terms of the loan agreement. (ii) Certification by a financial intermediary. In the case of a loan by a qualified financial institution to a financial intermediary, the financial intermediary must certify to the qualified financial institution (using the procedures described in paragraph (c)(11)(i) of this section) that it is a financial intermediary described in paragraph (c)(8)(iv)(H) of this section, and must furnish to the qualified financial institution a copy of the qualified recipient's certification described in paragraph (c)(11)(i) of this section and of its loan agreement with the qualified recipient. In addition, the financial intermediary must agree in the loan agreement with the qualified financial institution:

(A) To comply with the requirements of paragraph (c)(8)(iv) of this section; and (B) To permit examination by the office of the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all its necessary books and records that are sufficient to verify that the funds were used in conformity with the terms of the loan agreements. (12) Certification requirements. In order for an investment to be considered a qualified investment under section 936(d)(4), section 936(d)(4)(C)(i) requires that both the person in whose trade or business such investment is made and the financial institution certify to the Secretary of the Treasury and the Commissioner of Financial Institutions of Puerto Rico that the proceeds of the loan will be promptly used to acquire active business assets or to make other authorized expenditures. This certification requirement is satisfied as to the qualified financial institution, the financial intermediary (if any), and the qualified recipient if the qualified financial institution submits a certificate to both the Assistant Commissioner (International) and to the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to paragraph (c)(14) of this section upon authorization of the investment by the Commissioner of Financial Institutions and, in any event, prior to the first disbursement of the loan proceeds to the qualified recipient or to the financial intermediary (if any), in which the qualified financial institution- (i) Represents that, as of the date of the certification, the qualified recipient and the financial intermediary (if any) have complied with the requirements described in paragraph (c)(11) of this section; (ii) Describes the important terms of the loan to the financial intermediary (if any) and to the qualified recipient, including the amount of the loan, the nature of the investment, the basis for its qualification as an investment in active business assets or a development project under this section, the identity of the financial intermediary (if any) and of the qualified recipient, the qualified Caribbean Basin country involved, and the nature of the collateral used, including any guarantee; and (iii) Agrees to permit examination by the Assistant Commissioner (International) (or by the office of any District Director authorized by the Assistant Commissioner (International)) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) of all its necessary books and records that are sufficient to verify that the funds were used for investments in active business assets or development projects in conformity with the terms of the loan agreement or agreements with the financial intermediary (if any) and with the qualified recipient. (13) Continuing due diligence requirements. In order to maintain the qualification for an investment under paragraph (c)(1) of this section, the continuing due diligence requirements described in this paragraph (c)(13) must be satisfied. (i) Requirements of qualified recipient. A qualified recipient must- (A) Submit annually to the qualified financial institution or to the financial intermediary from which its qualified funds were obtained a copy of its most recent annual financial statement accompanied by an opinion of its independent auditors

disclosing the amount of the loan, the current outstanding balance of the loan, describing the assets financed with such loan and the qualified business activity in which such assets are used or the development project for which the loan is used, and stating that there are no reasons to doubt that the loan proceeds have been properly used and continue to be properly used, and (B) Act in a manner consistent with its representations and agreements described in paragraph (c)(11) of this section. (ii) Requirements of qualified financial institutions. Except as otherwise provided in paragraph (c)(13)(iii) of this section, a qualified financial institution described in paragraph (c)(3) of this section must maintain in its records and have available for inspection the documentation described in paragraph (c)(13)(ii) (A) or (B) of this section. In addition, the qualified financial institution is required to notify the Assistant Commissioner (International) and the Commissioner of Financial Institutions of Puerto Rico (or his delegate) pursuant to paragraph (c)(14) of this section upon becoming aware that a loan has ceased to be an investment in active business assets or a development project under this section. For purposes of this paragraph (c)(13)(ii), multiple loans for investment in a single qualified business activity or development project will be aggregated in determining what due diligence requirements apply. (A) In the case of a disbursement to a qualified recipient of loan proceeds amounting in the aggregate, at any time, to $1,000,000 or less, the following documents must be maintained and available for inspection: (1) The loan application or other similar document; (2) The financial statements of the qualified recipient filed as part of the loan application; (3) The statement required by section 6.4.3(a)(iii) of Puerto Rican Regulation No. 3582 or any successor thereof, signed by the qualified recipient (or its duly authorized representative), acknowledging the receipt of the loan proceeds, describing the assets financed with such loan and the business activity in which such assets are to be used or the development project for which the funds will be utilized, the collateral to be provided for the transaction including any guarantee, and the basis for its qualification as a qualified recipient; and (4) The loan documents, if any. (B) In the case of a disbursement to a qualified recipient of loan proceeds amounting in the aggregate, at any time, to more than $1,000,000, the following documents must be maintained and available for inspection, in addition to the documents required by paragraph (c)(13)(ii)(A) of this section: (1) A memorandum of credit prepared and signed by an officer of the qualified financial institution containing the details of the investigation and review that it conducted in order to evaluate whether the investment is qualified under paragraph (c)(1) of this section and his opinion that there is no reasonable ground for belief that the qualified funds will be diverted to a use that is not permitted under the

provisions of this section; in making this investigation and review, factors that must be utilized are ones similar to those listed in Puerto Rico Regulation No. 3582, section 6.4.2; (2) The annual financial statement of the qualified recipient; and (3) The written report of an officer of the qualified financial institution documenting his discussions, both before and after the disbursement of the loan proceeds, with each recipient's accounting, financial and executive personnel with respect to the proposed and actual use of the loan proceeds and his analysis of the annual financial statements of the qualified recipient including an analysis of the statement of sources and uses of funds. After the loan disbursement, such discussions and review shall occur annually during the term of the loan. Such report shall include the conclusion that in such officer's opinion there is no reasonable ground for belief that the qualified recipient is improperly utilizing the funds. (iii) Requirements in the case of a financial intermediary. Where a qualified financial institution lends funds to a financial intermediary which are on-lent to a qualified recipient- (A) The obligation to maintain the documentation described in paragraph (c)(13)(ii) (A) or (B) of this section shall apply only to the financial intermediary and not to the qualified financial institution and the provisions of paragraph (c)(13)(ii) (A) or (B) shall be read so as to impose on the financial intermediary any obligation imposed on the qualified financial institution. (B) The financial intermediary shall forward annually to the qualified financial institution a copy of the documentation it is required to maintain in its records pursuant to the provisions of this paragraph (c)(13)(iii) and shall notify the Assistant Commissioner (International), the Commissioner of Financial Institutions of Puerto Rico (or his delegate), and the qualified financial institution pursuant to paragraph (c)(14) of this section upon becoming aware that a loan has ceased to be an investment in active business assets or a development project under this section. The qualified financial institution must maintain in its records and have available for inspection the copied documentation furnished by the financial intermediary pursuant to this paragraph (c)(13)(iii)(B). (C) The qualified financial institution shall cause one of its officers to prepare a written report documenting his analysis of the copied documentation furnished by the financial intermediary pursuant to paragraph (c)(13)(iii)(B) of this section, his discussions, both before and after the disbursement of the loan proceeds, with the financial intermediary's accounting, financial and executive personnel with respect to the proposed and actual use of the loan proceeds, and his analysis of the annual financial statements of the qualified recipient including an analysis of the statement of sources and uses of funds. After the loan disbursement, such discussions and review shall occur annually during the term of the loan. Such report shall include the conclusion that in such officer's opinion there is no reasonable ground for belief that the qualified recipient is improperly utilizing the funds. (14) Procedures for notices and certifications. Notices and certifications to the Assistant Commissioner (International) required under paragraphs (c)(11), (c)(12) and (c)(13) of this section shall be addressed to the attention of the Assistant

Commissioner (International), Office of Taxpayer Service and Compliance, IN:C, 950 L'Enfant Plaza South, SW., Washington, DC 20024. Notices and certifications to the Commissioner of Financial Institutions of Puerto Rico required under paragraphs (c)(11), (c)(12), and (c)(13) of this section shall be addressed as follows: Commissioner of Financial Institutions, GPO Box 70324, San Juan, Puerto Rico 00936. (15) Effective dates. This paragraph (c) is effective for investments by a possessions corporation in a financial institution that are used by a financial institution for investments in accordance with a specific authorization granted by the Commissioner of Financial Institutions of Puerto Rico after September 22, 1989. OMB Control Numbers Under the Paperwork Reduction Act

PART 602-[AMENDED]

Par. 3. The authority for part 602 continues to read as follows:

Authority

26 U.S.C. 7805.

§602.101 [Amended]

Par. 4. Section 602.101(c) is amended by inserting in the appropriate place in the table: "1.936-10T(c).......... 1545-1138." Fred T. Goldberg, Jr., Commissioner of Internal Revenue. Approved: August 28, 1989. Kenneth W. Gideon, Assistant Secretary of the Treasury.

May 23, 1990

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final regulations concerning the low-income housing credit for certain Federally-assisted buildings under section 42 of the Internal Revenue Code of 1986, as enacted by section 252 of the Tax Reform Act of 1986 and, as amended by sections 1002(1) and 4003 of the Technical and Miscellaneous Revenue Act of 1988. The changes to section 42 under section 7108 of the Omnibus Reconciliation Act of 1989 are not reflected in these final regulations but will be the subject of a separate notice of proposed rulemaking. The regulations provide guidance concerning the low-income housing credit allowable for certain Federally-assisted buildings acquired during a 10-year period.

EFFECTIVE DATE

The regulations are effective January 1, 1987.

FOR FURTHER INFORMATION CONTACT

Susan Reaman, 202-377-6349 (not a toll-free number).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1005. The estimated average burden associated with the collection of information in this final rule is 3 hours per respondent or recordkeeper. These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents or recordkeepers may require greater or less time, depending upon their particular circumstances. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Office of Management and Budget, Paperwork Reduction Project, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer TR:FP, Washington, DC 20224.

Background

On November 3, 1987, the Federal Register published a notice of proposed rulemaking (52 FR 42116) by cross reference to temporary regulations published the same day (52 FR 42098) under section 42 of the Internal Revenue Code of 1986. A number of public comments were received concerning these regulations, and a public hearing was held on March 17, 1988. After consideration of the written comments and those presented at the hearing, the proposed regulations are adopted as revised by this Treasury decision.

Explanation of Provisions

Section 252 of the Tax Reform Act of 1986 (100 Stat. 2189) as amended by sections 1002(1) and 4003 of the Technical and Miscellaneous Act of 1988 (102 Stat. 3373, 3643) enacted a new low-income housing credit under section 42 of the Internal Revenue Code of 1986. The credit is equal to the applicable percentage of the qualified basis of each qualified low-income building. The temporary regulations published in the Federal Register on November 3, 1987, provide guidance with respect to the credit allowable for certain Federally-assisted buildings acquired during a 10-year period. The low-income housing credit is available to the acquirer of a qualified low-income building for which a special waiver is granted by the Internal Revenue Service in order to avert an assignment of the mortgage secured by the building to the Department of Housing and Urban Development or the Farmers' Home Administration, or to avert a claim against a Federal mortgage insurance fund with respect to a mortgage which is so secured.

Public Comment

Several commentators suggested that the waiver under section 42(d)(6) should apply to a project, as well as a building. In response to this comment, proposed §1.42-2(d)(3) has been revised to indicate that a single waiver application can be filed for a project consisting of multiple buildings as long as the information required for each building is identified by building address. Proposed §1.42-2(d)(3) has also been revised to indicate that a waiver application can be filed for specific buildings that are Federally-assisted in a project consisting of multiple buildings that may or may not be Federally-assisted. Several commentators requested that the certification that Federal mortgage funds are at risk should come from the Federal agency, rather than the taxpayer. This suggestion has been adopted, and proposed §1.42-2(c)(3) has been revised to indicate that the Federal agency is to provide such certification in the form of a letter or other written statement made or received and approved by the national office of the Federal agency. Several commentators contended that it is unclear what documentation taxpayers must provide to evidence the specified Federal agency action that must have been taken to demonstrate that a waiver is necessary to avert Federal mortgage funds being at risk. In response to this, proposed §1.42-2(c)(3) has been revised to indicate that a letter or other written statement made or received and approved by the national office of the Federal agency is sufficient specified Federal agency action.

Several commentators urged that a building should qualify as troubled if it shows a history of financial distress, whether or not the owner has defaulted on a mortgage payment. In response, the proposed rule has been revised to indicate that designation of troubled status must be based on a review by the Federal agency of the financial condition of the building or project and on a determination by the agency of a history of financial distress or mortgage defaults. See §1.42- 2(c)(3)(ii)(D). A commentator urged that the granting of a waiver under section 42(d)(6)(A) should be contingent on approval by the Federal agency of the past performance of the current owner/seller of the building or project. Because the Federal agency already has the ability to take this factor into account under proposed §1.42-2(c)(3) (relating to action by the Department of Housing and Urban Development or the Farmers' Home Administration), this comment is not specifically incorporated in the final regulations. A commentator requested that the waiver under section 42(d)(6) should be available where a change in ownership is being forced due to conditions beyond the control of the owner of the building or project, such as death or bankruptcy. Under section 42(d)(6)(A) and proposed §1.42-2(c)(3) the Federal agency already has sufficient latitude to consider circumstances such as death or bankruptcy. Therefore, the final regulations do not specifically adopt this recommendation. A commentator stated that proposed §1.42-2(a) should explicitly reference section 42(d)(2)(A)(i)(II) which permits the inclusion in eligible basis of amounts chargeable to capital account and incurred by the taxpayer (before the close of the 1st taxable year of the credit period for such building) for property (or additions or improvements to property) of a character subject to the allowance for depreciation. In response to this comment, proposed §1.42-2(a) has been revised to contain a reference to determining eligible basis under section 42(d)(2). A commentator recommended adding language to proposed §1.42-2(c)(4) (relating to the waiver requirement that no prior owner was allowed a low-income housing credit for the building) to cover situations where the building or project is acquired after the end of the 15-year compliance period in section 42(i)(1). This recommendation has not been adopted since section 42(n) provides that the State housing credit ceiling is zero for any calendar year after 1989. A commentator requested that since the existence of a mortgage is a prerequisite to a waiver application, proposed §1.42-2(d)(2)(ix) should change the phrase "any outstanding mortgage" to "the outstanding mortgage" and delete the phrase "if any,". The proposed rule has been clarified in response to this request. See §1.42- 2(d)(2)(vii). A commentator requested clarification concerning the effective date of a waiver. In response to this, proposed §1.42-2(d)(4) has been clarified to state that the waiver is effective when granted by the Internal Revenue Service. Previously, it was stated that a waiver will be effective when granted but in no event later than 60 days after a taxpayer files a substantially complete application for waiver. Some taxpayers believed this language granted an automatic waiver, if a waiver was not granted within 60 days. The intent behind the 60 day period was that if a waiver was granted after the expiration of 60 days from the date the application was filed, the waiver

would be effective starting 60 days after the filing date. Given this confusion, the 60 day language has been deleted from the proposed §1.42-2(d)(4). Several commentators urged that non-Federally-assisted buildings or projects should be eligible for the waiver of the 10-year rule under section 42(d)(6). This suggestion has not been adopted because only a Federally-assisted building, as defined in section 42(d)(6)(B), is eligible to apply for the waiver. Several commentators contended that buildings or projects that have already been foreclosed upon by the Department of Housing and Urban Development or the Farmers' Home Administration should be eligible for the waiver of the 10-year rule under section 42(d)(6). This suggestion has not been adopted as it is inconsistent with the section 42(d)(6)(A) requirement that a waiver be necessary "to avert an assignment of the mortgage" or "to avert a claim against a Federal mortgage insurance fund". Several commentators stated that the regulations should address "other circumstances of financial distress" contained in section 42(d)(6)(A)(iii) with respect to eligibility for waiver of the 10-year rule contained in section 42(d)(2)(B)(ii). Section 42(d)(6)(A)(iii) was eliminated by the Technical and Miscellaneous Revenue Act of 1988. The Internal Revenue Service also invited public comments on any other issues arising under section 42 with respect to which guidance is needed. A number of comments were received, and, while those comments are not discussed in this Treasury decision, they will be taken into account in promulgating other regulations under section 42. The Internal Revenue Service appreciates the submission of those comments.

Special Analyses

The Commissioner of Internal Revenue has determined that this final rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required. Although a notice of proposed rulemaking that solicited public comment was issued, the Internal Revenue Service concluded when the notice was issued that the regulations are interpretative and that the notice and public procedure requirements of 5 U.S.C. 553 did not apply. Accordingly, the final regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6).

Drafting Information

The principal author of these regulations is Susan Reaman of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries) Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and the Treasury Department participated in developing the regulations on matters of both substance and style.

List of Subjects

26 CFR 1.0-1 through 1.58-8 Income taxes, Tax liability, Tax rates, Credits. 26 CFR 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations The amendments to 26 CFR parts l and 602 are as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

1986 Paragraph 1. The authority for part 1 is amended by adding the following citation:

Authority

26 U.S.C. 7805. Section 1.42-2 also issued under 26 U.S.C. 42(m).

§1.42-1 [Removed and reserved]

Par. 2 New §§1.42-0 and 1.42-2 are added in the appropriate place and §1.42-1 is removed and reserved. The added provisions read as follows:

§1.42-0 Table of contents.

This section lists the paragraphs contained in §§1.42-1 and 1.42-2.

§1.42-1 [Reserved]

§1.42-2 Waiver of requirement that an existing building eligible for the low-income housing credit was last placed in service more than 10 years prior to acquisition by the taxpayer. (a) Low-income housing credit for existing building (b) Waiver of 10-year holding period requirement (c) Waiver requirements (1) Federally-assisted building (2) Federal mortgage funds at risk (3) Statement by the Department of Housing and Urban Development or the Farmers' Home Administration

(4) No prior credit allowed (d) Application for waiver (1) Time and manner (2) Information required (3) Other rules (4) Effective date of waiver (5) Attachment to return (e) Effective date of regulations

§1.42-1 [Reserved]

§1.42-2 Waiver of requirement that an existing building eligible for the low-income housing credit was last placed in service more than 10 years prior to acquisition by the taxpayer. (a) Low-income housing credit for existing building. Section 42 provides that, for purposes of section 38, new and existing qualified low-income buildings are eligible for a low-income housing credit. The eligibility rules for new and existing buildings differ. Under section 42(d)(2), an existing building may be eligible for the low-income housing credit based upon the acquisition cost and amounts chargeable to capital account (to the extent properly included in eligible basis) if- (1) The taxpayer acquires the building by purchase (as defined in section 179(d)(2), as applicable under section 42(d)(2)(D)(iii)(I)), (2) There is a period of at least 10 years between the date of the building's acquisition by the taxpayer and the later of-(i) The date the building was last placed in service, or (ii) The date of the most recent nonqualified substantial improvement of the building, and (3) The building was not previously placed in service by the taxpayer, or by a person who was a related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the building was last previously placed in service. (b) Waiver of 10-year holding period requirement. Section 42(d)(6) provides that a taxpayer may apply for a waiver of the 10-year holding period requirement specified in paragraph (a)(2) of this section. The Internal Revenue Service will grant a waiver only if- (1) The existing building satisfies all of the requirements in paragraph (c) of this section, and

(2) The taxpayer makes an application in conformity with the requirements in paragraph (d) of this section. (c) Waiver requirements-(1) Federally-assisted building. To satisfy the requirement of this paragraph, a building must be a Federally-assisted building. The term "Federally assisted building" means any building which is substantially assisted, financed, or operated under section B of the United States Housing Act of 1937, section 221(d)(3) or 236 of the National Housing Act, or section 515 of the Housing Act of 1949, as such acts were in effect on October 22, 1986. (2) Federal mortgage funds at risk. To satisfy the requirement of this paragraph, Federal mortgage funds must be at risk with respect to a mortgage that is secured by the building or a project of which the building is a part. For purposes of this paragraph, Federal mortgage funds are at risk if, in the event of a default by the mortgagor on the mortgage secured by the building or the project of which the building is a part- (i) The mortgage could be assigned to the Department of Housing and Urban Development or the Farmers' Home Administration, or (ii) There could arise a claim against a Federal mortgage insurance fund (or such Department or Administration). (3) Statement by the Department of Housing and Urban Development or the Farmers' Home Administration. (i) To satisfy the requirement of this paragraph, a letter or other written statement must be made or received and approved by the national office of the Department of Housing and Urban Development or the Farmers' Home Administration ("the Federal agency"). This letter or statement shall include the following: (A) A statement that, as of the earlier of the time of the taxpayer's acquisition of the building or the taxpayer's application for a waiver, the building is a Federally-assisted building within the meaning of paragraph (c)(1) of this section and identifies the source of Federal assistance; (B) A statement that a waiver of the 10-year holding period requirement is necessary to avert Federal mortgage funds being at risk within the meaning of paragraph (c)(2) of this section; and (C) A statement that the Federal agency has taken a Federal agency action as described in paragraph (c)(3)(ii) of this section. (ii) The following specified Federal agency actions shall be the only means of satisfying the requirement of this paragraph: (A) The Federal agency intends to accept an assignment of a mortgage secured by the building or the project of which the building is a part, and such assignment requires payments by the agency or a mortgage insurance fund maintained by the agency to the prior mortgagee;

(B) The Federal agency or a mortgage insurance fund maintained by the agency intends to accept, as a consequence of foreclosure proceedings or otherwise, conveyance of the building or the project of which the building is a part; (C) The Federal agency or a mortgage insurance fund maintained by the agency intends, as a consequence of default, to take possession of, hold title to, or otherwise assume ownership of the building or the project of which the building is a part; or (D) The Federal agency has designated the building or the project of which the building is a part as a troubled building or project. A designation of a troubled building or project must satisfy the following requirements: (1) Designation of troubled status must be based on a review by the Federal agency of the financial condition of the building or project and on a determination by the Federal agency of a history of financial distress or mortgage defaults; (2) Designation of troubled status must be made or received and approved by the national office of the Federal agency; and (3) Federal agency regulations or procedures must provide that, in the event of transfer of the ownership of a designated troubled building or project, the building or project may be subject to continued review by the Federal agency. Each Federal agency may prescribe its own standards and procedures for designating a troubled building or project so long as such standards are consistent with the requirements of this paragraph (c)(3)(ii)(D). (4) No prior credit allowed. The requirement of this paragraph is satisfied only if no prior owner was allowed a low-income housing credit under section 42 for the building. (d) Application for waiver-(1) Time and manner. In order to receive a waiver of the 10-year holding period requirement specified in paragraph (a)(2) of this section, a taxpayer must file an application (including the applicable user fee) that complies with the requirements of this paragraph (d) and Rev. Proc. 90-1, 1990-1 I.R.B. 8 (or any subsequent applicable revenue procedure). The application must be filed by a taxpayer who has acquired the building by purchase or who has a binding contract to purchase the building. Such binding contract may be conditioned upon the granting of a waiver under this section. The application may be filed at any time after a binding contract has been entered into, but no later than 12 months after the taxpayer's acquisition of the building. An application for a waiver of the 10-year holding period requirement must not contain a request for a ruling on any other issue arising under section 42 or other sections of the Internal Revenue Code. An application for a waiver of the 10-year holding period requirement must be mailed or delivered to the address listed in section 3.01 of Rev. Proc. 90-1 (or any subsequent applicable revenue procedure). (2) Information required. An application for a waiver of the 10-year holding period requirement must contain the following information: (i) The taxpayer's name, address and taxpayer identification number;

(ii) The name (if any) and address of the acquired building and the project (if any) of which it is a part; (iii) The date of acquisition or the date of the binding contract for acquisition of the building by the taxpayer and the expected date of acquisition, the amount of consideration paid or to be paid for the acquisition (including the value of any liabilities assumed by the taxpayer), and the taxpayer's certification that such acquisition is by purchase (as defined in section 179(d)(2), as applicable under section 42 (d)(2)(D)(iii)(I)); (iv) The identity of the person from whom the building is acquired, and whether such person is a Federal agency, a mortgagee holding title to the building, or the mortgagor or prior owner; (v) The date the building was last placed in service and the date of the most recent (if any) nonqualified substantial improvement of the building (as defined in section 42 (d)(2)(D)(i)); (vi) The taxpayer's certification that the building was not previously placed in service by the taxpayer, or by a person who was a related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the building was last placed in service; (vii) The amount and disposition (e.g., discharge, assignment, assumption, or refinance) of the outstanding mortgage at the time of acquisition and the identities of the mortgagee and mortgagor; (viii) The taxpayer's certification that no prior owner was allowed a low-income housing credit under section 42 for the building (made to the best of the taxpayer's knowledge, with no documentation from other persons needed to be submitted); and (ix) The statement from the Federal agency required by paragraph (c)(3)(i) of this section. (3) Other rules. (i) In the event that an acquired building will be owned by more than one taxpayer, a single application for waiver may be filed by one taxpayer on behalf of the co-owners if the application contains the names, addresses and taxpayer identification numbers of the other owners. A general partner or a designated limited partner may file an application for waiver on behalf of a partnership. (ii) In the event that multiple Federally-assisted buildings in a project are being acquired by the taxpayer, a single application for waiver with respect to such buildings may be filed if the application contains the required information set out for the address of each Federally-assisted building involved. (iii) In the event that specific Federally-assisted buildings are being acquired by the taxpayer in a project consisting of multiple buildings that may or may not be Federally-assisted, a single application for waiver with respect to the Federally-assisted buildings being acquired may be filed if the application contains the required

information set out for the address of each Federally-assisted building being acquired. (4) Effective date of waiver. A waiver will be effective when granted in writing by the Internal Revenue Service after submission of a completed application for waiver filed under this paragraph (d). (5) Attachment to return. A waiver letter granted by the Internal Revenue Service shall be filed with the taxpayer's Federal income tax return for the first taxable year the low-income housing credit is claimed by the taxpayer. (e) Effective date of regulations. The provisions of §1.42-2 are effective for buildings placed in service by the taxpayer after December 31, 1986.

§1.42-2T [Removed]

Par. 3. Section 1.42-2T is hereby removed.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

ACT Par. 4. The authority citation for part 602 continues to read as follows:

Authority

26 U.S.C. 7805. Par. 5. The table in §602.101 (c) is amended by removing the entry for §1.42-2T and adding in the appropriate place "§1.42-2 1545-1005". Michael J. Murphy, Acting Commissioner of Internal Revenue.

Approved

Kenneth W. Gideon, Assistant Secretary of the Treasury. February 2, 1990.

ACTION

Correction to final regulations.

SUMMARY

This document contains a correction to final regulations concerning the low-income housing credit for certain Federally-assisted buildings under section 42 of the Internal Revenue Code of 1986.

FOR FURTHER INFORMATION CONTACT

Susan Reaman at 202-377-6349 (not a toll-free number).

SUPPLEMENTARY INFORMATION

Background

The final regulations concern the low-income housing credit for certain Federally-assisted buildings under section 42 of the Internal Revenue Code of 1986, as enacted by section 252 of the Tax Reform Act of 1986 and, as amended by sections 1002(1) and 4003 of the Technical and Miscellaneous Revenue Act of 1988. The changes to section 42 under section 7108 of the Omnibus Reconciliation Act of 1989 were not reflected in the final regulations but will be the subject of a separate notice of proposed rulemaking.

Need for Correction

As published, the final regulations contain an error which may prove to be misleading and is in need of clarification.

Correction of Publication

PART 1-[AMENDED]

Accordingly, the final regulations published May 23, 1990 (55 FR 21187) FR Doc. 90- 1752, are corrected as follows:

§1.42-2 [Corrected]

Par. 1. On page 21189, column 3, the eighth line of §1.42-2(c)(1) should be corrected to read "operated under section 8 of the United". Dale D. Goode, Federal Register Liaison Officer, Assistant Chief Counsel (Corporate).

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final Income Tax Regulations concerning the low-income housing credit of section 42 of the Code. The final regulations address the question whether a building financed with the proceeds of a below market loan under an Affordable Housing Program established pursuant to section 721 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) is a federally subsidized building for purposes of section 42. This information will enable taxpayers who obtain financing under an Affordable Housing Program for a building eligible for the section 42 credit to determine the correct applicable percentage under section 42(b).

EFFECTIVE DATE

The regulations are effective for Affordable Housing Program loans made after August 8, 1989 (the effective date of FIRREA).

FOR FURTHER INFORMATION CONTACT

Christopher J. Wilson, 202-377-6349 (not a toll-free call).

SUPPLEMENTARY INFORMATION

Background

The notice of proposed rulemaking published in the Federal Register on February 5, 1991 (56 FR 4588), provides that a below market loan funded in whole or in part with funds from an Affordable Housing Program established under section 721 of FIRREA is not, solely by reason of the Affordable Housing Program funds, a below market Federal loan (as defined in section 42(i)(2)(D)), and that any building financed with the proceeds of such a loan is not, solely by reason of the Affordable Housing Program funds, a federally subsidized building for purposes of determining the applicable percentage under section 42(b). Section 42(i)(2)(D) defines a below market Federal loan, in part, as any loan funded in whole or in part with Federal funds. This proposed rule was predicated upon an examination of the characteristics of the Federal Home Loan Banks and the Affordable Housing Programs. Analysis of these characteristics leads to the conclusion that funds loaned under the Affordable Housing Programs should not be considered Federal funds for purposes of section 42. As a result, a new building financed with the proceeds of an Affordable Housing

Program loan will not, solely by reason of such proceeds, be ineligible for the applicable percentage described in section 42(b)(1)(A) (i.e., the appropriate monthly percentage that will yield, over a 10-year period, amounts of credit that have an aggregate present value equal to 70 percent of the qualified basis of the building).

Public Comment

All comments received by the Internal Revenue Service support the conclusion reached by the notice of proposed rulemaking. Several commentators urged that the final regulations also address the treatment of "direct subsidies" funded under an Affordable Housing Program. See, e.g., section 42(d)(5)(A). One commentator suggested that the final regulations clarify that a building that is financed with a below-market loan under an Affordable Housing Program and that is not otherwise federally funded will not be considered a federally subsidized building if the loan is insured by the Federal Housing Administration. These comments exceed the scope of the regulations as proposed and are not addressed by the final regulations.

Special Analyses

The Commissioner of Internal Revenue has determined that this final rule is not a major rule as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. Although a notice of proposed rulemaking that solicited public comment was issued, the Internal Revenue Service concluded when the notice was issued that the regulations are interpretative and that the notice and public procedure requirements of 5 U.S.C. 553 did not apply. Accordingly, the final regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. chapter 6). Pursuant to section 7805(f) of the Internal Revenue Code, the notice of the proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these final regulations is Christopher J. Wilson, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the Service and the Treasury Department participated in their development. List of Subjects in 26 CFR 1.37-1 Through 1.44A-4 Credits, Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations The amendments to 26 CFR part 1 are as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

1953

Paragraph 1. The authority for part 1 is amended by adding a citation to read as follows:

Authority

Sec. 7805, 68A Stat. 917 ( 26 U.S.C. 7805) Section 1.42-3 is also issued under 26 U.S.C. 42(n). Par. 2. New 1.42-3 is added to read as follows:

§1.42-3 Treatment of buildings financed with proceeds from a loan under an

Affordable Housing Program established pursuant to section 721 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). (a) Treatment under sections 42(i) and 42(b). A below market loan funded in whole or in part with funds from an Affordable Housing Program established under section 721 of FIRREA is not, solely by reason of the Affordable Housing Program funds, a below market Federal loan as defined in section 42(i)(2)(D). Thus, any building with respect to which the proceeds of the loan are used during the tax year is not, solely by reason of the Affordable Housing Program funds, treated as a federally subsidized building for that tax year and subsequent tax years for purposes of determining the applicable percentage for the building under section 42(b). (b) Effective date. The rules set forth in paragraph (a) of this section are effective for loans made after August 8, 1989. Fred T. Goldberg, Jr., Commissioner of Internal Revenue. Approved: September 3, 1991. Kenneth W. Gideon, Assistant Secretary of the Treasury.

May 15, 1992

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final and temporary regulations.

SUMMARY

This document contains final and temporary regulations relating to the limitation on passive activity losses and credits. This regulation adopts as final regulations amendments previously proposed that made corrective and clarifying changes to the existing regulations under section 469 of the Internal Revenue Code, as amended (the "Code"). This document also revises the temporary regulations to reflect where portions have been adopted as final. The final regulations affect taxpayers subject to the limitations on passive activity losses and passive activity credits and provide them with the guidance necessary to comply with the law.

EFFECTIVE DATES

The final regulations under §§1.469-0, 1.469.1, 1.469-2, 1.469-3 and 1.469-5, the addition of §§1.469-6 through 1.469-10, the removal of §§1.469-0T and 1.469.6T through 1.469.11T, and the amendments to §§1.469-1T, 1.469-2T, 1.469-3T and 1.469-5T are effective for taxable years ending after May 10, 1992. The final regulations under §1.469-11 are effective for taxable years beginning after December 31, 1986.

FOR FURTHER INFORMATION CONTACT

Donna J. Welch at (202) 566-4751 (not a toll-free number).

Background

Temporary regulations (TD 8175) under §§1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T and 1.469-11T were first published in the Federal Register for February 25, 1988 (53 FR 5686). A cross-reference notice of proposed rulemaking (PS-014-88) was published in the Federal Register on the same day. These temporary regulations were amended by temporary regulations (TD 8253) published in the Federal Register for May 12, 1989 (54 FR 20527). A notice of proposed rulemaking (PS-001-89) was also published. These regulations amended the authority for part 602. Written comments were received on the amendments to the temporary regulations and a hearing was held on November 28, 1989. To avoid possible disputes about whether the amendments made to §§1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T, and 1.469- 11T (the "amendments") "sunset" under section 7805(e)(2) of the Code, this Treasury Decision adopts the amendments as final regulations. This document also

reserves the corresponding temporary regulations and provides in the temporary regulations cross-references to the final regulations as appropriate.

Explanation of Provisions

In General The final regulations generally adopt the amendments as originally proposed. They only make certain minor technical modifications to the amendments, including changes that conform them to the proposed regulations under §1.469-4, relating to the definition of activity. Until the remaining regulations under §§1.469-1T, 1.469-2T, 1.469-3T, and 1.469- 5T are finalized, the portions of the regulations adopted as final in this Treasury Decision will appear separately in the Code of Federal Regulations from the portions still set forth as temporary regulations. To assist taxpayers, however, the Internal Revenue Service plans to publish a separate document in the Internal Revenue Bulletin that will integrate the final regulations with the temporary regulations.

Effective Dates

The final regulations include effective date rules for both the temporary regulations and the final regulations. Under these rules, the rules contained in the final regulations and the temporary regulations, as amended by this Treasury Decision, are effective for taxable years ending after May 10, 1992. The final regulations also include a transitional rule for the taxpayer's first taxable year ending after May 10, 1992, if it begins on or before May 10, 1992. In this case, the temporary regulations as they appeared prior to their amendment by this Treasury Decision may be applied. The final regulations also contain special effective date rules for investment credit property in order to take into account changes in the investment credit rules made by the Omnibus Reconciliation Act of 1990. This document also adopts the special effective date rules previously set forth in §1.469-11T(a)(2) through (a)(5). The final regulations, however, do not adopt those provisions previously set forth in §1.469-11T (b) and (c) relating to pre-enactment losses and credits and pre-enactment activites. Those rules related to the application of the phase-in rules of section 469(m) and were applicable only for taxable years beginning 1987 through 1990.

Special Analyses

These final regulations are not major rules as defined in Executive Order 12291. Therefore, a regulatory Impact Analysis is not required. It is hereby certified that section 553(b) of the Administrative Procedure Act (5. U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that these rules do not have a significant impact on a substantial number of small entities. Therefore, a final Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Administrator of the Small Business Administration for comments on their impact on small businesses.

Drafting Information

The principal author of these regulations is Donna J. Welch, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in their development. Adoption of Amendments to the Regulations. Accordingly, title 26, chapter 1, part 1 is amended as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

1953 Paragraph 1. The authority citation for part 1 is amended by removing the entry for "§§1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T and 1.469-11T" and adding the following citations:

Authority

26 U.S.C. 7805. Sections 1.469-1, 1.469-1T, 1.469-2, 1.469-2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T and 1.469-11 also issued under 26 U.S.C. 469( )(1).

§1.469-0T (Removed)

Par. 2. Section 1.469-0T is removed. Par. 2a. Section 1.469-0 is added to read as follows:

§1.469-O Table of contents.

This section lists the captions that appear in the regulations under section 469. Section 1.469-1 General rules. (a) through (d)(1) (Reserved). (2) Coordination with sections 613A(d) and 1211. (d)(3) through (e)(1) (Reserved). (2) Trade or business activity. (e)(3)(i) through (e)(3)(ii) (Reserved). (iii) Average period of customer use. (A) In general. (B) Average use factor.

(C) Average period of customer use for class of property. (D) Period of customer use. (E) Class of property. (F) Gross rental income and daily rent. (e)(3)(iv) through (e)(3)(vi)(C) (Reserved). (D) Lodging rented for convenience of employer. (E) Unadjusted basis. (e)(3)(vii) through (e)(4)(iii) (Reserved). (iv) Definition of "working interest." (e)(4)(v) through (vi) (Reserved). (5) Rental of dwelling unit. (e)(6) through (f)(3)(iii) (Reserved). (4) Carryover of disallowed deductions and credits. (i) In general. (ii) Operations continued through C corporations or similar entities. (iii) Examples (g)(1) through (g)(4)(ii)(B) (Reserved). (g)(4)(ii)(C) (no paragraph heading). (g)(5) through (h)(3) (Reserved). (4) Status and participation of members. (i) Determination by reference to status and participation of group. (ii) Determination of status and participation of consolidated group. (h)(5) through (k) (Reserved). Section 1.469-1T General rules (temporary). (a) Passive activity loss and credit disallowed.

(1) In general. (2) Exceptions. (b) Taxpayers to whom these rules apply. (c) Cross references. (1) Definition of passive activity. (2) Passive activity loss. (3) Passive activity credit. (4) Effect of rules for other purposes. (5) Special rule for oil and gas working interests. (6) Treatment of disallowed losses and credits. (7) Corporations subject to section 469. (8) Consolidated groups. (9) Joint returns. (10) Material participation. (11) Effective date and transition rules. (12) Future regulations. (d) Effect of section 469 and the regulations thereunder for other purposes. (1) Treatment of items of passive activity income and gain. (2) Coordination with sections 613A(d) and 1211 (Reserved). (3) Treatment of passive activity losses. (e) Definition of "passive activity". (1) In general. (2) Trade or business activity (Reserved). (3) Rental Activity. (i) In general.

(ii) Exceptions. (iii) Average period of customer use (Reserved). (A) In general (Reserved). (B) Average use factor (Reserved). (C) Average period of customer use for class of property (Reserved). (D) Period of Customer use (Reserved). (E) Class of property (Reserved). (F) Gross rental income and daily rent (Reserved). (iv) Significant personal services. (A) In general. (B) Excluded services (v) Extraordinary personal services. (vi) Rental of property incidental to a nonrental activity of the taxpayer. (A) In general. (B) Property held for investment. (C) Property used in a trade or business. (D) Lodging rented for convenience of employer (Reserved). (E) Unadjusted basis (Reserved). (vii) Property made available for use in a nonrental activity conducted by a partnership, S corporation or joint venture in which the taxpayer owns an interest. (viii) Examples. (4) Special rules for oil and gas working interests. (i) In general. (ii) Exception for deductions attributable to a period during which liability is limited. (A) In general.

(B) Coordination with rules governing the identification of disallowed passive activity deductions. (C) Meaning of certain terms. (1) Allocable deductions (2) Disqualified deductions. (3) Net loss. (4) Ratable portion. (iii) Examples. (iv) Definition of "working interest" (Reserved). (v) Entities that limit liability. (A) General rule. (B) Other limitations disregarded. (C) Examples. (vi) Cross reference to special rule for income from certain oil or gas properties. (5) Rental of dwelling unit (Reserved). (6) Activity of trading personal property. (i) In general. (ii) Personal property. (iii) Example. (f) Treatment of disallowed passive activity losses and credits. (1) Scope of this paragraph. (2) Identification of disallowed passive activity deductions. (i) Allocation of disallowed passive activity deductions. (A) General rule. (B) Loss from an activity.

(C) Significant participation passive activities. (D) Examples. (ii) Allocation with loss activities. (A) In general. (B) Excluded deductions. (iii) Separately identified deductions. (3) Identification of disallowed credits from passive activities. (i) General rule. (ii) Coordination rule. (iii) Separately identified credits. (4) Carryover of disallowed deductions and credits (Reserved). (i) In general. (ii) Operations continued through C corporations or similar entities. (iii) Examples. (g) Application of these rules to C corporations. (1) In general. (2) Definitions. (3) Participation of corporations. (i) Material participation. (ii) Significant participation. (iii) Participation of individual. (4) Modified computation of passive activity loss in the case of closely held corporations. (i) In general. (ii) Net active income.

(iii) Examples. (5) Allowance of passive activity credit of closely held corporations to extent of net active income tax liability. (i) In general. (ii) Net active income tax liability. (h) Special rules for affiliated group filing consolidated return. (1) In general. (2) Definitions. (3) Disallowance of consolidated group's passive activity loss or credit. (4) Status and participation of members (Reserved). (i) Determination by reference to status and participation of group (Reserved). (ii) Determination of status and participation of consolidated group (Reserved). (5) Modification of rules for identifying disallowed passive activity deductions and credits. (i) Identification of disallowed deductions. (ii) Ratable portion of disallowed passive activity losses. (iii) Identification of disallowed credits. (6) Transactions between members of a consolidated group. (i) Scope. (ii) Recharacterization of gain or loss from intercompany transactions other than deferred intercompany transactions. (A) In general. (B) Recharacterization of gain or loss as portfolio items. (iii) Deferred intercompany transactions. (A) In general. (B) Deferred intercompany transactions involving property subject to depreciation, amortization or depletion.

(C) Restoration of deferred gain or loss of dispositions. (D) Certain recharacterization items treated as portfolio items. (E) Property involved in deferred intercompany transactions. (iv) Definitions. (A) Deferred intercompany transactions. (B) Directly related. (C) Intercompany transaction. (D) Purchasing member. (E) Selling member. (7) Disposition of stock of a member of an affiliated group. (8) Dispositions of property used in multiple activities. (i) (Reserved). (j) Spouses filing joint returns. (1) In general. (2) Exceptions of treatment as one taxpayer. (i) Identification of disallowed deductions and credits. (ii) Treatment of deductions disallowed under sections 704(d), 1366(d) and 465. (iii) Treatment of losses from working interests. (3) Joint return no longer filed. (4) Participation of spouses. (k) Former passive activities and changes in status of corporations (Reserved). Section 1.469-2 Passive activity loss. (a) through (c)(2)(ii) (Reserved). (iii) Disposition of substantially appreciated property formerly used in a nonpassive activity.

(A) In general. (B) Date of disposition. (C) Substantially appreciated property. (D) Investment property. (E) Coordination with §l.469-2T(c)(2)(ii). (F) Coordination with section 163(d). (G) Examples. (iv) Taxable acquisitions. (v) Property held for sale to customers. (A) Sale incidental to another activity. (1) Applicability. (i) In general. (ii) Principal purpose. (2) Dealing activity not taken into account. (B) Use in a nondealing activity incidental to sale. (C) Examples. (c) (3) through (c)(5) (Reserved). (6) Gross income from certain oil or gas properties. (i) In general. (ii) Gross and net passive income from the property. (iii) Property. (iv) Examples 1 and 2. (c)(6)(iv) Example 3 through (c)(7)(vi) (Reserved). (d)(1) through (d)(2)(viii) (Reserved). (d)(2)(ix) (no paragraph heading).

(d)(2)(x) through (d)(2)(xi) (Reserved). (d)(2)(xii) (no paragraph heading). (d)(3) through (d)(5)(ii) (Reserved). (d)(5)(iii)(A) Applicability of rules in §1.469-2T(c)(2). (d)(5)(iii)(B) through (d)(6)(v)(D) (Reserved). (d)(6)(v)(E) (no paragraph heading). (d)(6)(v)(F) through (d)(7) (Reserved). (8) Taxable year in which item arises. (e)(1) through (e)(2)(i) (Reserved). (ii) Section 707(c). (iii) Payments in liquidation of a partner's interest in partnership property. (A) In general. (B) Payments in liquidation of a partner's interest in unrealized receivables and goodwill under section 736(a). (e)(3)(i) through (iii)(A) (Reserved). (e)(3)(iii)(B) (no paragraph heading). (e)(3)(iii)(C) through (f)(4) (Reserved). (5) Net income from certain property rented incidental to development activity. (i) In general. (f)(5)(ii)(B) through (f)(5)(iv) (Reserved). (6) Property rented to a nonpassive activity. (f)(7) through (f)(9)(ii) (Reserved). (f)(9)(iii) through (f)(9)(iv) (no paragraph heading). (10) Coordination with section 163(d). (f)(11) (Reserved).

Section 1.469-2T Passive activity loss (temporary). (a) Scope of this section. (b) Definition of passive activity loss. (1) In general. (2) Cross reference. (c) Passive activity group income. (1) In general. (2) Treatment of gain from disposition of an interest in an activity or an interest in property used in an activity. (i) In general. (A) Treatment of gain. (B) Dispositions of partnership interest and S corporation stock. (C) Interest in property. (D) Examples. (ii) Disposition of property used in more than one activity in 12-month period preceding disposition. (iii) Disposition of substantially appreciated property used in nonpassive activity (Reserved). (A) In general (Reserved). (B) Date of disposition (Reserved). (C) Substantially appreciated property (Reserved). (D) Investment property (Reserved). (E) Coordination with paragraph (c)(2)(ii) of this section (Reserved). (F) Coordination with section 163(d) (Reserved). (G) Examples (Reserved). (iv) Taxable acquisitions (Reserved).

(v) Property held for sale to customers (Reserved). (A) Sale incidental to another activity (Reserved). (1) Applicability (Reserved). (i) In general (Reserved). (ii) Principal purpose (Reserved). (2) Dealing activity not taken into account (Reserved). (B) Use in a nondealing activity incidental to sale (Reserved). (C) Examples (Reserved). (3) Items of portfolio income specifically excluded. (i) In general. (ii) Gross income derived in the ordinary course of a trade or business. (iii) Special rules. (A) Income from property held for investment by dealer. (B) Royalties derived in the ordinary course of the trade or business of licensing intangible property. (1) In general. (2) Substantial services or costs. (i) In general. (ii) Exception. (iii) Expenditures taken into account. (3) Passthrough entities. (4) Cross reference. (C) Mineral production payments. (iv) Examples. (4) Items of personal service income specifically excluded.

(i) In general. (ii) Example. (5) Income from section 481 adjustments. (i) In general. (ii) Positive section 481 adjustments. (iii) Ratable portion. (6) Gross income from certain oil or gas properties (Reserved). (i) In general (Reserved). (ii) Gross and net passive income from the properties (Reserved). (iii) Property (Reserved). (iv) Examples. (7) Other items specifically excluded. (d) Passive activity deductions. (1) In general. (2) Exceptions. (3) Interest expense. (4) Clearly and directly allocable expenses. (5) Treatment of loss from disposition. (i) In general. (ii) Disposition of property used in more than one activity in 12-month period preceding disposition. (iii) Other applicable rules. (A) Applicability or rules in paragraph (c)(2). (B) Dispositions of partnership interest and S corporation stock. (6) Coordination with other limitations on deductions that apply before section 469.

(i) In general. (ii) Proration of deductions disallowed under basis limitations. (A) Deductions disallowed under section 704(d). (B) Deductions disallowed under section 1366(d). (iii) Proration of deductions disallowed under at-risk limitations. (iv) Coordination of basis and at-risk limitations. (v) Separately identified items of deduction and loss. (7) Deductions from section 481 adjustment. (i) In general. (ii) Negative section 481 adjustment. (iii) Ratable portion. (8) Taxable year in which item arises. (e) Special rules for partners and S corporation shareholders. (1) In general. (2) Payments under sections 707(a), 707(c), and 736(b). (i) Section 707(a). (ii) Section 707(c). (iii) Payments in liquidation of a partner's interest in partnership property. (A) In general. (B) Payments in liquidation of a partner's interest of a partnership property. (3) Sale or exchange of interest in passthrough entity. (i) Application of this paragraph (e)(3). (ii) General rule. (A) Allocation among activities. (B) Ratable portions.

(1) Disposition on which gain is recognized. (2) Disposition on which loss is recognized. (C) Default rule. (D) Special rules. (1) Applicable valuation date. (i) In general. (ii) Exception. (2) Basis adjustment. (3) Tiered passthrough entities. (E) Meaning of certain terms. (iii) Treatment of gain allocated to certain passive activities as not from a passive activity. (iv) Dispositions occurring in taxable years beginning before February 19, 1988. (A) In general. (B) Exceptions. (v) Treatment of portfolio assets. (vi) Definitions. (vii) Examples. (f) Recharacterization of passive income in certain situations. (1) In general. (2) Special rule for significant participation. (i) In general. (ii) Significant participation passive activity. (iii) Example. (3) Rental of nondepreciable property.

(4) Net interest income from passive equity-financed lending activity. (i) In general. (ii) Equity-financed lending activity. (A) In general. (B) Certain liabilities not taken into account. (iii) Equity-financed interest income. (iv) Net interest income. (v) Interest-bearing assets. (vi) Liabilities incurred in the activity. (vii) Average outstanding balance. (viii) Example. (5) Net income from certain property rented incidental to development activity. (i) In general (Reserved). (ii) Commencement of use. (iii) Services performed for the purpose of enhancing the value of property. (iv) Example. (6) Property rented to a nonpassive activity. (7) Special rules applicable to the acquisition of an interest of a passthrough entity engaged in the trade or business of licensing intangible property. (i) In general. (ii) Royalty income from property. (iii) Exceptions. (iv) Capital expenditures. (v) Example. (8) Limitation on recharacterized income.

(9) Meaning of certain terms. (10) Coordination with section 163(d). (11) Effective date. Section 1.469-3 Passive activity credit. (a) through (d) (Reserved). (e) Coordination with section 38(b). (f) Coordination with section 50. (g) (Reserved). Section 1.469-3T Passive activity credit (temporary). (a) Computation of passive activity credit. (b) Credits subject to section 469. (1) In general. (2) Treatment of credits attributed to qualified progress expenditures. (3) Special rule for partners and S corporations shareholders. (4) Exception for pre-1987 credits. (c) Taxable year to which credit is attributable. (d) Regular tax liability allocable to passive activities. (1) In general. (2) Regular tax liability. (e) Coordination with section 38(b) (Reserved). (f) Coordination with section 47 (Reserved). (g) Examples. Section 1.469-4 Definition of activity. (Reserved) Section 1.469-5 Material participation. (a) through (e) (Reserved).

(f) Participation. (1) In general. (f)(2) through (h)(2) (Reserved). (3) Coordination with rules governing the treatment of passthroughs entities. (i) (Reserved). (j) Material participation for preceding taxable years. (1) In general. (2) Material participation test for taxable years beginning before January 1, 1987 (k) Examples (1) through (4) (Reserved). (k) Example (5). (k) Examples (6) through (8) (Reserved). Section 1.469-5T Material participation (temporary). (a) In general. (b) Facts and circumstances. (1) In general (Reserved). (2) Certain participation insufficient to constitute material participation under this paragraph (b). (i) Participation satisfying standards not contained in section 469. (ii) Certain management activities. (iii) Participation less than 100 hours. (c) Significant participation activity. (1) In general. (2) Significant participation. (d) Personal service activity. (e) Treatment of limited partners.

(1) General rule. (2) Exceptions. (3) Limited partnership interest. (i) In general. (ii) Limited partner holding general partner interest. (f) Participation (Reserved). (1) In general (Reserved). (2) Exceptions. (i) Certain work not customarily done by owners. (ii) participation as an investor. (A) In general. (B) Work done in individual's capacity as an investor. (3) Participation of spouses. (4) Methods of proof. (g) Material participation of trust and estates (Reserved). (h) Miscellaneous rules. (1) Participation of corporations. (2) Treatment of certain retired farmers and surviving spouses of retired or disabled farmers. (3) Coordination with rules governing the treatment of passthroughs entities (Reserved). (i) (Reserved). (j) Material participation for preceding taxable years (Reserved). (1) In general (Reserved). (2) Material participation for taxable years beginning before January 1, 1987 (Reserved).

(k) Examples. Section 1.469-6 Treatment of losses upon certain dispositions.(Reserved) Section 1.469-7 Treatment of self-charged items of income and expense. (Reserved) Section 1.469-8 Application of section 469 to trust, estates, and their beneficiaries. (Reserved) Section 1.469-9 Treatment of income, deductions and credits from certain rental real estate activities. Section 1.469-10 Application of section 469 to publicly traded partnerships. (Reserved) Section 1.469-11 Effective date and transition rules. (a) Generally applicable effective dates. (b) Additional effective dates. (1) Transition rule for 1992 amendments. (2) Certain investment credit property. (c) Special rules. (1) Applicability of certain income recharacterization rules. (i) in general. (ii) Property rented to a nonpassive activity. (2) Qualified low-income housing projects. (3) Effect of events occurring in years prior to 1987. (d) Examples. Par. 3. Section 1.469-1 is added to read as follows:

§1.469-1 General rules.

(a) through (d)(1). (Reserved) (d)(2) Coordination with sections 613A (d) and 1211. A passive activity deduction that is not disallowed for the taxable year under section 469 and the regulations thereunder may nonetheless be disallowed for the taxable year under section 613A(d) or 1211. The following example illustrates the application of this paragraph (d)(2):

Example. In 1993, an individual derives $10,000 of ordinary income from passive activity X, no gains from the sale or exchange of capital assets or assets used in a trade or business, $12,000 of capital loss from passive activity Y, and no income, gain, deductions, or losses from any other passive activity. The capital loss from activity Y is a passive activity deduction (within the meaning of §1.469-2T(d)). Under section 469 and the regulations thereunder, the taxpayer is allowed $10,000 of the $12,000 passive activity deduction and has a $2,000 passive activity loss for the taxable year. Since the $10,000 passive activity deduction allowed under section 469 is a capital loss, such deduction is allowable for the taxable year only to the extent provided under section 1211. Therefore, the taxpayer is allowed $3,000 of the $10,000 capital loss under section 1211 and has a $7,000 capital loss carryover (within the meaning of section 1212(b)) to the succeeding taxable year. (d)(3) through (e)(1). (Reserved). (e)(2) Trade or business activities. Trade or business activities are activities that constitute trade or business activities within the meaning of §1.469-4(b)(1). (e)(3)(i) through (e)(3)(ii) (Reserved) (e)(iii) Average period of customer use-(A) In general. For purposes of this paragraph (e)(3), the average period of customer use for property held in connection with an activity (the activity's average period of customer use) is the sum of the average use factors for each class of property held in connection with the activity. (B) Average use factor. The average use factor for a class of property held in connection with an activity is the average period of customer use for that class of property multiplied by the fraction obtained by dividing- (1) The activity's gross rental income attributable to that class of property; by (2) The activity's gross rental income. (C) Average period of customer use for class of property. In determining an activity's average period of customer use for a taxable year, the average period of customer use for a class of property held in connection with an activity is determined by dividing- (1) The aggregate number of days in all periods of customer use for property in the class (taking into account only periods that end during the taxable year or that include the last day of the taxable year); by (2) The number of those periods of customer use. (D) Period of customer use. Each period during which a customer has a continuous or recurring right to use an item of property held in connection with the activity (without regard to whether the customer uses the property for the entire period or whether the right to use the property is pursuant to a single agreement or to renewals thereof) is treated for purposes of this paragraph (e)(3)(iii) as a separate period of customer use. The duration of a period of customer use that includes the last day of a taxable year may be determined on the basis of reasonable estimates.

(E) Class of property. Taxpayers may organize property into classes for purposes of this paragraph (e)(3)(iii) using any method under which items of property for which the amount of the daily rent differs significantly are not included in the same class. (F) Gross rental income and daily rent. In determining an activity's average period of customer use for a taxable year- (1) The activity's gross rental income is the gross income from the activity for the taxable year taking into account only income that is attributable to amounts paid for the use of property; (2) The activity's gross rental income attributable to a class of property is the gross income from the activity for the taxable year taking into account only income that is attributable to amounts paid for the use of property in that class; and (3) The daily rent for items of property may be determined on any basis that reasonably reflects differences during the taxable year in the amounts ordinarily paid for one day's use of those items of property. (e)(3)(iv) through (e)(3)(vi)(C) (Reserved) (e)(3)(vi)(D) Lodging rented for convenience of employer. The provision of lodging to an employee or to an employee's spouse or dependents is treated as incidental to the activity (or activities) of the taxpayer in which the employee performs services if the lodging is furnished for the taxpayer's convenience (within the meaning of section 119). (E) Unadjusted basis. For purposes of this paragraph (e)(3)(vi), the term unadjusted basis means adjusted basis determined without regard to any adjustment described in section 1016 that decreases basis. (e)(3)(vii) through (e)(4)(iii) (Reserved) (e)(4)(iv) Definition of "working interest." For purposes of section 469 and the regulations thereunder, the term working interest means a working or operating mineral interest in any tract or parcel of land (within the meaning of §1.612-4(a)). (e)(4)(v) through (f)(3) (Reserved) (f)(4) Carryover of disallowed deductions and credits- (i) In general. In the case of an activity of a taxpayer with respect to which any deductions or credits are disallowed for a taxable year under §1.469-1T (f)(2) or (f)(3) (the loss activity)- (A) The disallowed deductions or credits is allocated among the taxpayer's activities for the succeeding taxable year in a manner that reasonably reflects the extent to which each activity continues the loss activity; and

(B) The disallowed deductions or credits allocated to an activity under paragraph (f)(4)(i)(A) of this section shall be treated as deductions or credits from the activity for the succeeding taxable year. (ii) Business continued through C corporations or similar entities. If a taxpayer continues part or all of a loss activity through a C corporation or similar entity (C corporation entity), the taxpayer's interest in the C corporation entity shall be treated for purposes of this paragraph (f)(4) as an interest in a passive activity that continues that loss activity in whole or part. An entity is similar to a C corporation for this purpose if the owners of interests in the entity derive only portfolio income (within the meaning of §1.469-2T(c)(3)(i)) from the interests. (iii) Examples. The following examples illustrate the application of this paragraph (f)(4). In each example, the taxpayer is an individual whose taxable year is the calendar year. Example 1. (i) The taxpayer owns interests in a convenience store and an apartment building. In each taxable year, the taxpayer's interests in the convenience store and the apartment building are treated under §1.469-4 as interests in two separate passive activities of the taxpayer. A $5,000 loss from the convenience-store activity and a $3,000 loss from the apartment-building activity are disallowed under §1.469- 1T(f)(2) for 1993. Under §1.469-1T(f)(2), the $5,000 loss from the convenience-store activity is allocated among the passive activity deductions from that activity for 1993, and the $3,000 loss from the apartment-building activity is treated similarly. (ii) In 1994, the convenience store is continued in a single activity, and the section 469 activities that constituted the apartment building is similarly continued in a separate activity. Thus, the disallowed deductions from the convenience-store activity for 1993 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's convenience-store activity in 1994. Similarly, the disallowed deductions from the apartment-building activity for 1993 must be allocated to the taxpayer's apartment-building activity in 1994. Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions allocated to the convenience-store activity in 1994 are treated as deductions from that activity for 1994, and the disallowed deductions allocated to the apartment-building activity for 1994 are treated as deductions from the apartment-building activity for 1994. Example 2. (i) In 1993, the taxpayer acquires a restaurant and a catering business. Assume that in 1993 and 1994 the restaurant and the catering business are treated under §1.469-4 as an interest in a single passive activity of the taxpayer (the restaurant and catering activity). A $10,000 loss from the activity is disallowed under

§1.469-1T(f)(2) for 1994. Assume that in 1995, the taxpayer's interests in the

restaurant and the catering business are treated under §1.469-4 as interests in two separate passive activities of the taxpayer. (ii) Under §1.469-1T(f) (2), the $10,000 loss from the restaurant and catering activity is allocated among the passive activity deductions from that activity for 1994. In 1995, the businesses that constituted the restaurant and catering activity are continued, but are treated as two separate activities under §1.469-4. Thus, the disallowed deductions from the restaurant and catering activity for 1994 must be allocated under paragraph (f) (4) (i) (A) of this section between the restaurant activity and the catering activity in 1995 in a manner that reasonably reflects the

extent to which each of the activities continues the single restaurant and catering activity. Under paragraph (f) (4) (i) (B) of this section, the disallowed deductions allocated to the restaurant activity in 1995 are treated as deductions from the restaurant activity for 1995, and the disallowed deductions allocated to the catering activity in 1995 are treated as deductions from the catering activity for 1995. Example 3. (i) In 1993, the taxpayer acquires a restaurant and a catering business. Assume that in 1993 and 1994 the restaurant and the catering business are treated under§1.469-4 as an interest in a single passive activity of the taxpayer (the restaurant and catering activity). A $10,000 loss from the activity is disallowed under

§1.469-1T(f) (2) for 1994. Assume that in 1995, the taxpayer's interests in the

restaurant and the catering business are treated under §1.469-4 as interestes in two separate passive activities of the taxpayer. In addition, a $20,000 loss from the activity was disallowed under §1.469-1T(f) (2) for 1993, and the gross income and deductions (including deductions that were disallowed for 1993 under §1.469-1T(f) (2)) from the restaurant and catering business for 1993 and 1994 are as follows: ---- -------------------------------------------------------------------------- Restaurant Catering business -------------------------------------------------------------------------- ---- 1993: Gross income ................................ $20,000 ................. $60,000 Deductions ................................... 40,000 .................. 60,000 Net income (loss) .......................... (20,000) ----------------------- 1994: Gross income ................................. 40,000 .................. 50,000 Deductions ................... [FN1] 30,000 .......... [FN2] 70,000 Net income (loss) ............................ 10,000 ................ (20,000) ---------------------------------------------------------------------- -------- 1 Includes $8,000 of deductions that were disallowed for 1993 ($20,000 x $40,000/$100,000). 2 Includes $12,000 of deductions that were disallowed for 1993 ($20,000 x $60,000/$100,000). (ii) Under paragraph (f)(4)(i)(A) of this section, the disallowed deductions from the restaurant and catering activity must be allocated among the taxpayer's activities for the succeeding year in a manner that reasonably reflects the extent to which those activities continue the restaurant and catering activity. The remainder of this example describes a number of allocation methods that will ordinarily satisfy the requirement of paragraph (f) (4)(i) (A) of this section. The description of specific allocation methods in this example does not preclude the use of other reasonable allocation methods for purposes of paragraph (f) (4) (i) (A) of this section. (iii) Ordinarily, an allocation of disallowed deductions from the restaurant to the restaurant activity and disallowed deductions from the catering business to the catering activity would satisfy the requirement of paragraph (f) (4) (i) (A) of this section. Under §1.469-1T (f) (2) (ii), a ratable portion of each deduction from the restaurant and catering activity is disallowed for 1994. Thus, $3,000 of the 1994 deductions from the rstaurant are disallowed ($10,000 x $30,000/$100,000), and $7,000 of the 1994 deductions from the catering business are disallowed ($10,000 x $70,000/$100,000). Thus, the taxpayer can ordinarily treat $3,000 of the disallowed deductions as deductions from the restaurant activity for 1995, and $7,000 of the disallowed deductions and deductions from the catering activity for 1995. (iv) Ordinarily, an allocation of disallowed deductions between the restaurant activity and catering activity in proportion to the losses from the restaurant and from the catering business for 1994 would also satisfy the requirement of paragraph (f) (4) (i) (A) of this section. If the restaurant and the catering business had been treated as

separate activities in 1994, the restaurant activity would have had net income of $10,000 and the catering activity would have had a $20,000 loss. Thus, the taxpayer can ordinarily treat all $10,000 or disallowed deductions as deductions from the catering activity for 1995. (v) Ordinarily, an allocation of disallowed deductions between the restaurant activity and catering activity in proportion to the losses from the restaurant and from the catering business for 1994 (determined as if the restaurant and the catering business had been separate activities for all taxable years) would also satisfy the requirement of paragraph (f)(4)(i)(A) of this section. If the restaurant and the catering business had been treated as separate activities for all taxable years, the entire $20,000 loss from the restaurant in 1993 would have been allocated to the restaurant activity in 1994, and the gross income and deductions from the separate activities for 1994 would be as follows: --------------------------------------------------- Restaurant Catering business --------------------------------------------------- Gross income ............ $40,000 .......... $50,000 Deductions ............... 42,000 ........... 58,000 Net income (loss) ....... (2,000) .......... (8,000) ----------------------------------------- ---------- Thus, the taxpayer can ordinarily treat $2,000 of the disallowed deductions as deductions from the restaurant activity for 1995, and $8,000 of the disallowed deductions as deductions from the catering activity for 1995. Example 4. (i) The taxpayer is a partner in a law partnership that acquires a building in December 1993 for use in the partnership's law practice. In taxable year 1993, four floors that are not needed in the law practice are leased to tenants; in taxable year 1994, two floors are leased to tenants; in taxable years after 1994, only one floor is leased to tenants and the rental operations are insubstantial. Assume that under §1.469-4, the law practice and the rental property are treated as a trade or business activity and a separate rental activity for taxable years 1993 and 1994. Assume further that the law practice and the rental operations are a single trade or business activity for taxable years after 1994 under §1.469-4. The trade or business activity is not a passive activity of the taxpayer. The rental activity, however, is a passive activity. Under §1.469-T(f)(2), a $12,000 loss from the rental activity is disallowed for 1993 and a $9,000 loss from the rental activity is disallowed for 1994. (ii) Under §1.469-1T(f)(2), the $12,000 loss from the rental activity for 1993 is allocated among the passive activity deductions from that activity for 1993. In 1994, the business of the rental activity is continued in two separate activities. Only two floors of the building remain in the rental activity, and the other two floors (i.e., the floors that were leased to tenants in 1993, but not in 1994) are used in the taxpayer's law-practice activity. Thus, the disallowed deductions from the rental activity for 1993 must be allocated under paragraph (f)(4)(i)(A) of this section between the rental activity and the law-practice activity in a manner that reasonably reflects the extent to which each of the activities continues business on the four floors that were leased to tenants in 1993. In these circumstances, the requirement of paragraph (f)(4)(i)(A) of this section would ordinarily be satisfied by any of the allocation methods illustrated in Example 3 or by an allocation of 50 percent of the disallowed deductions to each activity. Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions allocated to the rental activity in 1994 are treated as deductions from the rental activity for 1994, and the disallowed deductions ($6,000)

allocated to the law-practice activity in 1994 are treated as deductions from the law-practice activity for 1994. (iii) Under §1.469-1T(f)(2), the $9,000 loss from the rental activity for 1994 is allocated among the passive activity deductions from that activity for 1994. In 1995, the rental activity is continued in the taxpayer's law-practice activity. Thus, the disallowed deductions from the rental activity for 1994 must be allocated under paragraph (f)(4)(ii) of this section to the taxpayer's law-practice activity in 1995. Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions allocated to the law-practice activity are treated as deductions from the law-practice activity for 1995. (iv) Rules relating to former passive activities will be contained in paragraph (k) of this section. Under those rules, any disallowed deductions from the rental activity that are treated as deductions from the law-practice activity will be treated as unused deductions that are allocable to a former passive activity. Example 5. (i) The taxpayer owns stock in a corporation that is an S corporation for the taxpayer's 1993 taxable year and a C coporation thereafter. The only activity of the corporation is a rental activity. For 1993, the taxpayer's pro rata share of the corporation's loss from the rental activity is $5,000, and the entire loss is disallowed under §1.469-1T(f)(2) of this section. (ii) Under §1.469-1T(f)(2), the taxpayer's $5,000 loss from the rental activity is allocated among the taxpayer's deductions from that activity for 1993. In 1994, the rental activity is continued through a C corporation, and the taxpayer's interest in the C corporation is treated under paragraph (f)(4)(ii) of this section as a passive activity that continues the rental activity (the C corporation activity) for purposes of allocating the previously disallowed loss. Thus, the disallowed deductions from the rental activity for 1993 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation activity in 1994, and are treated under paragraph (f)(4)(i)(B) of this section as deductions from the C corporation activity for 1994. (iii) Treating the taxpayer's interest in the C corporation as an interest in a passive activity that continues the business of the rental activity does not change the character of the taxpayer's dividend income from the C corporation. Thus, the taxpayer's dividend income is portfolio income (within the meaning of §1.469- 2T(c)(3)(i)) and is not included in passive activity gross income. Accordingly, the taxpayer's loss from the C corporation activity for 1994 is $5,000. Example 6. (i)(i) The taxpayer owns stock in a corporation that is an S corporation for the taxpayer's 1993 taxable year and a C corporation thereafter. The only activity of the corporation is a rental activity. For 1993, the taxpayer's pro rata share of the corporation's loss from the rental activity is $5,000, and the entire loss is disallowed under §1.469-1T(f)(2). The taxpayer has $2,000 in income from other passive activities for 1994, and as a result, only 60% of the taxpayer's loss from the C corporation activity ($3,000) is disallowed for 1994 under §1.469-1T(f)(2). (ii) Under §1.469-1T(f)(2), the $3,000 disallowed loss from the C corporation activity is allocated among the passive activity deductions from that activity for 1994. In effect, therefore, 60 percent of each disallowed deduction from the rental activity for 1993 is again disallowed for 1994.

(iii) Under paragraph (f)(4) of this section, the taxpayer's interest in the C corporation is treated as a loss activity and as an interest in a passive activity that continues the business of that loss activity for 1995. Thus, the disallowed deductions from the C corporation activity for 1994 must be allocated under paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation activity in 1995, and are treated under paragraph (f)(4)(i)(B) of this section as deductions from that activity for 1995. (g)(1) through (g)(4)(ii)(B) (Reserved) (g)(4)(ii)(C) Portfolio income (within the meaning of §1.469-2T(c)(3)(i)), including any gross income that is treated as portfolio income under any other provision of the regulations (See, e.g., §1.469-2(c)(2)(iii)(F) (relating to gain from the disposition of substantially appreciated property formerly held for investment) and §1.469-2(f)(10) (relating to certain recharacterized passive activity gross income)) (g)(5) through (h)(3) (Reserved) (h)(4) Status and participation of members-(i) Determination by reference to status and participation of group. For purposes of section 469 and the regulations thereunder- (A) Each member of a consolidated group shall be treated as a closely held corporation or personal service corporation, respectively, for the taxable year, if and only if the consolidated group is treated (under the rules of paragraph (h)(4)(ii) of this section) as a closely held corporation or personal service corporation for that year; and (B) The determination of whether a trade or business activity (within the meaning of paragraph (e)(2) of this section) conducted by one or more members of a consolidated group is a passive activity of the members is made by reference to the consolidated group's participation in the activity. (ii) Determination of status and participation of consolidated group. For purposes of determining under §1.469-1T(g)(2) whether a consolidated group is treated as a closely held corporation or a personal service corporation, and determining under

§1.469-1T(g)(3) whether the consolidated group materially or significantly

participates in any activity conducted by one or more members of the group- (A) The members of the consolidated group shall be treated as one corporation; (B) Only the outstanding stock of the common parent shall be treated as outstanding stock of the corporation; (C) An employee of any member of the group shall be treated as an employee of the corporation; and (D) An activity is treated as the principal activity of the corporation if and only if it is the principal activity (within the meaning of §1.441-4T(f)) of the consolidated group. (h)(5) through (k) (Reserved)

Par. 4. Section 1.469-1T is amended by revising paragraphs (d)(2), (e)(2), (e)(3)(iii), (e)(3)(vi)(D) and (E), (e)(4)(iv), (e)(5), (f)(4), (g)(4)(ii)(C), and (h)(4) to read as follows:

§1.469-1T General rules.

(d) (2) Coordination with sections 613A(d) and 1211. (Reserved) See §1.469-1(d)(2) for rules relating to this paragraph. (e) (2) Trade or business activity. (Reserved) See §1.469-1(e)(2) for rules relating to this paragraph. (3) (iii) Average period of customer use. (Reserved) See §1.469-1(e)(3)(iii) for rules relating to this paragraph. (vi) (D) Lodging for convenience of employer. (Reserved) See §1.469-1(e)(3)(vi)(D) for rules relating to this paragraph. (E) Unadjusted basis. (Reserved) See §1.469-1(e)(3)(vi)(E) for rules relating to this paragraph. (4) (iv) Definition of "working interest." (Reserved) See §1.469-1(e)(4)(iv) for rules relating to this paragraph. (5) Rental of dwelling unit. (Reserved) See §1.469-1(e)(5) for rules relating to this paragraph. (f) (4) Carryover of disallowed deductions and credits. (Reserved) See §1.469-1(f)(4) for rules relating to this paragraph. (g) (4) (ii) (C) (Reserved) See §1.469-1(g)(4)(ii)(C) for rules relating to this paragraph.

(h) (4) (Reserved) See §1.469-1(h)(4) for rules relating to this paragraph. Par. 5. Section 1.469-2 is added to read as follows:

§1.469-2 Passive activity loss.

(a) through (c)(2)(ii) (Reserved) (c)(2)(iii) Disposition of substantially appreciated property formerly used in nonpassive activity-(A) In general. If an interest in property used in an activity is substantially appreciated at the time of its disposition, any gain from the disposition shall be treated as not from a passive activity unless the interest in property was used in a passive activity for either- (1) 20 percent of the period during which the taxpayer held the interest in property; or (2) The entire 24-month period ending on the date of the disposition. (B) Date of disposition. For purposes of this paragraph (c)(2)(iii), a disposition of an interest in property is deemed to occur on the date that the interest in property becomes subject to an oral or written agreement that either requires the owner or gives the owner an option to transfer the interest in property for consideration that is fixed or otherwise determinable on that date. (C) Substantially appreciated property. For purposes of this paragraph (c)(2)(iii), an interest in property is substantially appreciated if the fair market value of the interest in property exceeds 120 percent of the adjusted basis of the interest. (D) Investment property. For purposes of this paragraph (c)(2)(iii), an interest in property is treated as an interest in property used in an activity other than a passive activity and as an interest in property held for investment for any period during which the interest is held through a C corporation or similar entity. An entity is similar to a C corporation for this purpose if the owners of interests in the entity derive only portfolio income (within the meaning of §1.469-2T) from the interests. (E) Coordination with §1.469-2T(c)(2)(ii). If §1.469-2T(c)(2)(ii) applies to the disposition of an interest in property, this paragraph (6)(2)(iii) applies only to that portion of the gain from the disposition of the interest in property that is characterized as gain from a passive activity after the application of §1.469- 2T(c)(2)(ii). (F) Coordination with section 163(d). Gain that is treated as not from a passive activity under this paragraph (c)(2)(iii) is treated as income described in section 469(e)(1)(A) and §1.469-2T(c)(3)(i) if and only if the gain is from the disposition of an interest in property that was held for investment for more than 50 percent of the period during which the taxpayer held that interest in property in activities other than passive activities.

(G) Examples. The following examples illustrate the application of this paragraph (c)(2)(iii): Example 1. A acquires a building on January 1, 1993, and uses the building in a trade or business activity in which A materially participates until March 31, 2004. On April 1, 2004, A leases the building to B. On Decemner 31, 2005, A sells the building. At the time of the sale, A's interest in the building is substantially appreciated (within the meaning of paragraph (c)(2)(iii)(C) of this section). Assuming A's lease of the building to B constitutes a rental activity (within the meaning of §1.469-1T(e)(3)), the building is used in a passive activity for 21 months (April 1, 2004, through December 31, 2005). Thus, the building was not used in a passive activity for the entire 24-month period ending on the date of the sale. In addition, the 21-month period during which the building was used in a passive activity is less than 20 percent of A's holding period for the building (13 years). Therefore, the gain from the sale is treated under this paragraph (c)(2)(iii) as not from a passive activity. Example 2. (i) A, an individual, is a stockholder of corporation X. X is a C corporation until December 31, 1993, and is an S corporation thereafter. X acquires a building on January 1, 1993, and sells the building on March 1, 1994. At the time of the sale, A's interest in the building held through X is substantially appreciated (within the meaning of paragraph (c)(2)(iii)(C) of this section). The building is leased to various tenants at all times during the period in which it is held by X. Assume that the lease of the building would constitute a rental activity (within the meaning of §1.469- 1T(e)(3)) with respect to a person that holds the building directly or through an S corporation. (ii) Paragraph (c)(2)(iii)(D) of this section provides that an interest in property is treated for purposes of this paragraph (c)(2)(iii) as used in an activity other than a passive activity and as held for investment for any period during which the interest is held through a C corporation. Thus, for purposes of determining the character of A's gain from the sale of the building, A's interest in the building is treated as an interest in property held for investment for the period from January 1, 1993, to December 31, 1993, and as an interest in property used in a passive activity for the period from January 1, 1994, to February 28, 1994. (iii) A's interest in the building was not used in a passive activity for the entire 24-month period ending on the date of the sale. In addition, the 2-month period during which A's interest in the building was used in a passive activity is less than 20 percent of the period during which A held an interest in the building (14 months). Therefore, the gain from the sale is treated under this paragraph (c)(2)(iii) as not from a passive activity. (iv) Under paragraph (c)(2)(iii)(F) of this section, gain that is treated as nonpassive under this paragraph (c)(2)(iii) is treated as portfolio income (within the meaning of §1.469-2T(c)(3)(i)) if the gain is from the disposition of an interest in property that was held for investment for more than 50 percent of the period during which the taxpayer held the interest in activities other than passive activities. In this case, A's interest in the building was treated as held for investment for the entire period during which it was used in activities other than passive activities (i.e., the 12-month period from January 1, 1993, to December 31, 1993). Accordingly, A's gain from the sale is treated under this paragraph (c)(2)(iii) as portfolio income.

(iv) Taxable acquisitions. If a taxpayer acquires an interest in property in a transaction other than a nonrecognition transaction (within the meaning of section 7701(a)(45)), the ownership and use of the interest in property before the transaction is not taken into account for purposes of applying this paragraph (c)(2) to any subsequent disposition of the interest in property by the taxpayer. (v) Property held for sale to customers-(A) Sale incidental to another activity-(1) Applicability-(i) In general. This paragraph (c)(2)(v)(A) applies to the disposition of a taxpayer's interest in property if and only if- (A) At the time of the disposition, the taxpayer holds the interest in property in an activity that, for purposes of section 1221(1), involves holding the property or similar property primarily for sale to customers in the ordinary course of a trade or business (a dealing activity); (B) One or more other activities of the taxpayer do not involve holding similar property for sale to customers in the ordinary course of a trade or business (nondealing activities) and the interest in property was used in the nondealing activity or activities for more than 80 percent of the period during which the taxpayer held the interest in property; and (C) The interest in property was not acquired and held by the taxpayer for the principal purpose of selling the interest to customers in the ordinary course of a trade or business. (ii) Principal purpose. For purposes of this paragraph (c)(2)(v)(A), a taxpayer is rebuttably presumed to have acquired and held an interest in property for the principal purpose of selling the interest to customers in the ordinary course of a trade or business if- (A) The period during which the interest in property was used in nondealing activities of the taxpayer does not exceed the lesser of 24 months or 20 percent of the recovery period (within the meaning of section 168) applicable to the property; or (B) The interest in property was simultaneously offered for sale to customers and used in a nondealing activity of the taxpayer for more than 25 percent of the period during which the interest in property was used in nondealing activities of the taxpayer. For purposes of the preceding sentence, an interest in property is not considered to be offered for sale to customers solely because a lessee of the property has been granted an option to purchase the property. (2) Dealing activity not taken into account. If paragraph (c)(2)(v)(A) applies to the disposition of a taxpayer's interest in property, holding the interest in the dealing activity is treated, for purposes of §1.469-2T(c)(2), as the use of the interest in the last nondealing activity of the taxpayer in which the interest in property was used prior to its disposition. (B) Use in a nondealing activity incidental to sale. If paragraph (c)(2)(v)(A) of this section does not apply to the disposition of a taxpayer's interest in property that is

held in a dealing activity of the taxpayer at the time of disposition, the use of the interest in property in a nondealing activity of the taxpayer for any period during which the interest in property is also offered for sale to customers is treated, for purposes of §1.469-2T(c)(2), as the use of the interest in property in the dealing activity of the taxpayer. (C) Examples. The following examples illustrate the application of this paragraph (c)(2)(v): Example 1. (i) The taxpayer acquires a residential apartment building on January 1, 1993, and uses the building in a rental activity. In January 1996, the taxpayer converts the apartments into condominium units. After the conversion, the taxpayer holds the condominium units for sale to customers in the ordinary course of a trade or business of dealing in condominium units. (Assume that these are dealing operations treated as separate activities under §1.469-4, and that the taxpayer materially participates in the activity.) In addition, the taxpayer continues to use the units in the rental activity until they are sold. The units are first held for sale on January 1, 1996, and the last unit is sold on December 31, 1996. (ii) This paragraph (c)(2)(v) provides that holding an interest in property in a dealing activity (the marketing of the property) is treated for purposes of §1.469-2t(c)(2) as the use of the interest in a nondealing activity if the marketing of the property is incidental to the nondealing use. Under paragraph (c)(2)(v)(A)(2) of this section, the interests in property are treated as used in the last nondealing activity in which they were used prior to their disposition. In addition, paragraph (c)(2)(v)(A)(1) of this section provides rules for determining whether the marketing of the property is incidental to the use of an interest in property in a nondealing activity. Under these rules, the marketing of the property is treated as incidental to the use in a nondealing activity if the interest in property was used in nondealing activities for more than 80 percent of the taxpayer's holding period in the property (the holding period requirement) and the taxpayer did not acquire and hold the interest in property for the principal purpose of selling it to customers in the ordinary course of a trade or business (a dealing purpose). (iii) In this case, the apartments were used in a rental activity for the entire period during which they were held by the taxpayer. Thus, the apartments were used in a nondealing activity for more than 80 percent of the taxpayer's holding period in the property, and the marketing of the property satisfies the holding period requirement. (iv) Paragraph (c)(2)(v)(A)(1)(ii) of this section provides that a taxpayer is rebuttably presumed to have a dealing purpose unless the interest in property was used in nondealing activities for more than 24 months or 20 percent of the property's recovery period (whichever is less). The same presumption applies if the interest in property was offered for sale to customers during more than 25 percent of the period in which the interest was held in nondealing activities. In this case, the taxpayer used each apartment in a nondealing activity (the rental activity) for a period of 36 to 48 months (i.e., from January 1, 1993, to the date of sale in the period from January through December 1996). Thus, the apartments were used in nondealing activities for more than 24 months, and the first of the rebuttable presumptions described above does not apply. In addition, the apartments were offered for sale to customers for up to 12 months (depending on the month in which the apartment was sold) during the period in which the apartments were used in a nondealing activity.

The percentage obtained by dividing the period during which an apartment was held for sale to customers by the period during which the apartment was used in nondealing activities ranges from zero in the case of apartments sold on January 1, 1996, to 25 percent (i.e., 12 months/48 months) in the case of apartments sold on December 31, 1996. Thus, no apartment was offered for sale to customers during more than 25 percent of the period in which it was used in nondealing activities, and the second rebuttable presumption does not apply. (v) Because neither of the rebuttable presumptions in paragraph (c)(2)(v)(A)(1)((ii) of this section applies in this case, the taxpayer will not be treated as having a dealing purpose unless other facts and circumstances establish that the taxpayer acquired and held the apartments for the principal purpose of selling the apartments to customers in the ordinary course of a trade or business. Assume that none of the facts and circumstances suggest that the taxpayer had such a purpose. If that is the case, the taxpayer does not have a dealing purpose. (vi) The marketing of the property satisfies the holding period requirement, and the taxpayer does not have a dealing purpose. Thus, holding the apartments in the taxpayer's dealing activity is treated for purposes of this paragraph (c)(2) as the use of the apartments in a nondealing activity. In this case, the rental activity is the only nondealing activity in which the apartments were used prior to their disposition. Thus, the apartments are treated under paragraph (c)(2)(v)(A)(2) of this section as interests in property that were used only in the rental activity for the entire period during which the taxpayer held the interests. Accordingly, the rules in §1.469- 2T(c)(2)(ii) and paragraph (c)(2)(iii) of this section do not apply, and all gain from the sale of the apartments is treated as passive activity gross income. Example 2. (i) The taxpayer acquires a residential apartment building on January 1, 1993, and uses the building in a rental activity. The taxpayer converts the apartments into condominium units on July 1, 1993. After the conversion, the taxpayer holds the condominium units for sale to customers in the ordinary course of a trade or business of dealing in condominium units. (Assume that these are dealing operations treated as separate activities under §1.469-4, and that the taxpayer materially participates in the activities.) In addition, the taxpayer continues to use the units in the rental activity until they are sold. The first unit is sold on January 1, 1994, and the last unit is sold on December 31, 1996. (ii) In this case, all of the apartments were simultaneously offered for sale to customers and used in a nondealing activity of the taxpayer for more than 25 percent of the period during which the apartments were used in nondealing activities. Thus, the taxpayer is rebuttably presumed to have acquired the apartments (including apartments that are used in the rental activity for at least 24 months) for the principal purpose of selling them to customers in the ordinary course of a trade or business. Assume that the facts and circumstances do not rebut this presumption. If that is the case, the taxpayer has a dealing purpose, and paragraph (c)(2)(v)(A) of this section does not apply to the disposition of the apartments. (iii) Paragraph (c)(2)(v)(B) of this section provides that if paragraph (c)(2)(v)(A) of this section does not apply to the disposition of a taxpayer's interest in property that is held in a dealing activity of the taxpayer at the time of the disposition, the use of the interest in property in any nondealing activity of the taxpayer for any period during which the interest is also offered for sale to customers is treated as incidental

to the use of the interest in the dealing activity. Accordingly, for purposes of applying the rules of §1.469-2T(c)(2) to the disposition of the apartments, the rental of the apartments after July 1, 1993, is treated as the use of the apartments in the taxpayer's dealing activity. Example 3. (i) The taxpayer acquires a residential apartment building on January 1, 1993, and uses the building in a rental activity. In January 1996, the taxpayer converts the apartments into condominium units. After the conversion, the taxpayer holds the condominium units for sale to customers in the ordinary course of a trade or business of dealing in condominium units. (Assume that these are dealing operations treated as separate activities under §1.469-4, and that the taxpayer materially participates in the activities.) In addition, the taxpayer continues to use the units in the rental activity until they are sold. The units are first held for sale on January 1, 1996, and the last unit is sold in 1997. (ii) The treatment of apartments sold in 1996 is the same as in Example 1. The apartments sold in 1997, however, were simultaneously offered for sale to customers and used in a nondealing activity for more than 25 percent of the period during which the apartments were used in nondealing activities. (For example, an apartment that is sold on January 31, 1997, has been offered for sale for 13 months or 26.1 percent of the 49-month period during which it was used in nondealing activities.) Thus, the taxpayer is rebuttably presumed to have acquired the apartments sold in 1997 for the principal purpose of selling them to customers in the ordinary course of a trade of business. Assume that the facts and circumstances do not rebut this presumption. In that case, the marketing of the apartments sold in 1997 does not satisfy the principal purpose requirement, and paragraph (c)(2)(v)(A) of this section does not apply to the disposition of those apartments. Accordingly, for purposes of applying the rules of §1.469-2T(c)(2) to the disposition of the apartments sold in 1977, the rental of the apartments after January 1, 1996, is treated, under paragraph (c)(2)(v)(B) of this section, as the use of the apartments in the taxpayer's dealing activity. (c)(3) through (c)(5) (Reserved) (c)(6) Gross income from certain oil or gas properties-(i) In general. Notwithstanding any other provision of the regulations under section 469, passive activity gross income for any taxable year does not include an amount of the taxpayer's gross passive income for the year from a property described in this paragraph (c)(6)(i) equal to the taxpayer's net passive income from the property for the year. Property is described in this paragraph (c)(6)(i) if the property is- (A) An oil or gas property that includes an oil or gas well if, for any prior taxable year beginning after December 31, 1996, any of the taxpayer's loss from the well was treated, solely by reason of §1.469-1T(e)(4) (relating to a special rule for losses from oil and gas working interests), and not by reason of the taxpayer's material participation in the activity, as a loss that is not from a passive activity; or (B) Any property the basis of which is determined in whole or in part by reference to the basis of property described in paragraph (c)(6)(i)(A) of this section. (ii) Gross and net passive income from the property. For purposes of this paragraph (c)(6)-

(A) The taxpayer's gross passive income for any taxable year from any property described in paragraph (c)(6)(i) of this section is any passive activity gross income for the year (determined without regard to this paragraph (c)(6) and §1.469-2T(f)) from the property; (B) The taxpayer's net passive income for any taxable year from any property described in paragraph (c)(6)(i) of this section is the excess, if any, of- (1) The taxpayer's gross passive income for the taxable year from the property; over (2) Any passive activity deductions for the taxable year (including any deduction treated as a deduction for the year under §1.469-1T(f)(4)) that are reasonably allocable to the income; and (C) if any oil or gas well or other item of property (the item) is included in two or more properties described in paragraph (c)(6)(i) of this section (the properties), the taxpayer must allocate the passive activity gross income (determined without regard to this paragraph (c)(6) and §1.469-2T(f) from the item and the passive activity deductions reasonably allocable to the item among the properties. (iii) Property. For purposes of paragraph (c)(6)(i)(A) of this section, the term "property" does not have the meaning given the term by section 614(a) or the regulations thereunder, and an oil or gas property that includes an oil or gas well is- (A) The well; and (B) Any other item of property (including any oil or gas well) the value of which is directly enhanced by any drilling, logging, seismic testing, or other activities the costs of which were taken into account in determining the amount of the taxpayer's income or loss from the well. (iv) Examples. The following examples illustrate the application of this paragraph (c)(6): Example 1. A is a general partner in partnership P and a limited partner in partnership R. P and R own oil and gas working interests in two separate tracts of land acquired from two separate landowners. In 1993, P drills a well on its tract, and A's distributive share of P's losses from drilling the well are treated under §1.469- 1T(e)(4) as not from a passive activity. In the course of selecting the drilling site and drilling the well, P develops information indicating that the reservior in which the well was drilled underlies R's tract as well as P's. Under these facts, P's and R's tracts are treated as one property for purposes of this paragraph (c)(6), even if A's interests in the mineral deposits in the tracts are treated as separate properties under section 614(a). Accordingly, in 1994 and subsequent years, A's distributive share of both P's and R's income and expenses from their respective tracts is taken into account in computing A's net passive income from the property for purposes of this paragraph (c)(6). Example 2. B is a general partner in partnership S. S owns an oil and gas working interest in a single tract of land. In 1993, S drills a well, and B's distributive share of S's losses from drilling the well is treated under §1.469-1T(e)(4) as not from a

passive activity. In the course of drilling the well, S discovers two oil-bearing formations, one underlying the other. On December 1, 1993, S completes the well in the underlying formation. On January 1, 1994, B converts B's entire general partnership interest in S into a limited partnership interest. In 1994, S completes in, and commences production from, the shallow formation. Under these facts, the two mineral deposits in S's tract are treated as one property for purposes of this paragraph (c)(6), even if they are treated as separate properties under section 614(a). Accordingly, B's distributive share of S's income and expenses from both the underlying formation and from recompletion in and production from the shallow formation is taken into account in computing B's net passive income from the property for purposes of this paragraph (c)(6). (c)(6)(iv) Example 3 through (c)(7)(vi) (Reserved). (c)(7)(vii) Gross income or gain allocable to business or rental use of a dwelling unit for any taxable year in which section 280A(c)(5) applies to such business or rental use. (d)(1) through (d)(2)(viii) (Reserved). (d)(2)(ix) An item of loss or deduction that is carried to the taxable year under section 172(a), section 613A(d), section 1212(a)(1) (in the case of corporations), or section 1212(b) (in the case of taxpayers other than corporations); and (d)(2)(x) through (d)(2)(xi) (Reserved) (d)(2)(xii) A deduction or loss allocable to business or rental use of a dwelling unit for any taxable year in which section 280(c)(5) applies to such business or rental use. (d)(3) through (d)(5)(ii) (Reserved) (d)(5)(iii) Other applicable rules-(A) Applicability of rules in §1.469-2T(c)(2). For purposes of this paragraph (d)(5), a taxpayer's interests in property used in an activity and the amounts allocated to the interests shall be determined under

§1.469-2T(2)(i)(C). In addition, the rules contained in paragraph (c)(2) (iv) and (v)

of this section apply in determining for purposes of this paragraph (d)(5) the activity (or activities) in which an interest in property is used at the time of its disposition and during the 12-month period ending on the date of its disposition. (d)(5)(iii)(B) through (d)(6)(v)(D) (Reserved) (d)(6)(v)(E) Are taken into account under section 613A(d) (relating to limitations on certain depletion deductions), section 1211 (relating to the limitation on capital losses), or section 1231 (relating to property used in a trade or business and involuntary conversions); or (d)(6)(v)(F) through (d)(7) (Reserved) (d)(8) Taxable year in which item arises. For purposes of §1.469-2T(d), an item of deduction arises in the taxable year in which the item would be allowable as a

deduction under the taxpayer's method of accounting if taxable income for all taxable years were determined without regard to sections 469, 613A(d) and 1211. (e)(1) through (e)(2)(i) (Reserved) (e)(2)(ii) Section 707(c). Except as provided in paragraph (e)(2)(iii)(B) of this section, any payment to a partner for services or the use of capital that is described in section 707(c), including any payment described in section 736(a)(2) (relating to guaranteed payments made in liquidation of the interest of a retiring or deceased partner), is characterized as a payment for services or as the payment of interest, respectively, and not as a distributive share of partnership income. (iii) Payments in liquidation of a partner's interest in partnership property-(A) In general. If any gain or loss is taken into account by a retiring partner (or any other person that owns (directly or indirectly) an interest in the partner if the partner is a passthrough entity) or a deceased partner's successor in interest as a result of a payment to which section 736(b) (relating to payments made in exchange for a retired or deceased partner's interest in partnership property) applies, the gain or loss is treated as passive activity gross income or a passive activity deduction only to the extent that the gain or loss would have been passive activity gross income or a passive activity deduction of the retiring or deceased partner (or the other person) if it had been recognized at the time the liquidation of the partner's interest commenced. (B) Payments in liquidation of a partner's interest in unrealized receivables and goodwill under section 736(a). (1) If a payment is made in liquidation of a retiring or deceased partner's interest, the payment is described in section 736(a), and any income- (i) Is taken into account by the retiring partner (or any other person that owns (directly or indirectly) an interest in the partner if the partner is a passthrough entity) or the deceased partner's successor in interest as a result of the payment; and (ii) Is attributable to the portion (if any) of the payment that is allocable to the unrealized receivables (within the meaning of section 751(c)) and goodwill of the partnership; the percentage of the income that is treated as passive activity gross income shall not exceed the percentage of passive activity gross income that would be included in the gross income that the retiring or deceased partner (or the other person) would have recognized if the unrealized receivables and goodwill had been sold at the time that the liquidation of the partner's interest commenced. (2) For purposes of this paragarph (e)(2)(iii)(B), the portion (if any) of a payment under section 736(a) that is allocable to unrealized receivables and goodwill of a partnership shall be determined in accordance with the principles employed under §1.736-1(b) for determining the portion of a payment made under section 736 that is treated as a distribution under section 736(b).

(e)(3)(i) through (iii)(A) (Reserved) (e)(3)(iii)(B) An amount of gain that would have been treated as gain that is not from a passive activity under paragraph (c)(2)(iii) of this section (relating to substantially appreciated property formerly used in a nonpassive activity), paragraph (c)(6) of this section (relating to certain oil or gas properties), §1.469-2T(f)(5) (relating to certain property rented incidental to development), paragraph (f)(6) of this section (relating to property rented to a nonpassive activity), or §1.469-2T(f)(7) (relating to certain interests in a passthrough entity engaged in the trade or business of licensing intangible property) would have been allocated to the holder (or such other person) with respect to the interest if all of the property used in passive activity had been sold immediately prior to the disposition for its fair market value on the applicable valuation date (within the meaning of §1.469-2T(e)(3)(ii)(D)(1)); and (e)(3)(iii)(C) through (f)(4) (Reserved) (f)(5) Net income from certain property rented incidental to development activity-(i) In general. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from the item of property shall be treated as not from a passive activity if- (A) Any gain from the sale, exchange, or other disposition of the item of property is included in the taxpayer's income for the taxable year; (B) The taxpayer's use of the item of property in an activity involving the rental of the property commenced less than 12 months before the date of the disposition (within the meaning of paragraph (c)(2)(iii)(B) of this section) of such property; and (C) The taxpayer materially participated (within the meaning of §1.469-5T) or significantly participated (within the meaning of §1.469-5T(c)(2)) for any taxable year in an activity that involved for such year the performance of services for the purpose of enhancing the value of such item of property (or any other item of property if the basis of the item of property that is sold, exchanged, or otherwise disposed of is determined in whole or in part by reference to the basis of such other item of property). (f)(5)(ii) through (f)(5)(iv) (Reserved) (f)(6) Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property- (i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of §1.469-5T) for the taxable year; and (ii) Is not described in §1.469-2T(f)(5). (f)(7) through (f)(9)(ii) (Reserved)

(f)(9)(iii) The gross rental activity income for a taxable year from an item of property is any passive activity gross income (determined without regard to §1.469-2T(f)(2) through (f)(6)) that- (A) Is income for the year from the rental or disposition of such item of property; and (B) In the case of income from the disposition of such item of property, is income from an activity that involved the rental of such item of property during the 12-month period ending on the date of the disposition (see §1.469-2T(c)(2)(ii)); and (iv) The net rental activity income from an item of property for the taxable year is the excess, if any, of- (A) The gross rental activity income from the item of property for the taxable year; over (B) Any passive activity deductions for the taxable year (including any deduction treated as a deduction for the year under §1.469-1(f)(4)) that are reasonably allocable to the income. (10) Coordination with section 163(d). Gross income that is treated as not from a passive activity under §1.469-2T(f)(3), (4), or (7) is treated as income described in section 469(e)(1)(A) and §1.469-2T(c)(3)(i) except in determining whether- (i) Any property is treated for purposes of section 469(e)(1)(A)(ii)(I) and §1.469- 2T(c)(3)(i)(C) as property that produces income of a type described in §1.469- 2T(c)(3)(i)(A); (ii) Any property is treated for purposes of section 469(e)(1)(A)(ii)(II) and §1.469- 2T(c)(3)(i)(D) as property held for investment; (iii) An expense (other than interest expense) is treated for purposes of section 469(e)(1)(A)(i)(II) and §1.469-2T(d)(4) as clearly and directly allocable to portfolio income (within the meaning of §1.469-2T(c)(3)(i); and (iv) Interest expense is allocated under §1.163-8T to an investment expenditure (within the meaning of §1.163-8T(b)(3)) or to a passive activity expenditure (within the meaning of §1.163-8T(b)(4)). (11) (Reserved) Par. 6. Section 1.469-2T is amended by revising paragraphs (c)(2)(iii), (c)(2)(iv), (c)(2)(v), (c)(6)(i), (c)(6)(ii), (c)(6)(iii), (c)(6)(iv) Examples (1) and (2), (d)(2)(ix), (d)(5)(iii)(A), (d)(6)(v)(E), (d)(8), (e)(2)(ii) and (iii), (e)(3)(iii)(B), (f)(5)(i), (f)(6), (f)(9)(iii), (f)(9) (iv) and (f)(10) to read as follows:

§1.469-2T Passive activity loss.

(c)

(2) (iii) Disposition of substantially appreciated property formerly used in nonpassive activity. (Reserved) See §1.469-4(c)(2)(iii) for rules relating to this paragraph. (iv) Taxable acquisitions. (Reserved) See §1.469-2(c)(iv) for rules relating to this paragraph. (v) Property held for sale to customers. (Reserved) See §1.469-2(c)(v) for rules relating to this paragraph. (6) Gross income from certain oil or gas properties-(i) In general. (Reserved) See §1.469-2(c)(6)(i) for rules relating to this paragraph. (ii) Gross and net passive income from the property. (Reserved) See §1.469- 2(c)(6)(ii) for rules relating to this paragraph. (iii) Property. (Reserved) See 1.469-2(c)(6)(iii) for rules relating to this paragraph. (iv) Examples. Example 1. (Reserved) See §1.469-2(c)(6)(iv) Example 1. Example 2. (Reserved) See §1.469-2(c)(6)(iv) Example 2. (d) (2) (ix) (Reserved) See §1.469-2(d)(2)(ix) for rules relating to this paragraph. (5) (iii) (A) Applicability of rules in paragraph (c)(2). (Reserved) See §1.469-2(d)(5)(iii)(A) for rules relating to this paragraph. (6) (v) (E) (Reserved) See §1.469-2(d)(6)(v)(E) for rules relating to this paragraph. (8) Taxable year in which item arises. (Reserved) See §1.469-2(d)(8) for rules relating to this paragraph. (e) (2)

(ii) Section 707(c). (Reserved) See §1.469-2(e)(ii) for rules relating to this paragraph. (iii) Payments in liquidation of a partner's interest in partnership property. (Reserved) See §1.469-2(e)(iii) for rules relating to this paragraph. (3) (iii) (B) (Reserved) See §1.469-2(e)(3)(iii)(B) for rules relating to this paragraph. (f) (5) (i) In general. (Reserved) See §1.469-2(f)(5)(i) for rules relating to this paragraph. (6) Property rented to a nonpassive activity. (Reserved) See §1.469-2(f)(6) for rules relating to this paragraph. (9) (iii) (Reserved) See §1.469-2(f)(9)(iii) for rules relating to this paragraph. (iv) (Reserved) See §1.469-2(f)(9)(iv) for rules relating to this paragraph. (10) Coordination with section 163(d). (Reserved) See paragraph 1.469-2(f)(10) for rules relating to this paragraph. Par. 7. Section 1.469-3 is added to read as follows:

§1.469-3 Passive activity credit.

(a) through (d) (Reserved) (e) Coordination with section 38(b). Any credit described in section 38(b) (1) through (5) is taken into account in computing the current year business credit for the first taxable year in which the credit is subject to section 469 and is not disallowed by section 469 and the regulations thereunder. (f) Coordination with section 50. In the case of any cessation described in section 50(a) (1) or (2), the credits allocable to the taxpayer's activities under §1.469- 1(f)(4) shall be adjusted by reason of the cessation. (g) (Reserved) Par. 8. Section 1.469-3T is amended by revising paragraphs (e) and (f) to read as follows:

§1.469-3T Passive activity credit.

(e) Coordination with section 38(b). (Reserved) See §1.469-3(e) for rules relating to this paragraph. (f) Coordination with section 50. (Reserved) See §1.469-3(f) for rules relating to this paragraph. Par. 9. Section 1.469-5 is added to read as follows:

§1.469-5 Material participation.

(a) through (e) (Reserved) (f) Participation-(1) In general. Except as otherwise provided in this paragraph (f), any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity in which the individual owns an interest at the time the work is done shall be treated for purposes of this section as participation of the individual in the activity. (f)(2) through (h)(2) (Reserved) (h)(3) Coordination with rules governing the treatment of passthrough entities. If a taxpayer takes into account for a taxable year of the taxpayer any item of gross income or deduction from a partnership or S corporation that is characterized as an item of gross income or deduction from an activity in which the taxpayer materially participated under §1.469-2T(e)(1), the taxpayer is treated as materially participating in the activity for the taxable year for purposes of applying §1.469- 5T(a)(5) and (6) to any succeeding taxable year of the taxpayer. (i) (Reserved) (j) Material participation for preceding taxable years-(1) In general. For purposes of §1.469-5T(a)(5) and (6), a taxpayer has materially participated in an activity for a preceding taxable year if the activity includes significant section 469 activities that are substantially the same as significant section 469 activities that were included in an activity in which the taxpayer materially participated (determined without regard to §1.469-5T(a)(5)) for the preceding taxable year. (2) Material participation for taxable years beginning before January 1, 1987. In any case in which it is necessary to determine whether an individual materially participated in any activity for a taxable year beginning before January 1, 1987 (other than a taxable year of a partnership, S corporation, estate, or trust ending after December 31, 1986), the determination shall be made without regard to paragraphs (a)(2) through (7) of this section. (k) Examples. Example (1) through Example (4) (Reserved) Example (5). In 1993, D, an individual, acquires stock in an S corporation engaged in a trade or business activity (within the meaning of §1.469-1(e)(2)). For every taxable year from 1993 through 1997, D is treated as materially participating

(without regard to §1.469-5T(a)(5)) in the activity. D retires from the activity at the beginning of 1998, and would not be treated as materially participating in the activity for 1998 and subsequent taxable years if material participation of those years were determined without regard to §1.469-5T(a)(5). Under §1.469-5T(a)(5) of this section, however, D is treated as materially participating in the activity for taxable years 1998 through 2003 because D materially participated in the activity (determined without regard to §1.469-5T(a)(5) for five taxable years during the ten taxable years that immediately precede each of those years. D is not treated under

§1.469-5T(a)(5) as materially participating in the activity for taxable years beginning

after 2003 because for those years D has not materially participated in the activity (determined without regard to §1.469-5T(a)(5) for five of the last ten immediately preceding taxable years. Par. 10. Section 1.469-5T is amended by revising paragraphs (f)(1), (h)(3), (j) and (k) Example 5 to read as follows:

§1.469-5T Material participation.

(f)(1) (Reserved) See §1.469-5(f)(1) for rules relating to this paragraph. (h) (3) Coordination with rules governing the treatment of passthrough entities. (Reserved) See §1.469-5(h)(3) for rules relating to this paragraph. (j) Material participation for preceding taxable years. (Reserved) See §1.469-5(j) for rules relating to this paragraph. (k) Example 5. (Reserved) See §1.469-5(k) Example 5 for this example. §§1.469-6T-1.468-11T (Removed) Par. 11. Sections 1.469-6T through 1.468-11T are removed. Par. 12. Sections 1.469-6 through 1.469-10 are added and reserved and §1.469-11 is added to read as follows:

§1.469-6 Treatment of losses upon certain dispositions. (Reserved)

§1.469-7 Treatment of self-charged items of income and expense.

(Reserved)

§1.469-8 Application of section 469 to trust, estates, and their beneficiaries.

(Reserved)

§1.469-9 Treatment of income, deductions and credits from certain rental

real estate activities. (Reserved)

§1.469-10 Application of section 469 to publicly traded partnerships.

(Reserved)

§1.469-11 Effective date and transition rules.

(a) Generally applicable effective dates. Except as otherwise provided in this section- (1) The rules contained in §§1.469-1, 1.469-1T, 1.469-2, 1.469-2T, 1.469-3, 1.469- 3T, 1.469-5, and 1.469-5T apply for taxable years ending after May 10, 1992. (2) The rules contained in 26 CFR 1.469-1T, 1.469-2T, 1.469-3T, 1.469-4T, 1.469- 5T, 1.469-11T (b) and (c) (as contained in the CFR edition revised as of April 1, 1992) apply for taxable years beginning after December 31, 1986, and ending on or before May 10, 1992; and (3) This section applies for taxable years beginning after December 31, 1986. (b) Additional effective dates.-(1) Transition rule for 1992 amendments. If a taxpayer's first taxable year ending after May 10, 1992, begins on or before that date, the taxpayer may treat the taxable year, for purposes of paragraph (a) of this section, as a taxable year ending on or before May 10, 1992. (2) Certain investment credit property. (i) The rules contained in §1.469-3(f) apply with respect to property placed in service after December 31, 1990 (other than property described in section 11813 (c)(2) of the Omnibus Reconciliation Act of 1990 (P.L. 101-508)). (ii) The rules contained in 26 CFR 1.469-3T(f) (as contained in the CFR edition revised as of April 1, 1992) apply with respect to property placed in service on or before December 31, 1990, and property described in section 11813(c)(2) of the Omnibus Reconcilation Act of 1990. (c) Special rules-(1) Application of certain income recharacterization rules-(i) In general. No amount of gross income shall be treated under §1.469-2T(f)(3) through (7) as income that is not from a passive activity for any taxable year of the taxpayer beginning before January 1, 1988. (ii) Property rented to a nonpassive activity. In applying §1.469-2(f)(6) or §1.469- 2T(f)(6) to a taxpayer's rental of an item of property, the taxpayer's net rental activity income (within the meaning of §1.469-2(f)(9)(iv) or §1.469-2T(f)(9)(iv)) from the propety for any taxable year beginning after December 31, 1987, does not include the portion of the income (if any) that is attributable to the rental of that item of property pursuant to a written binding contract entered into before February 19, 1988. (2) Qualified low-income housing projects. For a transitional rule concerning the application of section 469 to losses from qualified low-income housing projects, see section 502 of the Tax Reform Act of 1986. (3) Effect of events occurring in years prior to 1987. The treatment for a taxable year beginning after December 31, 1986, of any item of income, gain, loss,

deduction, or credit as an item of passive activity gross income, passive activity deduction, or credit from a passive activity, is determined as if section 469 and the regulations thereunder had been in effect for taxable years beginning before January 1, 1987, but without regard to any passive activity loss or passive activity credit that would have been disallowed for any taxable year beginning before January 1, 1987, if section 469 and the regulations thereunder had been in effect for that year. For example, in determining whether a taxpayer materially participates in an activity under §1.469-5T(a)(5) (relating to taxpayers who have materially participated in an activity for five of the ten immediately preceding taxable years) for any taxable year beginning after December 31, 1986, the taxpayer's participation in the activity for all prior taxable years (including taxable years beginning before 1987) is taken into account. See §1.469-5(j) (relating to the determination of material participation for taxable years beginning before January 1, 1987). (d) Examples. The following examples illustrate the application of paragraph (c) of this section: Example 1. A, a calendar year individual, is a partner in a partnership with a taxable year ending on January 31. During its taxable year ending January 31, 1987, the partnership was engaged in a single activity involving the conduct of a trade or business. In applying section 469 and the regulations thereunder to A for calendar year 1987, A's distributive share of partnership items for the partnership's taxable year ending January 31, 1987, is taken into account. Therefore, under §1.469- 2T(e)(1) and paragraph (c)(3) of this section, A's participation in the activity throughout the partnership's taxable year beginning February 1, 1986, and ending January 31, 1987, is taken into account for purposes of determining the character under section 469 of the items of gross income, deduction, and credit allocated to A for the partnership's taxable year ending January 31, 1987. Example 2. B, a calendar year individual, is a beneficiary of a trust described in section 651 that has a taxable year ending January 31. The trust conducts a rental activity (within the meaning of §1.469-1T(e)(3)). Because the trust's taxable year ending January 31, 1987, began before January 1, 1987, section 469 and the regulations thereunder do not applying to the trust for that year. Section 469 and the regulations thereunder do apply, however, to B for B's calender year 1987. Therefore, income of the trust from the rental activity for the trust's taxable year ending January 31, 1987, that is included in B's gross income for 1987 is taken into account in apply section 469 to B for 1987. Shirley D. Peterson, Commissioner of Internal Revenue. Approved: May 7, 1992. Fred T. Goldberg, Jr., Assistant Secretary of the Treasury.

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final Income Tax Regulations concerning the low-income housing credit under section 42 of the Internal Revenue Code of 1986. The final regulations address the application of the not-for-profit rules of section 183 to activities entitling taxpayers to claim low-income housing credits.

EFFECTIVE DATE

The regulations are effective with respect to buildings placed in service after December 31, 1986.

FOR FURTHER INFORMATION CONTACT

Paul F. Handleman, (202) 377-6349 (not a toll-free call).

SUPPLEMENTARY INFORMATION

Background

On November 13, 1991, the Internal Revenue Service published in the Federal Register a notice of proposed rulemaking (56 FR 57605) under section 42. No public comments or requests for a public hearing were received concerning these regulations. Therefore, the proposed regulations are adopted by this Treasury decision unchanged.

Explanation of Provisions

Section 252 of the Tax Reform Act of 1986 (Pub. L. 99-514), as amended by the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 101-647), the Revenue Reconciliation Act of 1989 (Pub. L. 101-239), the Revenue Reconciliation Act of 1990 (Pub. L. 101-508), and the Tax Extension Act of 1991 (Pub. L. 102-227), enacted and amended the low-income housing credit under section 42 of the Internal Revenue Code of 1986. Since the enactment of the low-income housing credit, taxpayers have raised questions concerning the application of the not-for-profit rules of section 813 to low-income housing credit activities. The low-income housing credit under section 42 replaced a variety of tax preferences available under prior law for low-income rental housing because the credit was thought to be a more efficient mechanism for encouraging the provision of low-

income housing. See S. Rep. No. 313, 99th Cong., 2d Sess. 758-59 (1986), 1986-3 (Vol. 3) C.B. 758-59. Although no explicit reference is contained in section 42 or its legislative history regarding its interaction with section 183, the legislative history of the low-income housing credit indicates that Congress contemplated that tax benefits such as the credit and depreciation would be available to taxpayers investing in low-income housing, even though such an investment would not otherwise provide a potential for economic return. Therefore, to reflect the congressional intent in enacting section 42, the regulatory authority under section 42(n) is being exercised to provide that section 183 will not be used to limit or disallow the credit.

Special Analyses

These final regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Paul F. Handleman, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the Service and the Treasury Department participated in their development.

List of Subjects

26 CFR 1.37-1 through 1.44A-1 Credits, Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

1953 Paragraph 1. The authority citation for part 1 is amended by adding the following citation:

Authority

Sec. 7805, 68A Stat. 917 ( 26 U.S.C. 7805) Section 1.42-4 is also issued under 26 U.S.C. 42(n) Par. 2. New §1.42-4 is added to read as follows:

§1.42-4 Application of not-for-profit rules of section 183 to low-income

housing credit activities. (a) Inapplicability to section 42. In the case of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable, section 183 does not apply to disallow losses, deductions, or credits attributable to the ownership and operation of the building. (b) Limitation. Notwithstanding paragraph (a) of this section, losses, deductions, or credits attributable to the ownership and operation of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable may be limited or disallowed under other provisions of the Code or principles of tax law. See, e.g., sections 38(c), 163(d), 465, 469; Knetsch v. United States, 364 U.S. 361 (1960), 1961-1 C.B. 34 ("sham" or "economic substance" analysis); and Frank Lyon Co. v. Commissioner, 435 U.S. 561 (1978), 1978-1 C.B. 46 ("ownership" analysis). (c) Effective date. The rules set forth in paragraphs (a) and (b) of this section are effective with respect to buildings placed in service after December 31, 1986. Shirley D. Peterson, Commissioner of Internal Revenue. Approved: April 8, 1992. Fred T. Goldberg, Jr., Assistant Secretary of the Treasury

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final Income Tax Regulations relating to the requirement that State allocation plans provide a procedure for State and local housing credit agencies to monitor for compliance with the requirements of section 42 of the Internal Revenue Code. State and local housing credit agencies are to report any noncompliance to the Internal Revenue Service. These final regulations affect State and local housing credit agencies, owners of buildings or projects for which the low-income housing credit is claimed, and taxpayers claiming the low-income housing credit.

EFFECTIVE DATE

These final regulations are effective June 30, 1993.

FOR FURTHER INFORMATION CONTACT

Paul F. Handleman, (202) 622-3040 (not a toll-free call).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1291. The estimated annual burden per State or local government respondent/recordkeeper varies from 10 hours to 1,500 hours, with an estimated average of 250 hours. The estimated annual burden for all other respondent/recordkeepers varies from .5 hours to 3 hours, with an estimated average of 1 hour. These estimates are an approximation of the average time expected to be necessary for the collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances. Comments concerning the accuracy of this burden and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Background

On December 27, 1991, the Internal Revenue Service published in the Federal Register a notice of proposed rulemaking (56 FR 67018) under section 42 of the Internal Revenue Code of 1986 with respect to the low-income housing credit. A number of public comments were received concerning these regulations, and a public hearing was held on March 4, 1992. After consideration of the written comments and those presented at the hearing, the proposed regulations are adopted, as revised, by this Treasury decision.

Explanation of Provisions

Section 42 provides for a low-income housing credit that may be claimed as part of the general business credit under section 38. The credit determined under section 42 is allowable only to the extent the owner of a qualified low-income building receives a housing credit allocation from a State or local housing credit agency ("Agency"), unless the building is exempt from the allocation requirement by reason of section 42(h)(4)(B). Under section 42(m)(1)(A), the housing credit dollar amount for any building is zero unless the amount was allocated pursuant to a qualified allocation plan of the Agency. Similarly, under section 42(m)(1)(D), the housing credit dollar amount for any project qualifying under section 42(h)(4) is zero unless the project satisfies the requirements for allocation of a housing credit dollar amount under the qualified allocation plan of the Agency. Under section 42(m)(1)(B)(iii), which was amended and renumbered by the Revenue Reconciliation Act of 1990 (the "1990 Act"), an allocation plan is not qualified unless it contains a procedure that the Agency (or an agent of, or private contractor hired by, the Agency) will follow in monitoring compliance with the provisions of section 42. The Agency is to notify the Internal Revenue Service of any noncompliance of which the Agency becomes aware. Section 42(m)(1)(B)(iii) is effective on January 1, 1992, and applies to all buildings for which the low-income housing credit determined under section 42 is, or has been, allowable at any time. These final regulations provide guidance on section 42(m)(1)(B)(iii). Under the regulations, an allocation plan meets the requirement of section 42(m)(1)(B)(iii) if it includes a monitoring procedure that contains, in substance, all of the provisions specified in the regulations. The specified provisions are minimum requirements; a monitoring procedure may contain additional provisions or requirements. Moreover, the language, form, and order of the specified provisions as set forth in the regulations need not be exactly duplicated in an allocation plan in order for the plan to include a monitoring procedure as required by the regulations. As long as the substance of the provisions specified in the regulations is contained in the allocation plan as a whole, the allocation plan satisfies the monitoring procedure required by the regulations.

These regulations only address compliance monitoring procedures of Agencies. They do not address forms and other records that may be required by the Internal Revenue Service on examination or audit.

Public Comments

Comments on Recordkeeping and Record Retention One comment suggested that where an allocation of credit has been made on a project basis under section 42(h)(1)(F), the recordkeeping and record retention provisions should also apply on a project basis. This suggestion has not been adopted because only the minimum set-aside requirement under section 42(g)(1) is satisfied on a project-by-project basis. All other requirements of section 42 must be met on a building-by-building basis. Two comments suggested that owners of low-income housing projects be required to keep records describing how utility allowances are determined. Because utility allowances are taken into account in determining whether a unit is rent-restricted under section 42(g)(2)(B)(ii), the final regulations include utility allowances among the rent records to be retained by owners. Another comment suggested that owners should be required to keep records showing: (1) The number of occupants in each unit and changes in the number of occupants for those units where rent is determined by the number of occupants per unit; (2) information on unit size, including the number of bedrooms and square footage of the unit; and (3) how the eligible basis was calculated at the end of the first year of the credit period. These suggestions have been adopted by the final regulations. Also in response to this comment, the final regulations clarify that the records of tenant income should be kept on a per unit basis. However, this comment's suggestion that owners be required to retain marketing and advertising materials demonstrating that units are available to the general public has not been adopted by the final regulations because marketing and advertising materials may not be sufficient to demonstrate that a building satisfies the general public use requirement. One comment suggested that if a building is sold or transferred, the building owner should be required to transfer all records to the new owner. In the case of an audit, the new owner needs at least some of those records in order to demonstrate that any credit is allowable for the building and to avoid recapture. In particular, records of the first year of the credit period are necessary to show that credit is allowable for any later year in the credit period. The final regulations do not address transfers of records to new owners of buildings because these regulations are directed to Agencies and Agencies are not required to monitor prior years of the compliance period once those years end. Nevertheless, even without an Agency requirement, the transferee, as part of its transaction with the transferor, should obtain the first year information from the transferor in order to substantiate credits claimed. Several comments suggested that tenant participation in a housing assistance program under section 8 of the United States Housing Act of 1937 ("Section 8") should exempt the owner from having to obtain supporting income documentation from that tenant because public housing authorities verify each Section 8 tenant's income and assets. Participation in the Section 8 program does not necessarily

guarantee that a tenant has a qualifying income equal to or less than the income limitation under section 42(g). However, in response to this suggestion, the final regulations provide that if public housing authorities submit a statement to the building owner declaring that a Section 8 tenant's income does not exceed the applicable income limit under section 42(g), the owner is not required to obtain other documentation to verify that tenant's income. Several comments noted that the definition of annual income under the Section 8 program is based on the tenant's anticipated annual income for the 12 months following the income certification. These commentators suggested that federal income tax returns not be considered permissible documentation of income because tax returns only show income for the prior tax year. This suggestion has not been adopted by the final regulations because, although the determination of annual income is not based upon gross income for federal income tax purposes (tenant income is calculated in a manner consistent with the determination of annual income under Section 8), tax returns do supply evidence of a tenant's sources of income and are signed under penalty of perjury. Several comments stated that the requirement that owners retain each year's records for 6 years beyond the end of the building's compliance period is unreasonable. In response to these comments, the final regulations do not require owners to retain a year's records for more than 6 years after the due date (with extensions) for filing the federal income tax return for that year. However, because under the final regulations the records for the first year of the credit period are needed to prove the building's eligibility for the credit each year, those records must be retained for at least 6 years beyond the due date (with extensions) for filing the federal income tax return for the last year of the building's compliance period. This is appropriate because, as noted above, these records may be needed to show that credit is allowable. Two comments questioned whether records should be kept for the extended use period under section 42(h)(6)(D). The final regulations do not contain any such requirement because recapture of the credit can result only from noncompliance occurring during the compliance period. However, an Agency may require retention of records for a longer period if it desires. One comment questioned the period for which an Agency should retain its records. In response, the final regulations provide that an Agency must retain records of noncompliance or failure to certify for 6 years beyond the Agency's filing of the respective Form 8823, "Low-Income Housing Credit Agencies Report of Noncompliance." In all other cases, the Agency must retain the certifications and records for 3 years from the end of the calendar year the Agency receives the certifications and records. Comments on Certification and Review Two comments suggested that building owners be required to certify the applicable fraction and eligible basis claimed on the last filed Form 8609 (Schedule A), "Annual Statement." This suggestion has not been adopted because this information is already available to the Examination Division of the Internal Revenue Service. The Service bears the responsibility for determining whether a building owner has claimed the correct amount of credit each year and whether the building owner is

subject to recapture. It is not the intent of these regulations to have Agencies audit income tax returns. However, in response to this comment, the final regulations add to the list of certifications a requirement that owners certify that the applicable fraction under section 42(c)(1)(B) has not changed from the prior year or, if the applicable fraction has changed, that the owners describe the change. Several comments questioned whether an Agency is required to choose the reporting period the certifications cover or whether the certifications must cover the owner's taxable year. Those comments also suggested that the certifications should cover the preceding 12-month period. In response to this suggestion, the final regulations state that the annual owner certifications should cover the preceding 12-month period. However, an Agency is free to require more frequent certifications covering shorter time periods provided that all months within each 12-month period are subject to certification. One comment suggested that the review provision should include monitoring for violations of the rent restrictions under section 42(g)(2). This suggestion has been adopted by the final regulations. Another comment suggested that the final regulations provide that the "next available unit" rule is not violated, and credit is not recaptured, if a vacant low-income unit of comparable or smaller size is rented on a temporary basis to a market-rate tenant. This suggestion has not been adopted. The issue of whether temporary rentals result in recapture of the credit is not properly addressed in regulations on compliance monitoring, but will be addressed in future guidance on credit recapture. Two comments suggested that owners of buildings with 100 percent low-income occupancy should be required to submit tenant income certifications only for those units that became vacant after the previous year's compliance certifications were submitted. This suggestion has not been adopted because the determination of whether a tenant qualifies for purposes of the low-income set-aside is made on a continuing basis, both with regard to the tenant's income and the qualifying area income, rather than only on the date the tenant initially occupies the unit. See 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-93 (1986), 1986-3 (Vol. 4) C.B. 93. Numerous comments suggested that the review provision be revised to provide for random sampling in both review choices. In addition, the comments requested guidance as to the number of projects that must be inspected each year and the number of units in each project that must be examined. The comments also requested additional flexibility in designing a review procedure than that available under the proposed regulations. In response to these suggestions, the review provision of the final regulations has been revised to provide Agencies with more flexibility and certainty in designing monitoring procedures. The final regulations permit a review provision containing any one or more of the following three sets of requirements: (1) The owners of at least 50 percent of all low-income housing projects in the Agency's jurisdiction must submit to the Agency for compliance review a copy of the annual income certification, the documentation the owner has received to support that certification, and the rent record for each low-income tenant in at least 20 percent of the low-income units in their projects; (2) the Agency must inspect at least 20 percent of the low-income housing projects in the Agency's jurisdiction each year and must inspect the low-income certification, the

documentation the owner has received to support that certification, and the rent record for each low-income tenant in at least 20 percent of the low-income units in those projects; or (3) the owners of all low-income housing projects in the Agency's jurisdiction must submit to the Agency each year information on tenant income and rent for each low-income unit, in the form and manner designated by the Agency, and the owners of at least 20 percent of the projects in the Agency's jurisdiction must submit to the Agency for compliance review a copy of the annual income certification, the documentation the owner has received to support that certification, and the rent record fo r each low-income tenant in at least 20 percent of the low-income units in their projects. The Agency should determine which tenants' records are to be submitted by the owners for review. Numerous comments questioned how the permitted exception would operate with respect to certain buildings financed with tax-exempt bond proceeds or with loans made under the Farmers Home Administration (FmHA) section 515 program. In response to these comments, the final regulations clarify this exception. Under the final regulations, a monitoring procedure may except FmHA-financed or bond-financed buildings from the review provision if the FmHA or tax-exempt bond issuer agrees to provide information concerning the income and rent of the tenants in the building to the Agency. The Agency may assume the accuracy of the information provided by the FmHA or the tax-exempt bond issuer without verification. The Agency must review the information and determine that the income limitation and rent restriction of section 42 (g)(1) and (2) are met. However, if the information provided by the FmHA or tax-exempt bond issuer is not sufficient for the Agency to make this determination, the Agency must request the necessary additional income or rent information from the owner of the buildings. Comments on Auditing One comment suggested that the use of the term "auditing" in the proposed regulations is misleading because it implies that the Agency is to audit the tax records of the owner of the building for the Service. In response to this suggestion, the final regulations substitute the term "inspection." Another comment noted that the proposed regulations could be interpreted as prohibiting a separate physical inspection of a building without a review of the records. This interpretation was not intended. An inspection may include, but is not required to include, a review of records. Comments on Notification of Noncompliance Several comments suggested that notification of noncompliance to the Service not be required where the noncompliance has been corrected within a reasonable amount of time. This suggestion has not been adopted because it may not always be easy or even possible for an Agency to determine whether corrected noncompliance results in recapture of the credit. Accordingly, under the final regulations, all noncompliance, whether or not corrected, must be reported so that the Service can determine whether the taxpayer is subject to recapture of the credit. Another comment suggested that any change in a building's eligible basis should be considered noncompliance that must be reported to the Service. The commentator reasons that this is necessary to ensure that the information being provided on the

annual certifications and Form 8586, "Low-Income Housing Credit," and Form 8609 (Schedule A) are consistent. Changes in eligible basis and the applicable fraction that result in a decrease in qualified basis result in recapture of credit. Therefore, the final regulations provide that any change in either the applicable fraction or eligible basis that results in a decrease in the project's qualified basis should be considered noncompliance that must be reported to the Service. One comment suggested that tenant fraud should be reported to the Service. No specific changes to the regulations have been made in response to this suggestion. If tenant fraud results in noncompliance, the noncompliance should be reported. Comments suggested that any notice sent to a building owner and the Form 8823 sent to the Service should be required to be sent by certified mail. These suggestions have not been adopted; although an Agency is free to use certified mail, it is not required to do so. One comment suggested that any fees paid to an agent or other private contractor for delegated compliance monitoring should not be contingent upon a finding of compliance or noncompliance. The final regulations do not contain this suggested provision. However, it is the view of the Treasury and the Service that if an Agency makes the payment of compliance monitoring fees to an agent or private contractor contingent upon a finding of compliance or noncompliance, the Agency may not be using reasonable diligence to ensure that the agent or private contractor properly performs the delegated compliance monitoring responsibilities. One comment suggested that an Agency be permitted to delegate monitoring responsibilities to another Agency, including the responsibility of notifying the Service of any noncompliance of which the delegated Agency becomes aware. In response to this suggestion, the final regulations allow Agencies to delegate some or all of their compliance monitoring responsibilities for a building to another Agency within the State. One comment suggested that although compliance monitoring is not required of Agencies before January 1, 1992, if an Agency becomes aware of noncompliance that occurred before that date, the Agency should be required to notify the Service of that noncompliance. The final regulations adopt this comment which reflects section 42(m)(1)(B)(iii) as effective before its amendment by the 1990 Act. Several comments suggested that the regulations should expressly permit an Agency to establish reasonable administrative fees for covering an Agency's expenses in monitoring compliance, and other comments suggested that the failure to pay monitoring fees should be considered noncompliance. Section 42 does not prohibit an Agency from charging an administrative fee to cover the Agency's expenses in monitoring for compliance, but this is a matter for the determination of the Agency, rather than the Service. Accordingly, the regulations do not address any issues concerning Agency fees.

Special Analyses

It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553 (b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805 (f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Paul F. Handleman, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the Service and the Treasury Department participated in their development.

List of Subjects

26 CFR 1.37-1 through 1.44A-4 Credits, Income taxes, Reporting and Recordkeeping requirements. 26 CFR part 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31,

1953 Paragraph 1. The authority citation for part 1 is amended by adding the following citation:

Authority

26 U.S.C. 7805 Section 1.42-5 is also issued under 26 U.S.C. 42 (n) Par. 2. New §1.42-5 is added to read as follows:

§1.42-5 Monitoring compliance with low-income housing credit

requirements. (a) Compliance monitoring requirement-(1) In general. Under section 42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains a procedure that the State or local housing credit agency ("Agency") (or an agent of, or other private contractor hired by, the Agency) will follow in monitoring for noncompliance with the provisions of section 42 and in notifying the Internal Revenue Service of any noncompliance of which the Agency becomes aware. These regulations only address compliance monitoring procedures required of Agencies. The regulations do not

address forms and other records that may be required by the Service on examination or audit. For example, if a building is sold or otherwise transferred by the owner, the transferee should obtain from the transferor information related to the first year of the credit period so that the transferee can substantiate credits claimed. (2) Requirements for a monitoring procedure-(i) In general. A procedure for monitoring for noncompliance under section 42(m)(1)(B)(iii) must include- (A) The recordkeeping and record retention provisions of paragraph (b) of this section; (B) The certification and review provisions of paragraph (c) of this section; (C) The inspection provision of paragraph (d) of this section; and (D) The notification-of-noncompliance provisions of paragraph (e) of this section. (ii) Order and form. A monitoring procedure will meet the requirements of section 42 (m)(1)(B)(iii) if it contains the substance of these provisions. The particular order and form of the provisions in the allocation plan is not material. A monitoring procedure may contain additional provisions or requirements. (b) Recordkeeping and record retention provisions-(1) Recordkeeping provision. Under the recordkeeping provision, the owner of a low-income housing project must be required to keep records for each qualified low-income building in the project that show for each year in the compliance period- (i) The total number of residential rental units in the building (including the number of bedrooms and the size in square feet of each residential rental unit); (ii) The percentage of residential rental units in the building that are low-income units; (iii) The rent charged on each residential rental unit in the building (including any utility allowances); (iv) The number of occupants in each low-income unit, but only if rent is determined by the number of occupants in each unit under section 42(g)(2) (as in effect before the amendments made by the Revenue Reconciliation Act of 1989); (v) The low-income unit vacancies in the building and information that shows when, and to whom, the next available units were rented; (vi) The annual income certification of each low-income tenant per unit; (vii) Documentation to support each low-income tenant's income certification (for example, a copy of the tenant's federal income tax return, Forms W-2, or verifications of income from third parties such as employers or state agencies paying unemployment compensation). Tenant income is calculated in a manner consistent with the determination of annual income under section 8 of the United States Housing Act of 1937 ("Section 8"), not in accordance with the determination of gross

income for federal income tax liability. In the case of a tenant receiving housing assistance payments under Section 8, the documentation requirement of this paragraph (b)(1)(vii) is satisfied if the public housing authority provides a statement to the building owner declaring that the tenant's income does not exceed the applicable income limit under section 42 (g); (viii) The eligible basis and qualified basis of the building at the end of the first year of the credit period; and (ix) The character and use of the nonresidential portion of the building included in the building's eligible basis under section 42 (d) (e.g., tenant facilities that are available on a comparable basis to all tenants and for which no separate fee is charged for use of the facilities, or facilities reasonably required by the project). (2) Record retention provision. Under the record retention provision, the owner of a low-income housing project must be required to retain the records described in paragraph (b)(1) of this section for at least 6 years after the due date (with extensions) for filing the federal income tax return for that year. The records for the first year of the credit period, however, must be retained for at least 6 years beyond the due date (with extensions) for filing the federal income tax return for the last year of the compliance period of the building. (c) Certification and review provisions-(1) Certification. Under the certification provision, the owner of a low-income housing project must be required to certify at least annually to the Agency that, for the preceding 12-month period- (i) The project met the requirements of: (A) The 20-50 test under section 42 (g)(1)(A), the 40-60 test under section 42 (g)(1)(B), or the 25-60 test under sections 42 (g)(4) and 142 (d)(6) for New York City, whichever minimum set-aside test was applicable to the project; and (B) If applicable to the project, the 15-40 test under sections 42(g)(4) and 142 (d)(4)(B) for "deep rent skewed" projects; (ii) There was no change in the applicable fraction (as defined in section 42(c)(1)(B)) of any building in the project, or that there was a change, and a description of the change; (iii) The owner has received an annual income certification from each low-income tenant, and documentation to support that certification; or, in the case of a tenant receiving Section 8 housing assistance payments, the statement from a public housing authority described in paragraph (b)(1)(vii) of this section; (iv) Each low-income unit in the project was rent-restricted under section 42(g)(2); (v) All units in the project were for use by the general public and used on a nontransient basis (except for transitional housing for the homeless provided under section 42 (i)(3)(B)(iii));

(vi) Each building in the project was suitable for occupancy, taking into account local health, safety, and building codes; (vii) There was no change in the eligible basis (as defined in section 43(d)) of any building in the project, or if there was a change, the nature of the change (e.g., a common area has become commercial space, or a fee is now charged for a tenant facility formerly provided without charge); (viii) All tenant facilities included in the eligible basis under section 42(d) of any building in the project, such as swimming pools, other recreational facilities, and parking areas, were provided on a comparable basis without charge to all tenants in the building; (ix) If a low-income unit in the project became vacant during the year, that reasonable attempts were or are being made to rent that unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project were or will be rented to tenants not having a qualifying income; (x) If the income of tenants of a low-income unit in the project increased above the limit allowed in section 42(g)(2)(D)(ii), the next available unit of comparable or smaller size in the project was or will be rented to tenants having a qualifying income; and (xi) An extended low-income housing commitment as described in section 42(h)(6) was in effect (for buildings subject to section 7108(c)(1) of the Revenue Reconciliation Act of 1989). (2) Review. The review provision must- (i) require that the Agency review the certifications submitted under paragraph (c)(1) of this section for compliance with the requirements of section 42; (ii) contain at least one of the following requirements: (A) The owners of at least 50 percent of all low-income housing projects in the Agency's jurisdiction must submit to the Agency for compliance review a copy of the annual income certification, the documentation the owner has received to support that certification, and the rent record for each low-income tenant in at least 20 percent of the low-income units in their projects; (B) The Agency must inspect at least 20 percent of low-income housing projects each year and must inspect the low-income certification, the documentation the owner has received to support that certification, and the rent record for each low-income tenant in at least 20 percent of the low-income units in those projects; or (C) The owners of all low-income housing projects must submit to the Agency each year information on tenant income and rent for each low-income unit, in the form and manner designated by the Agency, and the owners of at least 20 percent of the projects must submit to the Agency for compliance review a copy of the annual income certification, the documentation the owner has received to support that

certification, and the rent record for each low-income tenant in at least 20 percent of the low-income units in their projects; and (iii) Require that the Agency determine which tenants' records are to be inspected or submitted by the owners for review. If a monitoring procedure includes the review provision described in paragraph (c)(2)(ii)(B) of this section, the records to be inspected must be chosen in a manner that will not give owners of low-income housing projects advance notice that their records for a particular year will or will not be inspected. However, an Agency may give an owner reasonable notice that an inspection will occur so that the owner may assemble records (for example, 30 days notice of inspection). See paragraph (d) of this section for the inspection provision that is required to be included in all monitoring procedures. (3) Frequency and form of certification. A monitoring procedure must require that the certifications and reviews of paragraph (c)(2) and (2) of this section be made at least annually covering each year of the 15-year compliance period under section 42(i)(1). The certifications must be made under penalty of perjury. A monitoring procedure may require certifications and reviews more frequently than on a 12-month basis, provided that all months within each 12-month period are subject to certification. (4) Exception for certain buildings-(i) In general. The review requirements under paragraph (c)(2)(ii) (A), (B), and (C) of this section may provide that owners are not required to submit, and the Agency is not required to review, the tenant income certifications, supporting documentation, and rent records for buildings financed by the Farmers Home Administration (FmHA) under the section 515 program, or buildings of which 50 percent or more of the aggregate basis (taking into account the building and the land) is financed with the proceeds of obligations the interest on which is exempt from tax under section 103 (tax-exempt bonds). In order for a monitoring procedure to except these buildings, the Agency must meet the requirements of paragraph (c)(4)(ii) of this section. (ii) Agreement and review. The Agency must enter into an agreement with the FmHA or tax-exempt bond issuer. Under the agreement, the FmHA or tax-exempt bond issuer must agree to provide information concerning the income and rent of the tenants in the building to the Agency. The Agency may assume the accuracy of the information provided by FmHA or the tax-exempt bond issuer without verification. The Agency must review the information and determine that the income limitation and rent restriction of section 42 (g)(1) and (2) are met. However, if the information provided by the FmHA or tax-exempt bond issuer is not sufficient for the Agency to make this determination, the Agency must request the necessary additional income or rent information from the owner of the buildings. For example, because FmHA determines tenant eligibility based on its definition of "adjusted annual income," rather than "annual income" as defined under Section 8, the Agency may have to calculate the tenant's income for section 42 purposes and may need to request additional income information from the owner. (iii) Example. The exception permitted under paragraph (c)(4)(i) and (ii) of this section is illustrated by the following example. Example. An Agency chooses the review requirement of paragraph (c)(2)(ii)(A) of this section and some of the buildings selected for review are buildings financed by

the FmHA. The Agency has entered into an agreement described in paragraph (c)(4)(ii) of this section with the FmHA with respect to those buildings. In reviewing the FmHA-financed buildings, the Agency obtains the tenant income and rent information from the FmHA for 20 percent of the low-income units in each of those buildings. The Agency calculates the tenant income and rent to determine whether the tenants meet the income and rent limitation of section 42 (g)(1) and (2). In order to make this determination, the Agency may need to request additional income or rent information from the owners of the FmHA buildings if the information provided by the FmHA is not sufficient. (d) Inspection provision. Under the inspection provision, the Agency must have the right to perform an on-site inspection of any low-income housing project at least through the end of the compliance period of the buildings in the project. The inspection provision of this paragraph (d) is separate from any review of low-income certifications, supporting documents, and rent records under paragraph (c)(2)(ii) of this section. (e) Notification-of-noncompliance provision-(1) In general. Under the notification-of-noncompliance provisions, the Agency must be required to give the notice described in paragraph (e)(2) of this section to the owner of a low-income housing project and the notice described in paragraph (e)(3) of this section to the Service. (2) Notice to owner The Agency must be required to provide prompt written notice to the owner of a low-income housing project if the Agency does not receive the certification described in paragraph (c)(1) of this section, or does not receive or is not permitted to inspect the tenant income certifications, supporting documentation, and rent records described in paragraph (c)(2(ii)(A), (B), or (c) of this section (whichever is applicable), or discovers by inspection, review, or in some other manner, that the project is not in compliance with the provisions of section 42. (3) Notice to Internal Revenue Service-(i) In general. The Agency must be required to file Form 8823, "Low-Income Housing Credit Agencies Report of Noncompliance," with the Service no later than 45 days after the end of the correction period (as described in paragraph (e)(4) of this section, including extensions permitted under that paragraph) and no earlier than the end of the correction period, whether or not the noncompliance or failure to certify is corrected. The Agency must explain on Form 8823 the nature of the noncompliance or failure to certify and indicate whether the owner has corrected the noncompliance or failure to certify. Any change in either the applicable fraction or eligible basis under paragraph (c)(1)(ii) and (vii) of this section, respectively, that results in a decrease in the qualified basis of the project under section 42 (c)(1)(A) is noncompliance that must be reported to the Service under this paragraph (e)(3). If an Agency reports on Form 8823 that a building is entirely out of compliance and will not be in compliance at any time in the future, the Agency need not file Form 8823 in subsequent years to report that building's noncompliance. (ii) Agency retention of records. An Agency must retain records of noncompliance or failure to certify for 6 years beyond the Agency's filing of the respective Form 8823. In all other cases, the Agency must retain the certifications and records described in paragraph (c) of this section for 3 years from the end of the calendar year the Agency receives the certifications and records.

(4) Correction period. The correction period shall be that period specified in the monitoring procedure during which an owner must supply any missing certifications and bring the project into compliance with the provisions of section 42. The correction period is not to exceed 90 days from the date of the notice to the owner described in paragraph (e)(2) of this section. An Agency may extend the correction period for up to 6 months, but only if the Agency determines there is good cause for granting the extension. (f) Delegation of Authority-(1) Agencies permitted to delegate compliance monitoring functions-(i) In general. An Agency may retain an agent or other private contractor ("Authorized Delegate") to perform compliance monitoring. The Authorized Delegate must be unrelated to the owner of any building that the Authorized Delegate monitors. The Authorized Delegate may be delegated all of the functions of the Agency, except for the responsibility of notifying the Service under paragraph (e)(3) of this section. For example, the Authorized Delegate may be delegated the responsibility of reviewing tenant certifications and documentation under paragraph (c) (1) and (2) of this section, the right to inspect buildings and records as described in paragraph (d) of this section, and the responsibility of notifying building owners of lack of certification or noncompliance under paragraph (e)(2) of this section. The Authorized Delegate must notify the Agency of any noncompliance or failure to certify. (ii) Limitations. An Agency that delegates compliance monitoring to an Authorized Delegate under paragraph (f)(1)(i) of this section must use reasonable diligence to ensure that the Authorized Delegate properly preforms the delegated monitoring functions. Delegation by an Agency of compliance monitoring functions to an Authorized Delegate does not relieve the Agency of its obligation to notify the Service of any noncompliance of which the Agency becomes aware. (2) Agencies permitted to delegate compliance monitoring functions to another Agency. An Agency may delegate all or some of its compliance monitoring responsibilities for a building to another Agency within the State. This delegation may include the responsibility of notifying the Service under paragraph (e)(3) of this section. (g) Liability. Compliance with the requirements of section 42 is the responsibility of the owner of the building for which the credit is allowable. The Agency's obligation to monitor for compliance with the requirements of section 42 does not make the Agency liable for an owner's noncompliance. (h) Effective date. Allocation plans must comply with these regulations by June 30, 1993. The requirement of section 42 (m)(1)(B)(iii) that allocation plans contain a procedure for monitoring for noncompliance becomes effective on January 1, 1992, and applies to buildings for which a low-income housing credit is, or has been, allowable at any time. Thus, allocation plans must comply with section 42(m)(1)(B)(iii) prior to June 30, 1993, the effective date of these regulations. An allocation plan that complies with these regulations, with the notice of proposed rulemaking published in the Federal Register on December 27, 1991, or with a reasonable interpretation of section 42(m)(1)(B)(iii) will satisfy the requirements of section 42(m)(1)(B)(iii) for periods before June 30, 1993. Section 42(m)(1)(B)(iii) and these regulations do not require monitoring for whether a building or project is in compliance with the requirements of section 42 prior to January 1, 1992.

However, if an Agency becomes aware of noncompliance that occurred prior to January 1, 1992, the Agency is required to notify the Service of that noncompliance.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

ACT Par. 3. The authority citation for part 602 continues to read as follows:

Authority

26 U.S.C. 7805.

§602.101 (Amended)

Par. 4. Section 602.101(c) is amended by adding the following entry to the table: 1.42-5 .. 1545-1291 Michael P. Dolan, Acting Commissioner of Internal Revenue. Approved: August 4, 1992. Fred T. Goldberg, Jr., Assistant Secretary of the Treasury.

June 18, 1993

FULL TEXT

AGENCY

Internal Revenue Service, Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final regulations on the arbitrage and related restrictions applicable to tax-exempt bonds issued by State and local governments. Changes to the applicable law were made by the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Revenue Reconciliation Act of 1989, and the Revenue Reconciliation Act of 1990. These regulations affect issuers of tax-exempt bonds and provide guidance for complying with the arbitrage and related restrictions.

DATES

These regulations are effective on July 1, 1993. For dates of applicability of these regulations to various bond issues, including certain elective retroactivity provisions and transition rules, see §1.148-11 of these regulations.

FOR FURTHER INFORMATION CONTACT

Scott R. Lilienthal or William P. Cejudo at 202-622-3980 (not a toll-free number).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1347. The estimated annual burden per recordkeeper varies from 12 hours to 15 hours, depending on individual circumstances, with an estimated average of 13.5 hours. These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to

the Internal Revenue Service. Individual respondents may require more or less time, depending on their particular circumstances. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Background

Explanation of Provisions

I. Background of Regulations Section 148 provides rules restricting the use of proceeds of tax-exempt State and local bonds to acquire higher yielding investments. Section 148(a) provides generally that interest on a State or local bond is tax-exempt only if the issuer invests bond proceeds at a yield that is not materially higher than the yield on the bond issue. Section 148(f) provides that interest on a State or local bond is tax-exempt only if the issuer rebates to the Federal government certain arbitrage earnings derived from investing gross proceeds at a yield exceeding the yield on the bond issue. Longstanding regulations relating to the arbitrage yield restriction rules are in §§1.103-13 through 1.103-15. On May 18, 1992, final regulations under section 148 were published at §§1.148-0 through 1.148-11 (the May 1992 regulations). At that time, the Internal Revenue Service and the Treasury Department announced that they would further simplify and clarify the regulations under section 148 by revising the arbitrage regulations and finalizing these rewritten regulations by June 1993. To evidence this commitment, the May 1992 regulations expire on June 30, 1993. Proposed regulations were published at §§1.148-0 through 1.148-11, 1.149(d)-1, 1.149(g)-1, 1.150-1, and 1.150-2 in the Federal Register for November 6, 1992. The proposed regulations would replace the existing yield restriction and rebate regulations currently provided in §§1.103-13 through 1.103-15, §1.103-13T, §§1.148-0 through 1.148-11, §1.148-12T, and §1.148-13T with coordinated, simplified regulations. The proposed regulations also propose to amend certain related regulations on advance refunding limitations in §1.149-1(d), definitions in §1.150-1, and reimbursement bonds in §1.103-18. Written comments were received on the proposed regulations, and additional public comments were received at a public hearing held on February 2, 1993. In addition, on October 10, 1990, proposed and temporary regulations under §1.149(b)(3)-1T were published in the Federal Register. These regulations provide that certain investments in obligations issued by the Resolution Funding Corporation under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 are excepted from the prohibition on federal guarantees of tax-exempt bonds under section 149(b).

After consideration of the comments, the proposed regulations have been modified and are adopted in final form. Certain comments on the proposed regulations, and responses to those comments, are discussed below. II. Comments on Proposed Regulations and Certain Changes in Final Regulations A. In general. The proposed regulations substantially revise the arbitrage regulations on tax-exempt bonds to simplify those rules and to reduce administrative burdens. The proposed regulations provide greater coordination of the rules on yield restriction and rebate, more unified definitions, general anti-abuse rules in lieu of numerous special rules, clarification of ambiguous areas, and new guidance on many previously reserved topics. Although numerous modifications have been made to clarify the regulations in various technical respects in response to comments received, the general principles behind the proposed regulations have been retained in the final regulations. B. Section 1.148-1 Definitions and Elections. 1. Computation Date and Computation Period. Rebate is computed over permitted computation periods occurring between computation dates. The proposed regulations generally provide issuers of variable yield issues with flexibility to choose computation dates and computation periods for computing yield on an issue for rebate purposes. Commentators requested clarification of the scope of this flexibility. The final regulations retain significant flexibility to choose these dates and periods until the date that the first required rebate payment must be made (i.e., 5 years after the issue date), but provide a more limited choice of permitted computation periods thereafter. 2. De Minimis Original Issue Discount or Premium. The proposed regulations generally permit issuers to value certain bonds and investments having standard features and not more than de minimis amounts of original issue discount or premium ("plain par bonds" and "plain par investments"), based on a simplified measure of outstanding principal amount. The definition of de minimis amount applies for a variety of purposes. De minimis original issue discount or premium is generally defined in the proposed regulations as an amount that does not exceed 0.25 percent multiplied by the product of the stated redemption price at maturity and the number of complete years to final maturity from the issue date. To decrease complexity and to minimize certain identified distortions, the final regulations limit the measure of this de minimis amount for valuation purposes to a flat percentage of the stated redemption price at maturity. In a related change, the final regulations clarify that plain par bonds eligible for the simplified valuation rules include certain tender option bonds (i.e., "qualified tender bonds" under Notice 88- 130, 1988-2 C.B. 543). 3. Program Investments. The proposed regulations change certain aspects of the existing definition of "program investments" under §1.103-13(h). Commentators recommended that the existing definition generally be retained, particularly its treatment of multifamily housing loans as eligible program investments. The final regulations revise this definition to be more consistent with the existing definition. 4. Investment-Type Property. Whether an item financed with bond proceeds is investment property, including investment-type property, generally determines whether that item is subject to arbitrage restrictions under section 148. The

proposed regulations provide a definition of investment-type property that includes certain prepayments based on the investment motivation for the prepayment. Commentators expressed concern that this provision was too broad and potentially covered common prepayments made for bona fide business reasons. The final regulations provide two exceptions to the general rule on prepayments. One exception focuses on whether the issuer has any commercially reasonable alternative to the prepayment. The other exception focuses on whether similar prepayments are customary among persons not eligible for tax-exempt financing. 5. Replacement Proceeds. The arbitrage restrictions apply to both proceeds received from the sale of bonds and amounts "replaced" by the proceeds. The proposed regulations generally provide that replacement proceeds include, but are not limited to, sinking funds, amounts that are pledged as security for an issue, working capital replacement funds, and amounts that are replaced because of their nexus to a governmental purpose of the issue. Commentators requested that the regulations provide a general definition of replacement proceeds. The final regulations provide a general definition of replacement proceeds based on whether the amounts have a sufficient nexus to the governmental purpose of the issue. The final regulations also clarify that replacement proceeds may arise at any time, regardless of whether the creation of the replacement proceeds is reasonably expected by the issuer on the issue date. Commentators also requested that the provision dealing with working capital replacement funds be revised or deleted. The final regulations do not include the working capital replacement fund rule. To reduce the arbitrage incentive to issue bonds with longer terms than necessary and to recognize the additional borrowing implicit in these issues, however, the final regulations generally provide that replacement proceeds arise if the term of an issue is reasonably expected to be longer than necessary to accomplish the governmental purpose of the issue and funds are expected to become available during the term of the issue. The final regulations provide two safe harbors against the application of this rule that apply if: (1) An otherwise-restricted working capital financing issue is not outstanding more than 2 years; or (2) a capital project financing issue has a weighted average maturity that does not exceed 120 percent of the economic life of the financed projects. These provisions are only safe harbors relating to the existence of replacement proceeds and are not intended to place a maturity limitation on tax-exempt bonds. C. Section 1.148-2 General Arbitrage Yield Restriction Rules. 1. Reasonable Expectations. Under section 148(a), bonds are generally taxable arbitrage bonds if, as of the issue date, the issuer reasonably expects to invest the proceeds in higher yielding investments. The proposed regulations permit an issuer to certify its expectations. The proposed regulations also provide certain requirements as a prerequisite to the use of the certification that were intended to encourage more complete disclosure of facts and material tax issues. Commentators expressed concern that some of these requirements were unduly burdensome and created practical difficulties for issuers. The final regulations significantly modify the certification requirements to address issuer concerns. The required complete disclosure of facts and material tax issues has been eliminated. The regulations clarify that the certification does not establish any presumptions about the reasonableness of an issuer's expectations. In general,

this and other certifications referred to in the final regulations have no special evidentiary status. 2. Temporary Periods. Under section 148(c), proceeds may be invested at a materially higher yield during a reasonable temporary period until needed for the governmental purpose of the issue without causing the bonds of the issue to be arbitrage bonds. Under the proposed regulations, an issuer must satisfy an expenditure test, a time test, and a due diligence test in order to qualify for the general 3-year temporary period for capital projects, and these tests apply separately to each capital project financed by an issue. Commentators expressed concern about the administrative burden associated with tracking individual capital projects and requested that these tests be applied on an aggregate basis to all capital projects financed by an issue. The final regulations generally adopt this comment, except in the case of certain pooled issues. Commentators expressed concern that the 13-month temporary period for proceeds used for working capital expenditures was inadequate for certain issuers who, under local law, have a longer period between their annual budget cycle and the tax collections for that period. The final regulations provide a temporary period of up to 2 years after the issue date for this type of issue. 3. Minor Portion. In response to comments, the final regulations permit issuers to waive at any time the ability to invest amounts constituting a minor portion of an issue at an unrestricted yield. D. Section 1.148-3 General Arbitrage Rebate Rules. 1. Computation Date Credit. The proposed regulations provide that, for purposes of computing rebate, an issuer is entitled to a computation date credit of $5,000 on the last day of each fifth bond year and on the final maturity date. In order to target the credit more closely to the periods associated with the computations, the final regulations change the credit to $1,000 for each bond year during which there are gross proceeds of the issue and for the final maturity date. 2. Bona Fide Debt Service Funds. In response to comments, the final regulations add a safe harbor relating to the statutory exception to the rebate requirement for certain bona fide debt service funds, based on a specified maximum average annual debt service on an issue. E. Section 1.148-4 Yield on an Issue of Bonds. 1. Yield Recomputation for a Fixed Yield Issue. The proposed regulations generally provide that yield on a fixed yield issue is determined as of the issue date and, except in narrow circumstances involving hedging transactions, is not recomputed to take into account subsequent unexpected events. The final regulations generally retain this approach for rebate purposes. Many commentators requested guidance on the Federal income tax consequences of an issuer's sale of a right associated with a bond, such as a call right, in a separate transaction from the original sale of the bond (e.g., so-called "detachable calls"). These comments included requests for guidance on whether the sale affects the yield on the bond for arbitrage purposes under section 148 and whether the sale results in

a deemed retirement of the related bond and the deemed issuance of a new bond (a reissuance) under the tax-exempt bond rules or section 1001. The final regulations clarify that amounts received by the issuer from the sale of a detachable call are taken into account as additional issue price on the issue for rebate purposes. No implication is intended on whether the sale of a detachable call results in a reissuance of the issue under section 1001. It is anticipated that this issue will be addressed in regulations under section 1001. 2. Bonds Subject to Mandatory or Contingent Early Redemption. Under the proposed regulations, the yield on certain fixed yield bonds subject to mandatory early redemption is computed by treating those bonds as redeemed on the reasonably expected early redemption date for an amount equal to their value. The proposed regulations further provide that the outstanding stated principal amount (plus accrued interest) of the bond may be treated as its value if the original issue discount on the bond does not exceed a de minimis amount. The final regulations generally retain this rule, but further limit the permitted de minimis amount to an amount based on the number of years to the weighted average maturity date, rather than the final maturity date, of substantially identical bonds. 3. Bonds Subject to Optional Early Redemption. The proposed regulations contain a special rule for computing the yield on an issue containing bonds that are subject to optional early redemption and that have certain early redemption rights, significant premium, or so-called "stepped-coupons." The yield on an issue subject to this special rule is computed by treating the bonds as redeemed on the optional redemption date that would produce the lowest yield. The final regulations generally retain this rule, but exclude certain bonds if their assumed redemption has only a minimal effect on the yield on the issue of which the bond is a part. 4. Qualified Guarantees. The proposed regulations provide simplified rules under which issuers may take into account certain fees for credit enhancement, such as bond insurance and letters of credit ("qualified guarantees") in computing yield on an issue. The final regulations clarify that certain liquidity arrangements may be qualified guarantees and provide a safe harbor for the allocation of qualified guarantee fees in variable yield issues. 5. Qualified Hedging Transactions. The proposed regulations permit issuers to take certain qualified hedging transactions into account for purposes of computing yield on an issue. Under the proposed regulations, a hedge is generally a qualified hedging transaction if the terms of the hedge closely correspond with the terms of the issue and if the hedge is adequately identified. Commentators requested that the types of qualified hedging transactions be expanded. The final regulations generally expand the definition of a qualified hedging transaction in various respects. The final regulations permit hedges for less than the entire term of the issue and hedges relating to less than all of the bonds of an issue. The final regulations also treat certain additional hedging products (e.g., interest rate caps) as qualified hedging transactions. The final regulations generally treat issues that involve qualified hedging transactions as variable yield issues. Certain variable rate issues that use interest rate swaps involving no nonperiodic hedge payments, however, are treated as fixed yield issues. The final regulations amend the identification, accounting, and other technical rules on qualified hedging transactions.

F. Section 1.148-5 Yield and Valuation of Investments. 1. Yield on a Separate Class of Investments. The proposed regulations provide that the yields on individual investments within the same class of investments are blended together for purposes of applying the arbitrage yield restriction rules. Under the proposed regulations, the determination of whether investments are part of the same class is based on whether the investments are subject to the same definition of "materially higher" under the arbitrage yield restriction rules. Commentators requested that issuers be given greater flexibility to blend the yields on individual investments for arbitrage yield restriction purposes. The final regulations provide expanded flexibility to blend yields on various categories of investments. The general anti-abuse rules in §1.148-10 clarify, however, that certain financing structures that improperly exploit these rules cause the bonds to be arbitrage bonds. 2. Yield Reduction Payments to the United States. The proposed regulations provide significant integration of the arbitrage yield restriction and rebate provisions by permitting certain payments to be made to the United States to reduce the yield on investments for yield restriction purposes. The proposed regulations permit these payments in specified circumstances in which arbitrage yield restriction creates administrative difficulties. Commentators requested that the scope of the rule on yield reduction payments be expanded in various respects. The final regulations expand the ability of issuers to make yield reduction payments in additional circumstances involving certain variable yield issues and certain reserve funds. For purpose investments, the final regulations also delay the due date for these payments. 3. Administrative Costs of Investments. The proposed regulations permit reasonable direct administrative costs on all investments to be taken into account in computing yield on the investments and rebate on the issue. The proposed regulations further provide, however, that indirect costs such as general overhead may not be taken into account. Commentators requested clarification of the scope of permitted administrative costs. The final regulations provide additional examples of the types of qualifying and nonqualifying administrative costs. The final regulations also provide special rules for administrative costs on regulated investment companies, certain external commingled funds, and program investments. G. Section 1.148-6 General Allocation and Accounting Rules. 1. Universal Cap on Value of Investments Allocated to an Issue. The proposed regulations generally retain the universal cap provided under the existing regulations that limits the amount of gross proceeds allocable to a bond issue. Commentators expressed concern that in some cases the application of the universal cap creates unnecessary administrative burdens. The final regulations reduce the frequency with which the universal cap must be applied and also permit issuers to disregard the universal cap altogether in specified circumstances. 2. Expenditures of Proceeds for Working Capital Purposes. For working capital expenditures, the proposed regulations generally retain the "proceeds-spent-last" accounting method from the existing regulations. Bond proceeds generally are not treated as spent under this rule until other available amounts have been spent. The proposed regulations permit an amount equal to 10 percent of the previous fiscal

year's working capital expenditures to be treated as an unavailable, reasonable reserve. Commentators requested certain clarifications, including whether an issuer may, in effect, finance the permitted working capital reserve (e.g., by issuing bonds in an amount equal to the working capital reserve and spending those proceeds while accumulating a like amount to serve as the reserve). Based on a review of these comments and re-consideration of this area in light of continuing policy concerns regarding the arbitrage incentives to issue larger working capital financings than necessary, the final regulations impose certain further limitations on working capital financings. The final regulations retain the approach of the existing and proposed regulations that measures the permitted working capital reserve by reference to the previous year's actual working capital expenditures. To further limit overissuance, the permitted working capital reserve has been reduced to 5 percent of the issuer's working capital expenditures for the prior year. In addition, the final regulations clarify that, except in the case of issues by certain small issuers and issues that are exempt from rebate under the section 148(f)(4)(B)(iii) rebate safe harbor, an issue indirectly used to finance a working capital reserve results in the creation of replacement proceeds that remain subject to the arbitrage rules. In a related change, the definition of "controlled group," which is relevant in determining the available amounts, has been narrowed. In addition, in response to comments, the final regulations also exclude from the amounts considered available for working capital purposes certain "quasi-endowment funds" held by hospitals, universities, or similar institutions. H. Section 1.148-7 Spending Exceptions to the Rebate Requirement. The proposed regulations provide a new 18-month spending exception to the rebate requirement that is broadly applicable and requires prompt expenditure of bond proceeds under a prescribed, approximately level spending schedule. This new spending exception was introduced because of the difficulties many issuers had using the existing spending exceptions. Commentators were largely supportive of the new 18-month exception, but requested that the spending percentage for the first 6-month period be reduced. The final regulations reduce the spending percentage for this period to 15 percent. I. Section 1.148-8 Small Issuer Exception to the Rebate Requirement. For purposes of the small issuer exception to rebate, bonds issued by a subordinate entity are treated as also issued by each entity to which it is subordinate. The proposed regulations provide a definition of "subordinate entity" based on issuing authority and control. Commentators requested that the general section 150 definition of "controlled entity" be extended to define a "subordinate entity." The final regulations adopt this comment. J. Section 1.148-9 Arbitrage Rules for Refunding Issues. 1. Transferred Proceeds Allocation Rule. The proposed regulations provide a "principal-to-principal" transferred proceeds allocation rule similar to that of the existing regulations, under which unspent proceeds of a prior issue become transferred proceeds of a refunding issue at the time that proceeds of the refunding issue discharge any of the outstanding principal amount of the prior issue. The proposed regulations generally do not include an "operating rule" (as under former §1.103-14(e)(1)) to divide a prior issue into refunded and unrefunded portions for transferred proceeds purposes.

Commentators requested that an operating rule be included to provide simplification and greater certainty in the planning of refunding issues. The final regulations provide such a rule. 2. Multipurpose Issue Allocations. The proposed regulations contain a flexible multipurpose issue allocation rule that permits issues used for separate governmental purposes to be treated as separate issues for prescribed purposes. In the case of a multipurpose issue a portion of which is a refunding issue, the proposed regulations permit issuers to use only certain specified allocation methods to allocate bonds of the multipurpose issue to the refunding of the prior issue. Commentators expressed concern that, in certain circumstances, an issuer may have no practical way to use any of the required allocation methods under this rule. The final regulations add another allocation rule permitting allocations in proportion to the average economic lives of the facilities financed by the overall multipurpose issue. In addition, the final regulations permit an issuer to use another reasonable allocation method in limited circumstances based on state law, existing legal restrictions, or similar circumstances. The final regulations expand the applicability of the multipurpose issue rule for an issue that refunds two or more prior issues and provide additional rules for allocating the proceeds of these issues. The final regulations also permit the application of the multipurpose issue rule to divide certain pooled issues for yield calculation purposes. K. Section 1.148-10 Anti-Abuse Rules and Authority of Commissioner. The proposed regulations provide a broad, general anti-abuse rule that treats bonds as taxable arbitrage bonds if the issuer uses an abusive device to obtain a material financial advantage based on arbitrage. This general anti-abuse rule proposes to replace the general artifice or device rules contained in §1.103-13(j) and §1.148-9(g) and numerous specific anti-abuse rules. Commentators expressed concern that the general anti-abuse rule in the proposed regulations is not sufficiently specific for issuers to determine whether a particular transaction violates the rule. The final regulations retain a broad, general anti-abuse rule, but provide additional specific guidance intended to clarify further the scope of covered abusive transactions. In large part, the revised abusive arbitrage device provision is based on the existing artifice or device prohibition in §1.103-13(j). The revised rule continues to focus on transactions that exploit the difference between tax-exempt and taxable interest rates and that overburden the tax-exempt bond market. Although many clarifications have been made to these rules, no implication is intended regarding the scope of the existing artifice or device rule or that the examples of abusive arbitrage devices do not involve artifices or devices. L. Section 149(d)-1 Limitations on Advance Refundings. 1. General Rule. Section 149(d) provides limits on advance refundings, including limitations on the number of permitted tax-exempt advance refundings. The final regulations provide additional guidance relating to the requirement that the refunded bonds be retired on their first call date and the related savings test. 2. Sales of Tax-exempt Conduit Loans. The proposed regulations include a provision under the anti-abuse rules that treats tax-exempt purpose investments financed by a conduit financing issue as taxable investments if they are subsequently transferred to another party. Without some limitations on these transactions, issuers could

effectively double the amount of tax-exempt bonds on the market for a single project. Commentators expressed concern that this provision is overly broad and recommended that these transactions instead be treated under a refunding analysis. The final regulations adopt this more direct approach by treating the actual issuer of the conduit financing and the conduit borrower as related parties for purposes of section 149(d). Thus, a later sale of the conduit loan is treated as a new issue the yield on which is determined based on the amounts derived from that sale. If the proceeds of that deemed new issue are used to pay debt service on the conduit financing issue, the conduit loan is treated as a refunding issue. Further, the abusive arbitrage device rules illustrate that this type of transaction may involve an exploitation of the difference between taxable and tax-exempt rates. M. Section 1.150-1 Definitions. 1. Issue. The proposed regulations provide a new definition of issue for arbitrage and related purposes. In response to comments, and to promote simplification, the final regulations extend this definition to apply for all tax-exempt bond purposes. The final regulations provide additional guidance on whether obligations are issued at substantially the same time, sold pursuant to the same plan of financing, and are reasonably expected to be paid from the same source of funds. The final regulations generally provide that taxable and tax-exempt bonds are not part of a single issue and clarify the special rules for commercial paper and draw-down loans. The final regulations also provide that issuers may treat tax-exempt governmental bonds and private activity bonds as separate issues under specified circumstances. 2. Controlled Group. The proposed regulations provide a definition of controlled group that focuses on control of the governing board, budgetary control, and control over the ability to issue debt obligations. The final regulations narrow the definition of controlled group to focus on board control and financial control. The final regulations also provide that certain general purpose governmental units are not controlled by any other entity. N. Section 1.150-2 Proceeds of Bonds used for Reimbursement. The proposed regulations provide simplified and expanded rules to determine when an allocation of bond proceeds to reimburse expenditures previously made by an issuer is treated as an expenditure of those bond proceeds. The proposed regulations require an issuer to reimburse past expenditures with bond proceeds within a prescribed period that is not later than 3 years after the expenditure is paid. Commentators expressed concern that the 3-year overall limit on the reimbursement period may be too short for certain types of projects. The final regulations expand the maximum reimbursement period to 5 years for certain long-term construction projects. Commentators also requested that a rule under prior regulations excluding certain preliminary expenditures from the reimbursement rules be reinserted. The final regulations include such a preliminary expenditures exception. Commentators also noted that the proposed regulations and §1.103-8(a)(5) were duplicative and requested clarification of the continued application of §1.103-8(a)(5). The final regulations eliminate the official action requirement of §1.103-8(a)(5). O. Federal Guarantees. The final regulations also finalize the regulations under §1.149(b)(3)-1T relating to the exception from the section 149(d) prohibition against federal guarantees for certain investments in obligations issued by the Resolution Funding Corporation under the Financial Institutions Reform, Recovery, and

Enforcement Act of 1989. In addition, the final regulations provide an expanded exception under which bonds are not federally guaranteed as a result of an investment in a refunding escrow. P. Effective Dates. The final regulations generally apply to bonds issued after June 30, 1993. To simplify the area and promote compliance, the final regulations generally permit elective, retroactive application of the final regulations in whole, but not in part, to outstanding issues issued prior to July 1, 1993, that are subject to the rebate requirement. The 18-month spending exception, however, may not be applied retroactively. The final regulations also provide certain other transition and related rules. The final regulations also extend the due date for rebate payments due after June 30, 1993, to a date not earlier than September 1, 1993. Finally, in order to not interfere with ongoing transactions, at the issuer's option, certain existing provisions may be applied to bonds issued before August 15, 1993.

Special Analyses

It has been determined that these final regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal authors of these regulations are Scott R. Lilienthal, William P. Cejudo, Michael G. Bailey, Lon B. Smith, and John J. Cross III of the Office of Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service, and Mitchell H. Rapaport, Office of Tax Legislative Counsel, Department of the Treasury. However, other personnel from the Service and Treasury Department participated in their development.

List of Subjects

26 CFR Parts 1 and 6a Income taxes, Reporting and recordkeeping requirements. 26 CFR 602 Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1, 6a and 602 are amended as follows:

Paragraph 1. The authority citation for part 1 is amended by removing the entries for "Sections 1.148-0 through 1.148-9," "Section 1.148-10," "Section 1.148-11", "Section 1.148-12T" "Section 1.148-13T" and "Section 1.149(b)(3)-1T" and adding the following citations to read as follows:

Authority

26 U.S.C. 7805 Sections 1.148-0 through 1.148-11 also issued under 26 U.S.C. 148 (f), (g), and (i). Section 1.149(b)-1 also issued under 26 U.S.C. 149(b)(3)(B) (v). Section 1.149(g)-1 also issued under 26 U.S.C. 149(g)(5). Par. 2. Section 1.103-8(a)(5) is revised to read as follows:

§1.103-8 Interest on bonds to finance certain exempt facilities.

(a) (5) Limitation. (i) A facility qualifies under this section only to the extent that there is a valid reimbursement allocation under §1.150-2 with respect to expenditures that are incurred before the issue date of the bonds to provide the facility and that are to be paid with the proceeds of the issue. In addition, if the original use of the facility begins before the issue date of the bonds, the facility does not qualify under this section if any person or related person who is a substantial user of the facility during the 5-year period beginning on the issue date was a substantial user of the facility during the 5-year period ending on the issue date. (ii) Except to the extent provided in §1.150-2(j), this paragraph (a)(5) applies to bonds issued after June 30, 1993. §§1.103-13, 1.103-13T, 1.103-14, 1.103-15 and 1.103-18 (Removed) Par. 3. Sections 1.103-13, 1.103-13T, 1.103-14, 1.103-15, and 1.103-18 are removed. Par. 4. Section 1.147(b)-1 is added to read as follows: §1.147(b)-1 Bond maturity limitation-treatment of working capital. Section 147(b) does not apply to proceeds of a private activity bond issue used to finance working capital expenditures. Par. 5. Sections 1.148-0 through 1.148-11 are revised to read as set forth below:

§1.148-0 Scope and table of contents.

(a) Overview. Under section 103(a), interest on certain obligations issued by States and local governments is excludable from the gross income of the owners. Section

148 was enacted to minimize the arbitrage benefits from investing gross proceeds of tax-exempt bonds in higher yielding investments and to remove the arbitrage incentives to issue more bonds, to issue bonds earlier, or to leave bonds outstanding longer than is otherwise reasonably necessary to accomplish the governmental purposes for which the bonds were issued. To accomplish these purposes, section 148 restricts the direct and indirect investment of bond proceeds in higher yielding investments and requires that certain earnings on higher yielding investments be rebated to the United States. Violation of these provisions causes the bonds in the issue to become arbitrage bonds, the interest on which is not excludable from the gross income of the owners under section 103(a). The regulations in §§1.148-1 through 1.148-11 apply in a manner consistent with these purposes. (b) Scope. Sections 1.148-1 through 1.148-11 apply generally for purposes of the arbitrage restrictions on State and local bonds under section 148. (c) Table of contents. This paragraph (c) lists the table of contents for §§1.148-1 through 1.148-11. §1.148-1 Definitions and elections. (a) In general. (b) Certain definitions. (c) Definition of replacement proceeds. (1) In general. (2) Sinking fund. (3) Pledged fund. (4) Other replacement proceeds. (d) Elections. §1.148-2 General arbitrage yield restriction rules. (a) In general. (b) Reasonable expectations. (1) In general. (2) Certification of expectations. (c) Intentional acts. (d) Materially higher yielding investments. (1) In general. (2) Definitions of materially higher yield. (3) Mortgage loans. (e) Temporary periods. (1) In general. (2) General 3-year temporary period for capital projects and qualified mortgage loans. (3) Temporary period for restricted working capital expenditures. (4) Temporary period for pooled financings. (5) Temporary period for replacement proceeds. (6) Temporary period for investment proceeds. (7) Other amounts. (f) Reserve or replacement funds. (1) General 10 percent limitation on funding with sale proceeds. (2) Exception from yield restriction for reasonably required reserve or replacement funds. (3) Certain parity reserve funds. (g) Minor portion. (h) Certain waivers permitted. §1.148-3 General arbitrage rebate rules. (a) In general. (b) Definition of rebate amount. (c) Computation of future value of a payment or receipt. (d) Payments and receipts. (1) Definition of payments. (2) Definition of receipts. (3) Special rules for commingled funds. (e) Computation dates. (1) In general. (2) Final computation date. (f) Amount of required rebate installment payment. (1) Amount of interim rebate payments. (2) Amount of final rebate payment. (3) Future value of rebate payments. (g) Time and manner of payment. (h) Penalty in lieu of loss of tax exemption. (1) In general. (2) Interest on underpayments. (3) Waivers of the penalty. (4) Application to alternative penalty under §1.148-7. (i) Recovery of overpayment of rebate. (1) In general. (2) Limitations on recovery. (j) Examples. (k) Bona fide debt service fund exception.

§1.148-4 Yield on an issue of bonds. (a) In general. (b) Computing yield on a fixed

yield issue. (1) In general. (2) Yield on certain fixed yield bonds subject to mandatory or contingent early redemption. (3) Yield on certain fixed yield bonds subject to optional early redemption. (4) Yield recomputed upon transfer of certain rights associated with the bond. (5) Examples. (c) Computing yield on a variable yield issue. (1) In general. (2) Payments on bonds included in yield for a computation period. (3) Example. (d) Conversion from variable yield issue to fixed yield issue. (e) Value of bonds. (1) Plain par bonds. (2) Other bonds. (f) Qualified guarantees. (1) In general. (2) Interest savings. (3) Guarantee in substance. (4) Reasonable charge. (5) Guarantee of purpose investments. (6) Allocation of qualified guarantee payments. (7) Refund or reduction of guarantee payments. (g) Yield on certain mortgage revenue and student loan bonds. (h) Qualified hedging transactions. (1) In general. (2) Qualified hedge defined. (3) Accounting for qualified

hedges. (4) Certain variable yield issues treated as fixed yield issues. (5) Authority of the Commissioner. §1.148-5 Yield and valuation of investments. (a) In general. (b) Yield on an investment. (1) In general. (2) Yield on a separate class of investments. (3) Investments to be held beyond issue's maturity or beyond temporary period. (4) Consistent redemption assumptions on purpose investments. (5) Student loan special allowance payments included in yield. (c) Yield reduction payments to the United States. (1) In general. (2) Manner of payment. (3) Applicability of special yield reduction rule. (d) Value of investments. (1) In general. (2) Mandatory valuation of yield restricted investments at present value. (3) Mandatory valuation of certain investments at fair market value. (4) Special transition rule for transferred proceeds. (5) Definition of present value of an investment. (6) Definition of fair market value. (e) Administrative costs of investments. (1) In general. (2) Qualified administrative costs on nonpurpose investments. (3) Qualified administrative costs on purpose investments. §1.148-6 General allocation and accounting rules. (a) In general. (1) Reasonable accounting methods required. (2) Bona fide deviations from accounting method. (b) Allocation of gross proceeds to an issue. (1) One-issue rule and general ordering rules. (2) Universal cap on value of nonpurpose investments allocated to an issue. (c) Fair market value limit on allocations to nonpurpose investments. (d) Allocation of gross proceeds to expenditures. (1) Expenditures in general. (2) Treatment of gross proceeds invested in purpose investments. (3) Expenditures for working capital purposes. (4) Expenditures for grants. (5) Expenditures for reimbursement purposes. (6) Expenditures of certain commingled investment proceeds of governmental issues. (7) Payments to related parties. (e) Special rules for commingled funds. (1) In general. (2) Investments held by a commingled fund. (3) Certain expenditures involving a commingled fund. (4) Fiscal periods. (5) Unrealized gains and losses on investments of a commingled fund. (6) Allocations of commingled funds serving as common reserve funds or sinking funds. §1.148-7 Spending exceptions to the rebate requirement. (a) Scope of section. (1) In general. (2) Relationship of spending exceptions. (3) Spending exceptions not mandatory. (b) Rules applicable for all spending exceptions. (1) Special transferred proceeds rules. (2) Application of multipurpose issue rules. (3) Expenditures for governmental purposes of the issue. (4) De minimis rule. (5) Special definition of reasonably required reserve or replacement fund. (6) Pooled financing issue. (c) 6-month exception. (1) General rule. (2) Additional period for certain bonds. (3) Amounts not included in gross proceeds. (4) Series of refundings. (d) 18-month exception. (1) General rule. (2) Extension for reasonable retainage. (3) Gross proceeds. (4) Application to multipurpose issues. (e) 2-year exception. (1) General rule. (2) Extension for reasonable retainage. (3) Definitions. (f) Construction issue. (1) Definition. (2) Use of actual facts. (3) Ownership requirement. (g) Construction expenditures. (1) Definition. (2) Certain acquisitions under turnkey contracts treated as construction expenditures. (3) Constructed personal property. (4) Specially developed computer software. (5) Examples. (h) Reasonable retainage definition. (i) Available construction proceeds. (1) Definition in general. (2) Earnings on a reasonably required reserve or replacement fund. (3) Reasonable expectations test for future earnings. (4) Issuance costs. (5) One and one-half percent penalty in lieu of arbitrage rebate. (6) Payments on purpose investments and repayments of grants. (7) Examples. (j) Election to treat portion of issue used for construction as separate issue. (1) In general. (2) Example. (k) One and one-half percent penalty in lieu of arbitrage rebate. (1) In general. (2) Application to reasonable retainage. (3) Coordination with rebate requirement. (l) Termination of 11/2 percent penalty. (1) Termination after initial temporary period. (2) Termination before end of initial temporary period. (3) Application to reasonable retainage. (4) Example. (m)

Payment of penalties. §1.148-8 Small issuer exception to rebate requirement. (a) Scope. (b) General taxing powers. (c) Size limitation. (1) In general. (2) Aggregation rules. (3) Certain refunding bonds not taken into account. (d) Pooled financings. (1) Treatment of pool issuer. (2) Treatment of conduit borrowers. (e) Refunding issues. (1) In general. (2) Multipurpose issues. §1.148-9 Arbitrage rules for refunding issues. (a) Scope of application. (b) Transferred proceeds allocation rule. (1) In general. (2) Special definition of principal amount. (3) Relation of transferred proceeds rule to universal cap rule. (4) Limitation on multi-generational transfers. (c) Special allocation rules for refunding issues. (1) Allocations of investments. (2) Allocations of mixed escrows to expenditures for principal, interest, and redemption prices on a prior issue. (d) Temporary periods in refundings. (1) In general. (2) Types of temporary periods in refundings. (e) Reasonably required reserve or replacement funds in refundings. (f) Minor portions in refundings. (g) Certain waivers permitted. (h) Multipurpose issue allocations. (1) Application of multipurpose issue allocation rules. (2) Rules on allocations of multipurpose issues. (3) Separate purposes of a multipurpose issue. (4) Allocations of bonds of a multipurpose issue. (5) Limitation on multi-generation allocations. (i) Operating rules for separation of prior issues into refunded and unrefunded portions. (1) In general. (2) Allocations of proceeds and investments in a partial refunding. (3) References to prior issue.

§1.148-10 Anti-abuse rules and authority of Commissioner. (a) Abusive arbitrage

device. (1) In general. (2) Abusive arbitrage device defined. (3) Exploitation of tax-exempt interest rates. (4) Overburdening the tax-exempt market. (b) Consequences of overburdening the tax-exempt bond market. (1) In general. (2) Application. (c) Anti-abuse rules on excess gross proceeds of advance refunding issues.(1) In general.(2) Definition of excess gross proceeds.(3) Special treatment of transferred proceeds.(4) Special rule for crossover refundings.(5) Special rule for gross refundings.(d) Examples.(e) Authority of the Commissioner to clearly reflect the economic substance of a transaction.(f) Authority of the Commissioner to require an earlier date for payment of rebate.(g) Authority of the Commissioner to waive regulatory limitations.§1.148-11 Effective dates.(a) In general.(b) Elective retroactive application in whole.(1) In general.(2) No elective retroactive application for 18-month spending exception.(c) Elective retroactive application of certain provisions.(1) In general.(2) Certain allocations of multipurpose issues.(3) Special limitation.(d) Transition rule excepting certain state guarantee funds from the definition of replacement proceeds.(1) Certain perpetual trust funds.(2) Permanent University Fund.(e) Transition rule regarding special allowance payments.(f) Transition rule regarding applicability of yield reduction rule.(g) Extension of due date for rebate payments.(h) Elective application of existing regulations.

§1.148-1 Definitions and elections.

(a) In general. The definitions in this section and the definitions under section 150 apply for purposes of section 148 and §§1.148-1 through 1.148-11. (b) Certain definitions. The following definitions apply: Accounting method means both the overall method used to account for gross proceeds of an issue (e.g., the cash method or a modified accrual method) and the method used to account for or allocate any particular item within that overall accounting method (e.g., accounting for investments, expenditures, allocations to and from different sources, and particular items of the foregoing).

Annuity contract means annuity contract as defined in section 72. Available amount means available amount as defined in §1.148-6(d)(3)(iii). Bona fide debt service fund means a fund, which may include proceeds of an issue, that- (1) Is used primarily to achieve a proper matching of revenues with principal and interest payments within each bond year; and (2) Is depleted at least once each bond year, except for a reasonable carryover amount not to exceed the greater of: (i) the earnings on the fund for the immediately preceding bond year; or (ii) one-twelfth of the principal and interest payments on the issue for the immediately preceding bond year. Bond year means, in reference to an issue, each 1-year period that ends on the day selected by the issuer. The first and last bond years may be short periods. If no day is selected by the issuer before the earlier of the final maturity date of the issue or the date that is 5 years after the issue date, bond years end on each anniversary of the issue date and on the final maturity date. Capital project or capital projects means all capital expenditures, plus related working capital expenditures to which the de minimis rule under §1.148- 6(d)(3)(ii)(A) applies, that carry out the governmental purposes of an issue. For example, a capital project may include capital expenditures for one or more buildings, plus related start-up operating costs. Commingled fund means any fund or account containing both gross proceeds of an issue and amounts in excess of $25,000 that are not gross proceeds of that issue if the amounts in the fund or account are invested and accounted for collectively, without regard to the source of funds deposited in the fund or account. An open-end regulated investment company under section 851, however, is not a commingled fund. Computation date means each date on which the rebate amount for an issue is computed under §1.148-3(e). Computation period means the period between computation dates. The first computation period begins on the issue date and ends on the first computation date. Each succeeding computation period begins on the date immediately following the computation date and ends on the next computation date. Consistently applied means applied uniformly within a fiscal period and between fiscal periods to account for gross proceeds of an issue and any amounts that are in a commingled fund. De minimis amount means-

(1) In reference to original issue discount (as defined in section 1273(a)(1)) or premium on an obligation- (i) An amount that does not exceed 2 percent multiplied by the stated redemption price at maturity; plus (ii) Any original issue premium that is attributable exclusively to reasonable underwriters' compensation; and (2) In reference to market discount (as defined in section 1278(a)(2)(A)) or premium on an obligation, an amount that does not exceed 2 percent multiplied by the stated redemption price at maturity. Economic accrual method (also known as the constant interest method or actuarial method) means the method of computing yield that is based on the compounding of interest at the end of each compounding period. Fair market value means fair market value as defined in §1.148-5(d)(6). Fixed rate investment means any investment whose yield is fixed and determinable on the issue date. Fixed yield bond means any bond whose yield is fixed and determinable on the issue date using the assumptions and rules provided in §1.148-4(b). Fixed yield issue means any issue if each bond that is part of the issue is a fixed yield bond. Gross proceeds means any proceeds and replacement proceeds of an issue. Guaranteed investment contract includes any nonpurpose investment that has specifically negotiated withdrawal or reinvestment provisions and a specifically negotiated interest rate, and also includes any agreement to supply investments on two or more future dates (e.g., a forward supply contract). Higher yielding investments means higher yielding investments as defined in section 148(b)(1). Investment means any investment property as defined in sections 148(b)(2) and 148(b)(3), and any other tax-exempt bond. Investment proceeds means any amounts actually or constructively received from investing proceeds of an issue. Investment-type property includes any property, other than property described in section 148(b)(2) (A), (B), (C), or (E), that is held principally as a passive vehicle for the production of income. Except as otherwise provided, a prepayment for property or services is investment-type property if a principal purpose for prepaying is to receive an investment return from the time the prepayment is made until the time payment otherwise would be made. A prepayment is not investment-type property if-

(1) The prepayment is made for a substantial business purpose other than investment return and the issuer has no commercially reasonable alternative to the prepayment, or (2) Prepayments on substantially the same terms are made by a substantial percentage of persons who are similarly situated to the issuer but who are not beneficiaries of tax-exempt financing. Issue price means, except as otherwise provided, issue price as defined in sections 1273 and 1274. Generally, the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public. Ten percent is a substantial amount. The public does not include bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters or wholesalers. The issue price does not change if part of the issue is later sold at a different price. The issue price of bonds that are not substantially identical is determined separately. The issue price of bonds for which a bona fide public offering is made is determined as of the sale date based on reasonable expectations regarding the initial public offering price. If a bond is issued for property, the applicable Federal tax-exempt rate is used in lieu of the Federal rate in determining the issue price under section 1274. The issue price of bonds may not exceed their fair market value as of the sale date. Issuer generally means the entity that actually issues the issue, and, unless the context or a provision clearly requires otherwise, each conduit borrower of the issue. For example, rules imposed on issuers to account for gross proceeds of an issue apply to a conduit borrower to account for any gross proceeds received under a purpose investment. Provisions regarding elections, filings, liability for the rebate amount, and certifications of reasonable expectations apply only to the actual issuer. Multipurpose issue means an issue the proceeds of which are used for two or more separate purposes determined in accordance with §1.148-9(h). Net sale proceeds means sale proceeds, less the portion of those sale proceeds invested in a reasonably required reserve or replacement fund under section 148(d) and as part of a minor portion under section 148(e). Nonpurpose investment means any investment property, as defined in section 148(b), that is not a purpose investment. Payment means a payment as defined in §1.148-3(d) for purposes of computing the rebate amount, and a payment as defined in §1.148-5(b) for purposes of computing the yield on an investment. Plain par bond means a qualified tender bond or a bond- (1) Issued with not more than a de minimis amount of original issue discount or premium; (2) Issued for a price that does not include accrued interest other than pre-issuance accrued interest;

(3) That bears interest from the issue date at a single, stated, fixed rate or that is a variable rate debt instrument under section 1275, in each case with interest unconditionally payable at least annually; and (4) That has a lowest stated redemption price that is not less than its outstanding stated principal amount. Plain par investment means an investment that is an obligation- (1) Issued with not more than a de minimis amount of original issue discount or premium, or, if acquired on a date other than the issue date, acquired with not more than a de minimis amount of market discount or premium; (2) Issued for a price that does not include accrued interest other than pre-issuance accrued interest; (3) That bears interest from the issue date at a single, stated, fixed rate or that is a variable rate debt instrument under section 1275, in each case with interest unconditionally payable at least annually; and (4) That has a lowest stated redemption price that is not less than its outstanding stated principal amount. Pre-issuance accrued interest means amounts representing interest that accrued on an obligation for a period not greater than one year before its issue date but only if those amounts are paid within one year after the issue date. Proceeds means any sale proceeds, investment proceeds, and transferred proceeds of an issue. Proceeds do not include, however, amounts actually or constructively received with respect to a purpose investment that are properly allocable to the immaterially higher yield under §1.148-2(d) or section 143(g) or to qualified administrative costs recoverable under §1.148-5(e). Program investment means a purpose investment that is part of a governmental program in which- (1) The program involves the origination or acquisition of purpose investments; (2) At least 95 percent (90 percent for qualified student loans under section 144(b)(1)(A)) of the cost of the purpose investments acquired under the program represents one or more loans to a substantial number of persons representing the general public, States or political subdivisions, 501(c)(3) organizations, persons who provide housing and related facilities, or any combination of the foregoing; (3) At least 95 percent of the receipts from the purpose investments are used to pay principal, interest, or redemption prices on issues that financed the program, to pay or reimburse administrative costs of those issues or of the program, to pay or reimburse anticipated future losses directly related to the program, to finance additional purpose investments for the same general purposes of the program, or to redeem and retire governmental obligations at the next earliest possible date of redemption;

(4) The program documents prohibit any obligor on a purpose investment financed by the program or any related party to that obligor from purchasing bonds of an issue that finance the program in an amount related to the amount of the purpose investment acquired from that obligor; and (5) The issuer has not waived the right to treat the investment as a program investment. Purpose investment means an investment that is acquired to carry out the governmental purpose of an issue. Qualified administrative costs means qualified administrative costs as defined in §1.148-5(e). Qualified guarantee means a qualified guarantee as defined in §1.148-4(f). Qualified hedge means a qualified hedge as defined in §1.148-4(h)(2). Reasonable expectations or reasonableness. An issuer's expectations or actions are reasonable only if a prudent person in the same circumstances as the issuer would have those same expectations or take those same actions, based on all the objective facts and circumstances. Factors relevant to a determination of reasonableness include the issuer's history of conduct concerning stated expectations made in connection with the issuance of obligations, the level of inquiry by the issuer into factual matters, and the existence of covenants, enforceable by bondholders, that require implementation of specific expectations. For a conduit financing issue, factors relevant to a determination of reasonableness include the reasonable expectations of the conduit borrower, but only if, under the circumstances, it is reasonable and prudent for the issuer to rely on those expectations. Rebate amount means 100 percent of the amount owed to the United States under section 148(f)(2), as further described in §1.148-3. Receipt means a receipt as defined in §1.148-3(d) for purposes of computing the rebate amount, and a receipt as defined in §1.148-5(b) for purposes of computing yield on an investment. Refunding escrow means one or more funds established as part of a single transaction or a series of related transactions, containing proceeds of a refunding issue and any other amounts to provide for payment of principal or interest on one or more prior issues. For this purpose, funds are generally not so established solely because of- (1) The deposit of proceeds of an issue and replacement proceeds of the prior issue in an escrow more than 6 months apart, or (2) The deposit of proceeds of completely separate issues in an escrow. Restricted working capital expenditures means working capital expenditures that are subject to the proceeds-spent-last rule in §1.148-6(d)(3)(i) and are ineligible for any exception to that rule.

Sale proceeds means any amounts actually or constructively received from the sale of the issue, including amounts used to pay underwriters' discount or compensation and accrued interest other than pre-issuance accrued interest. Stated redemption price means the redemption price of an obligation under the terms of that obligation, including any call premium. Transferred proceeds means transferred proceeds as defined in §1.148-9 (or the applicable corresponding provision of prior law). Unconditionally payable means payable under terms in which- (1) Late payment or nonpayment results in a significant penalty to the borrower or reasonable remedies to the lender, and (2) It is reasonably certain on the issue date that the payment will actually be made. Value means value determined under §1.148-4(e) for a bond, and value determined under §1.148-5(d) for an investment. Variable yield bond means any bond that is not a fixed yield bond. Variable yield issue means any issue that is not a fixed yield issue. Yield means yield computed under §1.148-4 for an issue, and yield computed under

§1.148-5 for an investment.

Yield restricted means required to be invested at a yield that is not materially higher than the yield on the issue under section 148(a) and §1.148-2. (c) Definition of replacement proceeds-(1) In general. Amounts are replacement proceeds of an issue if the amounts have a sufficiently direct nexus to the issue or to the governmental purpose of the issue to conclude that the amounts would have been used for that governmental purpose if the proceeds of the issue were not used or to be used for that governmental purpose. For this purpose, governmental purposes include the expected use of amounts for the payment of debt service on a particular date. The mere availability or preliminary earmarking of amounts for a governmental purpose, however, does not in itself establish a sufficient nexus to cause those amounts to be replacement proceeds. Replacement proceeds include, but are not limited to, sinking funds, pledged funds, and other replacement proceeds described in paragraph (c)(4) of this section, to the extent that those funds or amounts are held by or derived from a substantial beneficiary of the issue. A substantial beneficiary of an issue includes the issuer and any related party to the issuer, and, if the issuer is not a state, the state in which the issuer is located. A person is not a substantial beneficiary of an issue solely because it is a guarantor under a qualified guarantee. (2) Sinking fund. Sinking fund includes a debt service fund, redemption fund, reserve fund, replacement fund, or any similar fund, to the extent reasonably expected to be used directly or indirectly to pay principal or interest on the issue.

(3) Pledged fund-(i) In general. A pledged fund is any amount that is directly or indirectly pledged to pay principal or interest on the issue. A pledge need not be cast in any particular form but, in substance, must provide reasonable assurance that the amount will be available to pay principal or interest on the issue, even if the issuer encounters financial difficulties. A pledge to a guarantor of an issue is an indirect pledge to secure payment of principal or interest on the issue. A pledge of more than 50 percent of the outstanding stock of a corporation that is a conduit borrower of the issue is not treated as a pledge for this purpose, unless the corporation is formed or availed of to avoid the creation of replacement proceeds. (ii) Negative pledges. An amount is treated as pledged to pay principal or interest on an issue if it is held under an agreement to maintain the amount at a particular level for the direct or indirect benefit of the bondholders or a guarantor of the bonds. An amount is not treated as pledged under this paragraph (c)(3)(ii), however, if- (A) The issuer or a substantial beneficiary may grant rights in the amount that are superior to the rights of the bondholders or the guarantor; or (B) The amount does not exceed reasonable needs for which it is maintained, the required level is tested no more frequently than every 6 months, and the amount may be spent without any substantial restriction other than a requirement to replenish the amount by the next testing date. (4) Other replacement proceeds-(i) Bonds outstanding longer than necessary-(A) In general. Replacement proceeds arise to the extent that the issuer reasonably expects as of the issue date that- (1) The term of an issue will be longer than is reasonably necessary for the governmental purposes of the issue, and (2) There will be available amounts during the period that the issue remains outstanding longer than necessary. Whether an issue is outstanding longer than necessary is determined under §1.148-10. Replacement proceeds are created under this paragraph (c)(4)(i)(A) at the beginning of each fiscal year during which an issue remains outstanding longer than necessary in an amount equal to available amounts of the issuer as of that date. (B) Safe harbor against creation of replacement proceeds. As a safe harbor, replacement proceeds do not arise under paragraph (c)(4)(i)(A) of this section- (1) For the portion of an issue that is to be used to finance restricted working capital expenditures, if that portion is not outstanding longer than 2 years; (2) For the portion of an issue that is to be used to finance capital projects, if that portion has a weighted average maturity that does not exceed 120 percent of the average reasonably expected economic life of the financed capital projects, determined in the same manner as under section 147(b); or (3) For the portion of an issue that is a refunding issue, if that portion has a weighted average maturity that does not exceed the remaining weighted average

maturity of the prior issue, and the issue of which the prior issue is a part satisfies paragraph (c)(4)(i)(B) (1) or (2) of this section. (ii) Bonds financing a working capital reserve-(A) In general. Except as otherwise provided in paragraph (c)(4)(ii)(B) of this section, replacement proceeds arise to the extent a working capital reserve is, directly or indirectly, financed with the proceeds of the issue (regardless of the expenditure of proceeds of the issue). Thus, for example, if an issuer that does not maintain a working capital reserve borrows to fund such a reserve, the issuer will have replacement proceeds. (B) Exception to creation of replacement proceeds. Replacement proceeds do not arise under paragraph (c)(4)(ii)(A) of this section with respect to an issue- (1) All of the net proceeds of which are spent within 6 months of the issue date under section 148(f)(4)(B)(iii)(I); or (2) That is not subject to the rebate requirement under the exception provided by section 148(f)(4)(D). (d) Elections. Except as otherwise provided, any required elections must be made in writing, and, once made, may not be revoked without the permission of the Commissioner.

§1.148-2 General arbitrage yield restriction rules.

(a) In general. Under section 148(a), the direct or indirect investment of the gross proceeds of an issue in higher yielding investments causes the bonds of the issue to be arbitrage bonds. The investment of proceeds in higher yielding investments, however, during a temporary period described in paragraph (e) of this section, as part of a reasonably required reserve or replacement fund described in paragraph (f) of this section, or as part of a minor portion described in paragraph (g) of this section does not cause the bonds of the issue to be arbitrage bonds. Bonds are not arbitrage bonds under this section as a result of an inadvertent, insubstantial error. (b) Reasonable expectations-(1) In general. Except as provided in paragraph (c) of this section, the determination of whether an issue consists of arbitrage bonds under section 148(a) is based on the issuer's reasonable expectations as of the issue date regarding the amount and use of the gross proceeds of the issue. (2) Certification of expectations-(i) In general. An officer of the issuer responsible for issuing the bonds must, in good faith, certify the issuer's expectations as of the issue date. The certification must state the facts and estimates that form the basis for the issuer's expectations. The certification is evidence of the issuer's expectations, but does not establish any conclusions of law or any presumptions regarding either the issuer's actual expectations or their reasonableness. (ii) Exceptions to certification requirement. An issuer is not required to make a certification for an issue under paragraph (b)(2)(i) of this section if- (A) The issuer reasonably expects as of the issue date that there will be no unspent gross proceeds after the issue date, other than gross proceeds in a bona fide debt

service fund (e.g., equipment lease financings in which the issuer purchases equipment in exchange for an installment payment note); or (B) The issue price of the issue does not exceed $250,000. (c) Intentional acts. The taking of any deliberate, intentional action by the issuer or person acting on its behalf after the issue date in order to earn arbitrage causes the bonds of the issue to be arbitrage bonds if that action, had it been expected on the issue date, would have caused the bonds to be arbitrage bonds. An intent to violate the requirements of section 148 is not necessary for an action to be intentional. (d) Materially higher yielding investments-(1) In general. The yield on investments is materially higher than the yield on the issue to which the investments are allocated if the yield on the investments over the term of the issue exceeds the yield on the issue by an amount in excess of the applicable definition of materially higher set forth in paragraph (d)(2) of this section. If yield restricted investments in the same class are subject to different definitions of materially higher, the applicable definition of materially higher that produces the lowest permitted yield applies to all the investments in the class. The yield on the issue is determined under §1.148-4. The yield on investments is determined under §1.148-5. (2) Definitions of materially higher yield-(i) General rule for purpose and nonpurpose investments. For investments that are not otherwise described in this paragraph (d)(2), materially higher means one-eighth of 1 percentage point. (ii) Refunding escrows and replacement proceeds. For investments in a refunding escrow or for investments allocable to replacement proceeds, materially higher means one-thousandth of 1 percentage point. (iii) Program investments. For program investments that are not described in paragraph (d)(2)(iv) of this section, materially higher means 1 and one-half percentage points. (iv) Student loans. For qualified student loans that are program investments, materially higher means 2 percentage points. (v) Tax-exempt investments. For investments that are tax-exempt bonds and are not investment property under section 148(b)(3), no yield limitation applies. (3) Mortgage loans. Qualified mortgage loans that satisfy the requirements of section 143(g) are treated as meeting the requirements of this paragraph (d). (e) Temporary periods-(1) In general. During the temporary periods set forth in this paragraph (e), the proceeds and replacement proceeds of an issue may be invested in higher yielding investments without causing bonds in the issue to be arbitrage bonds. This paragraph (e) does not apply to refunding issues (see §1.148-9). (2) General 3-year temporary period for capital projects and qualified mortgage loans-(i) In general. The net sale proceeds and investment proceeds of an issue reasonably expected to be allocated to expenditures for capital projects qualify for a temporary period of 3 years beginning on the issue date (the 3-year temporary

period). The 3-year temporary period also applies to the proceeds of qualified mortgage bonds and qualified veterans' mortgage bonds by substituting qualified mortgage loans in each place that capital projects appears in this paragraph (e)(2). The 3-year temporary period applies only if the issuer reasonably expects to satisfy the expenditure test, the time test, and the due diligence test. These rules apply separately to each conduit loan financed by an issue (other than qualified mortgage loans), with the expenditure and time tests measured from the issue date of the issue. (A) Expenditure test. The expenditure test is met if at least 85 percent of the net sale proceeds of the issue are allocated to expenditures on the capital projects by the end of the 3-year temporary period. (B) Time test. The time test is met if the issuer incurs within 6 months of the issue date a substantial binding obligation to a third party to expend at least 5 percent of the net sale proceeds of the issue on the capital projects. An obligation is not binding if it is subject to contingencies within the issuer's or a related party's control. (C) Due diligence test. The due diligence test is met if completion of the capital projects and the allocation of the net sale proceeds of the issue to expenditures proceed with due diligence. (ii) 5-year temporary period. In the case of proceeds expected to be allocated to a capital project involving a substantial amount of construction expenditures (as defined in §1.148-7), a 5-year temporary period applies in lieu of the 3-year temporary period if the issuer satisfies the requirements of paragraph (e)(2)(i) of this section applied by substituting "5 years" in each place that "3 years" appears, and both the issuer and a licensed architect or engineer certify that the longer period is necessary to complete the capital project. (3) Temporary period for restricted working capital expenditures-(i) General rule. The proceeds of an issue that are reasonably expected to be allocated to restricted working capital expenditures within 13 months after the issue date qualify for a temporary period of 13 months beginning on the issue date. Paragraph (e)(2) of this section contains additional temporary period rules for certain working capital expenditures that are treated as part of a capital project. (ii) Longer temporary period for certain tax anticipation issues. If an issuer reasonably expects to use tax revenues arising from tax levies for a single fiscal year to redeem or retire an issue, and the issue matures by the earlier of 2 years after the issue date or 60 days after the last date for payment of those taxes without interest or penalty, the temporary period under paragraph (e)(3)(i) of this section is extended until the maturity date of the issue. (4) Temporary period for pooled financings-(i) In general. Proceeds of a pooled financing issue reasonably expected to be used to finance purpose investments qualify for a temporary period of 6 months while held by the issuer before being loaned to a conduit borrower. Any otherwise available temporary period for proceeds held by a conduit borrower, however, is reduced by the period of time during which those proceeds were held by the issuer before being loaned. For example, if the proceeds of a pooled financing issue loaned to a conduit borrower would qualify for a 3-year temporary period, and the proceeds are held by the issuer for 5 months

before being loaned to the conduit borrower, the proceeds qualify for only an additional 31-month temporary period after being loaned to the conduit borrower. This paragraph (e)(4) does not apply to any qualified mortgage bond or qualified veterans' mortgage bond under section 143. (ii) Loan repayments-(A) Amount held by the issuer. The temporary period under this paragraph (e)(4) for proceeds from the sale or repayment of any loan that are reasonably expected to be used to make or finance new loans iSection 3 months. (B) Amounts re-loaned to conduit borrowers. Any temporary period for proceeds held by a conduit borrower under a new loan from amounts described in paragraph (e)(4)(ii)(A) of this section is determined by treating the date the new loan is made as the issue date and by reducing the temporary period by the period the amounts were held by the issuer following the last repayment. (iii) Construction issues. If all or a portion of a pooled financing issue qualifies as a construction issue under §1.148-7(b)(6), paragraph (e)(4)(i) of this section is applied by substituting "2 years" for "6 months." (5) Temporary period for replacement proceeds-(i) In general. Except as otherwise provided, replacement proceeds qualify for a temporary period of 30 days beginning on the date that the amounts are first treated as replacement proceeds. (ii) Temporary period for bona fide debt service funds. Amounts in a bona fide debt service fund for an issue qualify for a temporary period of 13 months. If only a portion of a fund qualifies as a bona fide debt service fund, only that portion qualifies for this temporary period. (6) Temporary period for investment proceeds. Except as otherwise provided in this paragraph (e), investment proceeds qualify for a temporary period of 1 year beginning on the date of receipt. (7) Other amounts. Gross proceeds not otherwise eligible for a temporary period described in this paragraph (e) qualify for a temporary period of 30 days beginning on the date of receipt. (f) Reserve or replacement funds-(1) General 10 percent limitation on funding with sale proceeds. An issue consists of arbitrage bonds if sale proceeds of the issue in excess of 10 percent of the stated principal amount of the issue are used to finance any reserve or replacement fund, without regard to whether those sale proceeds are invested in higher yielding investments. If an issue has more than a de minimis amount of original issue discount or premium, the issue price (net of pre-issuance accrued interest) is used to measure the 10-percent limitation in lieu of stated principal amount. This rule does not limit the use of amounts other than sale proceeds of an issue to fund a reserve or replacement fund. (2) Exception from yield restriction for reasonably required reserve or replacement funds-(i) In general. The investment of amounts that are part of a reasonably required reserve or replacement fund in higher yielding investments will not cause an issue to consist of arbitrage bonds. A reasonably required reserve or replacement fund may consist of all or a portion of one or more funds, however labelled, derived

from one or more sources. Amounts in a reserve or replacement fund in excess of the amount that is reasonably required are not part of a reasonably required reserve or replacement fund. (ii) Size limitation. The amount of gross proceeds of an issue that qualifies as a reasonably required reserve or replacement fund may not exceed an amount equal to the least of 10 percent of the stated principal amount of the issue, the maximum annual principal and interest requirements on the issue, or 125 percent of the average annual principal and interest requirements on the issue. If an issue has more than a de minimis amount of original issue discount or premium, the issue price of the issue (net of pre-issuance accrued interest) is used to measure the 10 percent limitation in lieu of its stated principal amount. For a reserve or replacement fund that secures more than one issue (e.g. a parity reserve fund), the size limitation may be measured on an aggregate basis. (iii) Valuation of investments. Investments in a reasonably required reserve or replacement fund may be valued in any reasonable, consistently applied manner that is permitted under §1.148-5. (iv) 150 percent debt service limitation on investment in nonpurpose investments for certain private activity bonds. Section 148(d)(3) contains additional limits on the amount of gross proceeds of an issue of private activity bonds, other than qualified 501(c)(3) bonds, that may be invested in higher yielding nonpurpose investments without causing the bonds to be arbitrage bonds. For purposes of these rules, initial temporary period means the temporary periods under paragraphs (e)(2), (e)(3), and (e)(4) of this section and under §1.148-9(d)(2)(i), (ii), and (iii). (3) Certain parity reserve funds. The limitation contained in paragraph (f)(1) of this section does not apply to an issue if the master legal document authorizing the issuance of the bonds (e.g., a master indenture) was adopted before August 16, 1986, and that document- (i) Requires a reserve or replacement fund in excess of 10 percent of the sale proceeds, but not more than maximum annual principal and interest requirements; (ii) Is not amended after August 31, 1986 (other than to permit the issuance of additional bonds as contemplated in the master legal document); and (iii) Provides that bonds having a parity of security may not be issued by or on behalf of the issuer for the purposes provided under the document without satisfying the reserve fund requirements of the indenture. (g) Minor portion. Under section 148(e), a bond of an issue is not an arbitrage bond solely because of the investment in higher yielding investments of gross proceeds of the issue in an amount not exceeding the lesser of- (1) 5 percent of the sale proceeds of the issue; or (2) $100,000.

(h) Certain waivers permitted. On or before the issue date, an issuer may elect to waive the right to invest in higher yielding investments during any temporary period under paragraph (e) of this section or as part of a reasonably required reserve or replacement fund under paragraph (f) of this section. At any time, an issuer may waive the right to invest in higher yielding investments as part of a minor portion under paragraph (g) of this section.

§1.148-3 General arbitrage rebate rules.

(a) In general. Section 148(f) requires that certain earnings on nonpurpose investments allocable to the gross proceeds of an issue be paid to the United States to prevent the bonds in the issue from being arbitrage bonds. The arbitrage that must be rebated is based on the difference between the amount actually earned on nonpurpose investments and the amount that would have been earned if those investments had a yield equal to the yield on the issue. (b) Definition of rebate amount. As of any date, the rebate amount for an issue is the excess of the future value, as of that date, of all receipts on nonpurpose investments over the future value, as of that date, of all payments on nonpurpose investments. (c) Computation of future value of a payment or receipt. The future value of a payment or receipt at the end of any period is determined using the economic accrual method and equals the value of that payment or receipt when it is paid or received (or treated as paid or received), plus interest assumed to be earned and compounded over the period at a rate equal to the yield on the issue, using the same compounding interval and financial conventions used to compute that yield. (d) Payments and receipts- (1) Definition of payments. For purposes of this section, payments are- (i) Amounts actually or constructively paid to acquire a nonpurpose investment (or treated as paid to a commingled fund); (ii) For a nonpurpose investment that is first allocated to an issue on a date after it is actually acquired (e.g., an investment that becomes allocable to transferred proceeds or to replacement proceeds) or that becomes subject to the rebate requirement on a date after it is actually acquired (e.g., an investment allocated to a reasonably required reserve or replacement fund for a construction issue at the end of the 2-year spending period), the value of that investment on that date; (iii) For a nonpurpose investment that was allocated to an issue at the end of the preceding computation period, the value of that investment at the beginning of the computation period; (iv) On the last day of each bond year during which there are amounts allocated to gross proceeds of an issue that are subject to the rebate requirement, and on the final maturity date, a computation credit of $1,000; and (v) Yield reduction payments on nonpurpose investments made pursuant to §1.148- 5(c).

(2) Definition of receipts. For purposes of this section, receipts are- (i) Amounts actually or constructively received from a nonpurpose investment (including amounts treated as received from a commingled fund), such as earnings and return of principal; (ii) For a nonpurpose investment that ceases to be allocated to an issue before its disposition or redemption date (e.g., an investment that becomes allocable to transferred proceeds of another issue or that ceases to be allocable to the issue pursuant to the universal cap under §1.148-6) or that ceases to be subject to the rebate requirement on a date earlier than its disposition or redemption date (e.g., an investment allocated to a fund initially subject to the rebate requirement but that subsequently qualifies as a bona fide debt service fund), the value of that nonpurpose investment on that date; and (iii) For a nonpurpose investment that is held at the end of a computation period, the value of that investment at the end of that period. (3) Special rules for commingled funds. Section 1.148-6(e) provides special rules to limit certain of the required determinations of payments and receipts for investments of a commingled fund. (e) Computation dates-(1) In general. For a fixed yield issue, an issuer may treat any date as a computation date. For a variable yield issue, an issuer: (i) May treat the last day of any bond year ending on or before the latest date on which the first rebate amount is required to be paid under paragraph (f) of this section (the first required payment date) as a computation date but may not change that treatment after the first payment date; and (ii) After the first required payment date, must consistently treat either the end of each bond year or the end of each fifth bond year as computation dates and may not change these computation dates after the first required payment date. (2) Final computation date. The date that an issue is discharged is the final computation date. For an issue retired within 3 years of the issue date, however, the final computation date need not occur before the end of 8 months after the issue date or during the period in which the issuer reasonably expects that any of the spending exceptions under §1.148-7 will apply to the issue. (f) Amount of required rebate installment payment-(1) Amount of interim rebate payments. The first rebate installment payment must be made for a computation date that is not later than 5 years after the issue date. Subsequent rebate installment payments must be made for a computation date that is not later than 5 years after the previous computation date for which an installment payment was made. A rebate installment payment must be in an amount that, when added to the future value, as of the computation date, of previous rebate payments made for the issue, equals at least 90 percent of the rebate amount as of that date. (2) Amount of final rebate payment. For the final computation date, a final rebate payment must be paid in an amount that, when added to the future value of

previous rebate payments made for the issue, equals 100 percent of the rebate amount as of that date. (3) Future value of rebate payments. The future value of a rebate payment is determined under paragraph (c) of this section. This value is computed by taking into account recoveries of overpayments. (g) Time and manner of payment. Each rebate payment must be paid no later than 60 days after the computation date to which the payment relates. Any rebate payment paid within this 60-day period may be treated as paid on the computation date to which it relates. A rebate payment is paid when it is filed with the Internal Revenue Service at the place or places designated by the Commissioner. A payment must be accompanied by the form provided by the Commissioner for this purpose. (h) Penalty in lieu of loss of tax exemption-(1) In general. The failure to pay the correct rebate amount when required will cause the bonds of the issue to be arbitrage bonds, unless the Commissioner determines that the failure was not caused by willful neglect and the issuer promptly pays a penalty to the United States. If no bond of the issue is a private activity bond (other than a qualified 501(c)(3) bond), the penalty equals 50 percent of the rebate amount not paid when required to be paid, plus interest on that amount. Otherwise, the penalty equals 100 percent of the rebate amount not paid when required to be paid, plus interest on that amount. (2) Interest on underpayments. Interest accrues at the underpayment rate under section 6621, beginning on the date the correct rebate amount is due and ending on the date 10 days before it is paid. (3) Waivers of the penalty. The penalty is automatically waived if the rebate amount that the issuer failed to pay plus interest is paid within 180 days after discovery of the failure, unless, the Commissioner determines that the failure was due to willful neglect, or the issue is under examination by the Commissioner at any time during the period beginning on the date the failure first occurred and ending on the date 90 days after the receipt of the rebate amount. Generally, extensions of this 180-day period and waivers of the penalty in other cases will be granted by the Commissioner only in unusual circumstances. (4) Application to alternative penalty under §1.148-7. Paragraphs (h) (1), (2), and (3) of this section apply to failures to pay penalty payments under §1.148-7 (alternative penalty amounts) by substituting alternative penalty amounts for rebate amount and the last day of each spending period for computation date. (i) Recovery of overpayment of rebate-(1) In general. An issuer may recover an overpayment for an issue of tax-exempt bonds by establishing to the satisfaction of the Commissioner that the overpayment occurred. An overpayment is the excess of the amount paid to the United States for an issue under section 148 over the sum of the rebate amount for the issue as of the most recent computation date and all amounts that are otherwise required to be paid under section 148 as of the date the recovery is requested.

(2) Limitations on recovery. (i) An overpayment may be recovered only to the extent that a recovery on the date that it is first requested would not result in an additional rebate amount if that date were treated as a computation date. (ii) Except for overpayments of penalty in lieu of rebate under section 148(f)(4)(C)(vii) and §1.148-7(k), an overpayment of less than $5,000 may not be recovered before the final computation date. (j) Examples. The provisions of this section may be illustrated by the following examples. Example 1. Calculation and payment of rebate for a fixed yield issue. (i) Facts. On January 1, 1994, City A issues a fixed yield issue and invests all the sale proceeds of the issue ($49 million). There are no other gross proceeds. The issue has a yield of 7.0000 percent per year compounded semiannually (computed on a 30 day month/360 day year basis). City A receives amounts from the investment and immediately expends them for the governmental purpose of the issue as follows: ---- ----------------- Date Amount --------------------- 2/1/1994 .. $3,000,000 4/1/1994 ... 5,000,000 6/1/1994 .. 14,000,000 9/1/1994 .. 20,000,000 7/1/1995 .. 10,000,000 --------------------- (ii) First computation date. (A) City A selects a bond year ending on January 1, and thus the first required computation date is January 1, 1999. The rebate amount as of this date is computed by determining the future value of the receipts and the payments for the investment. The compounding interval is each 6-month (or shorter) period and the 30 day month/360 day year basis is used because these conventions were used to compute yield on the issue. The future value of these amounts, plus the computation credit, as of January 1, 1999, is: --------------------------------------- ------------------------------- Date Receipts (payments) FV (7.0000 percent) ---------- ------------------------------------------------------------ 1/1/1994 ........................... ($49,000,000) ...... ($69,119,339) 2/1/1994 ............................... 3,000,000 .......... 4,207,602 4/1/1994 ............................... 5,000,000 .......... 6,932,715 6/1/1994 .............................. 14,000,000 ......... 19,190,277 9/1/1994 .............................. 20,000,000 ......... 26,947,162 1/1/1995 ................................. (1,000) ............ (1,317) 7/1/1995 .............................. 10,000,000 ......... 12,722,793 1/1/1996 ................................. (1,000) ............ (1,229) Rebate amount (1/01/1999) .. -------------------- ............ 878,664 ---------- ------------------------------------------------------------ (B) City A pays 90 percent of the rebate amount ($790,798) to the United States within 60 days of January 1, 1999. (iii) Second computation date. (A) On the next required computation date, January 1, 2004, the future value of the payments and receipts is: ----------------------------- ----------------------------------------- Date Receipts (payments) FV (7.0000 percent) ---------------------------------------------------------------------- 1/1/1999 ................................ $878,664 ......... $1,239,442 Rebate amount (1/01/2004) .. - ------------------- .......... 1,239,442 ------------------------------------------------------ ---------------- (B) As of this computation date, the future value of the payment treated as made on January 1, 1999, is $1,115,499, which equals at least 90 percent of the rebate

amount as of this computation date ($1,239,442 0.9), and thus no additional rebate payment is due as of this date. (iv) Final computation date. (A) On January 1, 2009, City A redeems all the bonds, and thus this date is the final computation date. The future value of the receipts and payments as of this date is: --------------------------------------------------------------- ------- Date Receipts (payments) FV (7.0000 percent) ---------------------------------- ------------------------------------ 1/1/2004 .............................. $1,239,442 ......... $1,748,355 1/1/2009 ................................. (1,000) ............ (1,000) Rebate amount (1/01/2009) .. -------------------- .......... 1,747,355 --------------------------- ------------------------------------------- (B) As of this computation date, the future value of the payment made on January 1, 1999, is $1,573,521 and thus an additional rebate payment of $173,834 is due. This payment reflects the future value of the 10 percent unpaid portion, and thus would not be owed had the issuer paid the full rebate amount as of any prior computation date. Example 2. Calculation and payment of rebate for a variable yield issue. (i) Facts. On July 1, 1994, City B issues a variable yield issue and invests all of the sale proceeds of the issue ($30 million). There are no other gross proceeds. As of July 1, 1999, there are nonpurpose investments allocated to the issue. Prior to July 1, 1999, City B receives amounts from nonpurpose investments and immediately expends them for the governmental purpose of the issue as follows: ---------------------- Date Amount ---------------------- 8/1/1994 ... $5,000,000 7/1/1995 .... 8,000,000 12/1/1995 .. 17,000,000 7/1/1999 ...... 650,000 ---------------------- (ii) First computation date. (A) City B treats the last day of the fifth bond year (July 1, 1999) as a computation date. The yield on the variable yield issue during the first computation period (the period beginning on the issue date and ending on the first computation date) is 6.0000 percent per year compounded semiannually. The value of the nonpurpose investments allocated to the issue as of July 1, 1999, is $3 million. The rebate amount as of July 1, 1999, is computed by determining the future value of the receipts and the payments for the nonpurpose investments. The compounding interval is each 6-month (or shorter) period and the 30 day month/360 day year basis is used because these conventions were used to compute yield on the issue. The future value of these amounts and of the computation date credits as of July 1, 1999, is: ---------------------------------------------------------------------- Date Receipts (payments) FV (6.0000 percent) ------------------------------------------------ ---------------------- 7/1/1994 ........................... ($30,000,000) ...... ($40,317,491) 8/1/1994 ............................... 5,000,000 .......... 6,686,560 7/1/1995 ................................. (1,000) ............ (1,267) 7/1/1995 ............................... 8,000,000 ......... 10,134,161 12/1/1995 ............................. 17,000,000 ......... 21,011,112 7/1/1996 ................................. (1,000) ............ (1,194) 7/1/1997 ................................. (1,000) ............ (1,126) 7/1/1998 ................................. (1,000) ............ (1,061) 7/1/1999 ............................... 3,000,000 .......... 3,000,000 7/1/1999 ................................. 650,000 ............ 650,000 7/1/1999 ................................. (1,000) ............ (1,000) Rebate amount (7/01/1999) .. ---- ---------------- .......... 1,158,694 --------------------------------------------------------- -------------

(B) City B pays 90 percent of the rebate amount ($1,042,824.60) to the United States within 60 days of July 1, 1999. (iii) Next computation date. (A) On July 1, 2004, City B redeems all of the bonds. Thus, the next computation date is July 1, 2004. On July 30, 1999, City B chose to compute rebate for periods following the first computation period by treating the end of each fifth bond year as a computation date. The yield during the second computation period is 5.0000 percent per year compounded semiannually. The computation of the rebate amount as of this date reflects the value of the nonpurpose investments allocated to the issue at the end of the prior computation period. On July 1, 2004, City B sells those nonpurpose investments for $3,925,000 and expends that amount for the governmental purpose of the issue. (B) As of July 1, 2004, the future value of the rebate amount computed as of July 1, 1999, and of all other payments and receipts is: ---------------------------------------- ------------- Date Receipts (payments) FV (5.0000 percent) ---------------------------- ------------------------- 7/1/1999 ............. $1,158,694 ......... $1,483,226 7/1/1999 ............ (3,000,000) ........ (3,840,254) 7/1/2000 ................ (1,000) ............ (1,218) 7/1/2001 ................ (1,000) ............ (1,160) 7/1/2002 ................ (1,000) ............ (1,104) 7/1/2003 ................ (1,000) ............ (1,051) 7/1/2004 ................ (2,000) ............ (2,000) 7/1/2004 .............. 3,925,000 .......... 3,925,000 -------------------- .......... 1,561,439 ----------------------------------------- ------------ (C) As of this computation date, the future value of the payment made on July 1, 1999, is $1,334,904 and thus an additional rebate payment of $226,535 is due. (k) Bona fide debt service fund exception. Under section 148(f)(4)(A), the rebate requirement does not apply to amounts in certain bona fide debt service funds. An issue with an average annual debt service that is not in excess of $2,500,000 may be treated as satisfying the $100,000 limitation in section 148(f)(4)(A)(ii).

§1.148-4 Yield on an issue of bonds.

(a) In general. The yield on an issue of bonds is used to apply investment yield restrictions under section 148(a) and to compute rebate liability under section 148(f). Yield is computed under the economic accrual method using any consistently applied compounding interval of not more than one year. A short first compounding interval and a short last compounding interval may be used. Yield is expressed as an annual percentage rate that is calculated to at least four decimal places (e.g., 5.2525 percent). Other reasonable, standard financial conventions, such as the 30 days per month/360 days per year convention, may be used in computing yield but must be consistently applied. The yield on an issue that would be a purpose investment (absent section 148(b)(3)(A)) is equal to the yield on the conduit financing issue that financed that purpose investment. The Commissioner may permit issuers of qualified mortgage bonds or qualified student loan bonds to use a single yield for two or more issues. (b) Computing yield on a fixed yield issue-(1) In general-(i) Yield on an issue. The yield on a fixed yield issue is the discount rate that, when used in computing the present value as of the issue date of all unconditionally payable payments of principal, interest, and fees for qualified guarantees on the issue and amounts

reasonably expected to be paid as fees for qualified guarantees on the issue, produces an amount equal to the present value, using the same discount rate, of the aggregate issue price of bonds of the issue as of the issue date. Further, payments include certain amounts properly allocable to a qualified hedge. Yield on a fixed yield issue is computed as of the issue date and is not affected by subsequent unexpected events, except to the extent provided in paragraphs (b)(4) and (h)(3) of this section. (ii) Yield on a bond. Yield on a fixed yield bond is computed in the same manner as yield on a fixed yield issue. (2) Yield on certain fixed yield bonds subject to mandatory or contingent early redemption-(i) In general. The yield on a fixed yield issue that includes a bond subject to mandatory early redemption or expected contingent redemption is computed by treating that bond as redeemed on its reasonably expected early redemption date for an amount equal to its value on that date. Reasonable expectations are determined on the issue date. A bond is subject to mandatory early redemption if it is unconditionally payable in full before its final maturity date. A bond is subject to a contingent redemption if it must be, or is reasonably expected to be, redeemed prior to final maturity upon the occurrence of a contingency. A contingent redemption is taken into account only if the contingency is reasonably expected to occur, in which case the date of occurrence of the contingency must be reasonably estimated. For example, if bonds are reasonably expected to be redeemed early using excess revenues from general or special property taxes or benefit assessments or similar amounts, the reasonably expected redemption schedule is used to determine yield. For purposes of this paragraph (b)(2)(i), excess proceeds calls for issues for which the requirements of §1.148-2(e) (2) or (3) are satisfied, calamity calls, and refundings do not cause a bond to be subject to early redemption. The value of a bond is determined under paragraph (e) of this section. (ii) Substantially identical bonds subject to mandatory early redemption. If substantially identical bonds of an issue are subject to specified mandatory redemptions prior to final maturity (e.g., a mandatory sinking fund redemption requirement), yield on that issue is computed by treating those bonds as redeemed in accordance with the redemption schedule for an amount equal to their value. Generally, bonds are substantially identical if the stated interest rate, maturity, and payment dates are the same. In computing the yield on an issue containing bonds described in this paragraph (b)(2)(ii), each of those bonds must be treated as redeemed at its present value, unless the stated redemption price at maturity of the bond does not exceed the issue price of the bond by more than one-fourth of one percent multiplied by the product of the stated redemption price at maturity and the number of years to the weighted average maturity date of the substantially identical bonds, in which case each of those bonds must be treated as redeemed at its outstanding stated principal amount, plus accrued, unpaid interest. Weighted average maturity is determined by taking into account the mandatory redemption schedule. (3) Yield on certain fixed yield bonds subject to optional early redemption-(i) In general. If a fixed yield bond is subject to optional early redemption and is described in paragraph (b)(3)(ii) of this section, the yield on the issue containing the bond is

computed by treating the bond as redeemed at its stated redemption price on the optional redemption date that would produce the lowest yield on the issue. (ii) Fixed yield bonds subject to special yield calculation rule. A fixed yield bond is described in this paragraph (b)(3)(ii) only if it- (A) Is subject to optional redemption within five years of the issue date, but only if the yield on the issue computed by assuming all bonds in the issue subject to redemption within 5 years of the issue date are redeemed at maturity is more than one-eighth of one percentage point higher than the yield on that issue computed by assuming all bonds subject to optional redemption within 5 years of the issue date are redeemed at the earliest date for their redemption; (B) Is issued at an issue price that exceeds the stated redemption price at maturity by more than one-fourth of one percent multiplied by the product of the stated redemption price at maturity and the number of complete years to the first optional redemption date for the bond; or (C) Bears interest at increasing interest rates (i.e., a stepped coupon bond). (4) Yield recomputed upon transfer of certain rights associated with the bond. For purposes of §1.148-3, as of the date of any transfer, waiver, modification, or similar transaction (collectively, a transfer) of any right that is part of the terms of a bond or is otherwise associated with a bond (e.g., a redemption right), in a transaction that is separate and apart from the original sale of the bond, the issue is treated as if it were retired and a new issue issued on the date of the transfer (reissued). The redemption price of the retired issue and the issue price of the new issue equal the aggregate values of all the bonds of the issue on the date of the transfer. In computing yield on the new issue, any amounts received by the issuer as consideration for the transfer are taken into account. (5) Examples. The provisions of this paragraph (b) may be illustrated by the following examples. Example 1. No early call-(i) Facts. On January 1, 1994, City A issues an issue consisting of four identical fixed yield bonds. The stated final maturity date of each bond is January 1, 2004, and no bond is subject to redemption before this date. Interest is payable on January 1 of each year at a rate of 6.0000 percent per year on the outstanding principal amount. The total stated principal amount of the bonds is $20 million. The issue price of the bonds $20,060,000. (ii) Computation. The yield on the issue is computed by treating the bonds as retired at the stated maturity under the general rule of §1.148-4(b)(1). The bonds are treated as redeemed for their stated redemption prices. The yield on the issue is 5.8731 percent per year compounded semiannually, computed as follows: ----------- --------------------------------- Date Payments PV (5.8731 percent) -------------------- ------------------------ 1/1/1995 .... $1,200,000 ......... $1,132,510 1/1/1996 ..... 1,200,000 .......... 1,068,816 1/1/1997 ..... 1,200,000 .......... 1,008,704 1/1/1998 ..... 1,200,000 ............ 951,973 1/1/1999 ..... 1,200,000 ............ 898,433 1/1/2000 ..... 1,200,000 ............ 847,903 1/1/2001 ..... 1,200,000 ............ 800,216 1/1/2002 ..... 1,200,000 ............ 755,210 1/1/2003 ..... 1,200,000

............ 712,736 1/1/2004 .... 21,200,000 ......... 11,883,498 ----------- ......... 20,060,000 -------------------------------------------- Example 2. Mandatory calls. (i) Facts. The facts are the same as in Example 1. In this case, however, the bonds are subject to mandatory sinking fund redemption on January 1 of each year, beginning January 1, 2001. On each sinking fund redemption date, one of the bonds is chosen by lottery and is required to be redeemed at par plus accrued interest. (ii) Computation. Because the bonds are subject to specified redemptions, yield on the issue is computed by treating the bonds as redeemed in accordance with the redemption schedule under §1.148-4(b)(2)(ii). Because the bonds are not sold at a discount, the bonds are treated as retired at their stated redemption prices. The yield on the issue is 5.8678 percent per year compounded semiannually, computed as follows: -------------------------------------------- Date Payments PV (5.8678 percent) -------------------------------------------- 1/1/1995 .... $1,200,000 ......... $1,132,569 1/1/1996 ..... 1,200,000 .......... 1,068,926 1/1/1997 ..... 1,200,000 .......... 1,008,860 1/1/1998 ..... 1,200,000 ............ 952,169 1/1/1999 ..... 1,200,000 ............ 898,664 1/1/2000 ..... 1,200,000 ............ 848,166 1/1/2001 ..... 6,200,000 .......... 4,135,942 1/1/2002 ..... 5,900,000 .......... 3,714,650 1/1/2003 ..... 5,600,000 .......... 3,327,647 1/1/2004 ..... 5,300,000 .......... 2,972,407 ----------- ........ $20,060,000 -------------------------------------------- Example 3. Optional early call. (i) Facts. On January 1, 1994, City C issues an issue consisting of three bonds. Each bond has a stated principal amount of $10 million dollars and is issued for par. Bond X bears interest at 5 percent per year and matures on January 1, 1999. BondY bears interest at 6 percent per year and matures on January 1, 2002. Bond Z bears interest at 7 percent per year and matures on January 1, 2004. Bonds Y and Z are callable by the issuer at par plus accrued interest after December 31, 1998. (ii) Computation. (A) The yield on the issue computed as if each bond is outstanding to its maturity is 6.0834 percent per year compounded semiannually, computed as follows: -------------------------------------------- Date Payments PV (6.0834 percent) -------------------------------------------- 1/1/1995 .... $1,800,000 ......... $1,695,299 1/1/1996 ..... 1,800,000 .......... 1,596,689 1/1/1997 ..... 1,800,000 .......... 1,503,814 1/1/1998 ..... 1,800,000 .......... 1,416,342 1/1/1999 .... 11,800,000 .......... 8,744,830 1/1/2000 ..... 1,300,000 ............ 907,374 1/1/2001 ..... 1,300,000 ............ 854,595 1/1/2002 .... 11,300,000 .......... 6,996,316 1/1/2003 ....... 700,000 ............ 408,190 1/1/2004 .... 10,700,000 .......... 5,876,551 -------- --- ......... 30,000,000 -------------------------------------------- (B) The yield on the issue computed as if all bonds are called at the earliest date for redemption is 5.9126 percent per year compounded semiannually, computed as follows: -------------------------------------------- Date Payments PV (5.9126 percent) -------------------------------------------- 1/1/1995 .... $1,800,000 ......... $1,698,113 1/1/1996 ..... 1,800,000 .......... 1,601,994 1/1/1997 ..... 1,800,000 .......... 1,511,315 1/1/1998 ..... 1,800,000 .......... 1,425,769 1/1/1999 .... 31,800,000 ......... 23,762,809 ----------- ......... 30,000,000 ---------------------------------------- ----

(C) Because the yield on the issue computed by assuming all bonds in the issue subject to redemption within 5 years of the issue date are redeemed at maturity is more than one-eighth of one percentage point higher than the yield on the issue computed by assuming all bonds subject to optional redemption within 5 years of the issue date are redeemed at the earliest date for their redemption, each bond is treated as redeemed on the date that would produce the lowest yield for the issue. The lowest yield on the issue would result from a redemption of all the bonds on January 1, 1999. Thus, the yield on the issue is 5.9126 percent per year compounded semiannually. (c) Computing yield on a variable yield issue-(1) In general. The yield on a variable yield issue is computed separately for each computation period. The yield for each computation period is the discount rate that, when used in computing the present value as of the first day of the computation period of all the payments of principal and interest and fees for qualified guarantees that are attributable to the computation period, produces an amount equal to the present value, using the same discount rate, of the aggregate issue price (or deemed issue price, as determined in paragraph (c)(2)(iv) of this section) of the bonds of the issue as of the first day of the computation period. The yield on a variable yield bond is computed in the same manner as the yield on a variable yield issue. Except as provided in paragraph (c)(2) of this section, yield on any fixed yield bond in a variable yield issue is computed in the same manner as the yield on a fixed yield issue as provided in paragraph (b) of this section. (2) Payments on bonds included in yield for a computation period-(i) Payments in general. The payments on a bond that are attributable to a computation period include any amounts actually paid during the period for principal on the bond. Payments also include any amounts paid during the current period both for interest accruing on the bond during the current period and for interest accruing during the prior period that was included in the deemed issue price of the bond as accrued unpaid interest at the start of the current period under this paragraph (c)(2). Further, payments include any amounts properly allocable to fees for a qualified guarantee of the bond for the period and to any amounts properly allocable to a qualified hedge for the period. (ii) Payments at actual redemption. If a bond is actually redeemed during a computation period, an amount equal to the greater of its value on the redemption date or the actual redemption price is a payment on the actual redemption date. (iii) Payments for bonds outstanding at end of computation period. If a bond is outstanding at the end of a computation period, a payment equal to the bond's value is taken into account on the last day of that period. (iv) Issue price for bonds outstanding at beginning of next computation period. A bond outstanding at the end of a computation period is treated as if it were immediately reissued on the next day for a deemed issue price equal to the value from the day before as determined under paragraph (c)(2)(iii) of this section. (3) Example. The provisions of this paragraph (c) may be illustrated by the following example.

Example. On January 1, 1994, City A issues an issue of identical plain par bonds in an aggregate principal amount of $1,000,000. The bonds pay interest at a variable rate on each June 1 throughout the term of the issue. The entire principal amount of the bonds plus accrued, unpaid interest is payable on the final maturity date of January 1, 2000. No bond year is selected. On June 1, 1994, 1995, 1996, 1997, and 1998, interest in the amounts of $30,000, $55,000, $57,000, $56,000, and $45,000 is paid on the bonds. From June 1, 1998, to January 1, 1999, $30,000 of interest accrues on the bonds. From January 1, 1999, to June 1, 1999, another $35,000 of interest accrues. On June 1, 1999, the issuer actually pays $65,000 of interest. On January 1, 2000, $1,000,000 of principal and $38,000 of accrued interest are paid. The payments for the computation period starting on the issue date and ending on January 1, 1999, include all annual interest payments paid from the issue date to June 1, 1998. Because the issue is outstanding on January 1, 1999, it is treated as redeemed on that date for amount equal to its value ($1,000,000 plus accrued, unpaid interest of $30,000 under paragraph (e)(1) of this section). Thus, $1,030,000 is treated as paid on January 1, 1999. The issue is then treated as reissued on January 1, 1999, for $1,030,000. The payments for the next computation period starting on January 1, 1999, and ending on January 1, 2000, include the interest actually paid on the bonds during that period ($65,000 on June 1, 1999, plus $38,000 paid on January 1, 2000). Because the issue was actually redeemed on January 1, 2000, an amount equal to its stated redemption price is also treated as paid on January 1, 2000. (d) Conversion from variable yield issue to fixed yield issue. As of the first day on which a variable yield issue would qualify as a fixed yield issue if it were newly issued on that date (a conversion date), that issue is treated as if it were reissued as a fixed yield issue on the conversion date. The redemption price of the variable yield issue and the issue price of the fixed yield issue equal the aggregate values of all the bonds on the conversion date. Thus, for example, for plain par bonds (e.g., tender bonds), the deemed issue price would be the outstanding principal amount, plus accrued unpaid interest. If the conversion date occurs on a date other than a computation date, the issuer may continue to treat the issue as a variable yield issue until the next computation date, at which time it must be treated as converted to a fixed yield issue. (e) Value of bonds-(1) Plain par bonds. Except as otherwise provided, the value of a plain par bond is its outstanding stated principal amount, plus accrued unpaid interest. The value of a plain par bond that is actually redeemed or treated as redeemed is its stated redemption price on the redemption date, plus accrued, unpaid interest. (2) Other bonds. The value of a bond other than a plain par bond on a date is its present value on that date. The present value of a bond is computed under the economic accrual method taking into account all the unconditionally payable payments of principal, interest, and fees for a qualified guarantee to be paid on or after that date and using the yield on the bond as the discount rate, except that for purposes of §1.148-6(b)(2) (relating to the universal cap), these values may be determined by consistently using the yield on the issue of which the bonds are a part. To determine yield on fixed yield bonds, see paragraph (b)(1) of this section. The rules contained in paragraphs (b)(2) and (b)(3) of this section apply for this purpose. In the case of bonds described in paragraph (b)(2)(ii) of this section, the present value of those bonds on any date is computed using the yield to the final

maturity date of those bonds as the discount rate. In determining the present value of a variable yield bond under this paragraph (e)(2), the initial interest rate on the bond established by the interest index or other interest rate setting mechanism is used to determine the interest payments on that bond. (f) Qualified guarantees-(1) In general. Fees properly allocable to payments for a qualified guarantee for an issue (as determined under paragraph (f)(6) of this section) are treated as additional interest on that issue under section 148. A guarantee is a qualified guarantee if it satisfies each of the requirements of paragraphs (f)(2) through (f)(4) of this section. (2) Interest savings. As of the date the guarantee is obtained, the issuer must reasonably expect that the present value of the fees for the guarantee will be less than the present value of the expected interest savings on the issue as a result of the guarantee. For this purpose, present value is computed using the yield on the issue, determined with regard to guarantee payments, as the discount rate. (3) Guarantee in substance. The arrangement must create a guarantee in substance. The arrangement must impose a secondary liability that unconditionally shifts substantially all of the credit risk for all or part of the payments, such as payments for principal and interest, redemption prices, or tender prices, on the guaranteed bonds. Reasonable procedural or administrative requirements of the guarantee do not cause the guarantee to be conditional. In the case of a guarantee against failure to remarket a qualified tender bond, commercially reasonable limitations based on credit risk, such as limitations on payment in the event of default by the primary obligor or the bankruptcy of a long-term credit guarantor, do not cause the guarantee to be conditional. The guarantee may be in any form. The guarantor may not be a co-obligor. Thus, the guarantor must not expect to make any payments other than under a direct-pay letter of credit or similar arrangement for which the guarantor will be reimbursed immediately. The guarantor and any related parties together must not use more than 10 percent of the proceeds of the portion of the issue allocable to the guaranteed bonds. (4) Reasonable charge-(i) In general. Fees for a guarantee must not exceed a reasonable, arm's-length charge for the transfer of credit risk. In complying with this requirement, the issuer may not rely on the representations of the guarantor. (ii) Fees for services other than transfer of credit risk must be separately stated. A fee for a guarantee must not include any payment for any direct or indirect services other than the transfer of credit risk, unless the compensation for those other services is separately stated, reasonable, and excluded from the guarantee fee. Fees for the transfer of credit risk include fees for the guarantor's overhead and other costs relating to the transfer of credit risk. For example, a fee includes payment for services other than transfer of credit risk if- (A) It includes payment for the cost of underwriting or remarketing bonds or for the cost of insurance for casualty to bond-financed property; (B) It is refundable upon redemption of the guaranteed bond before the final maturity date and the amount of the refund would exceed the portion of the fee that had not been earned; or

(C) The requirements of §1.148-2(e)(2) (relating to temporary periods for capital projects) are not satisfied, and the guarantor is not reasonably assured that the bonds will be repaid if the project to be financed is not completed. (5) Guarantee of purpose investments. Except for guarantees of qualified mortgage loans and qualified student loans, a guarantee of payments on a purpose investment is a qualified guarantee of the issue if all payments on the purpose investment reasonably coincide with payments on the related bonds and the payments on the purpose investment are unconditionally payable no more than 6 months before the corresponding interest payment and 12 months before the corresponding principal payments on the bonds. This paragraph (f)(5) only applies if, in addition to satisfying the other requirements of this paragraph (f), the guarantee is, in substance, a guarantee of the bonds allocable to that purpose investment and to no other bonds except for bonds that are equally and ratably secured by purpose investments of the same conduit borrower. (6) Allocation of qualified guarantee payments-(i) In general. Payments for a qualified guarantee must be allocated to bonds and to computation periods in a manner that properly reflects the proportionate credit risk for which the guarantor is compensated. Proportionate credit risk for bonds that are not substantially identical may be determined using any reasonable, consistently applied method. For example, this risk may be based on the ratio of the total principal and interest paid and to be paid on a guaranteed bond to the total principal and interest paid and to be paid on all bonds of the guaranteed issue. An allocation method generally is not reasonable, for example, if a substantial portion of the fee is allocated to the construction portion of the issue and a correspondingly insubstantial portion is allocated to the later years covered by the guarantee. Reasonable letter of credit set up fees may be allocated ratably during the initial term of the letter of credit. Upon an early redemption of a variable yield bond, fees otherwise allocable to the period after the redemption are allocated to remaining outstanding bonds of the issue or, if none remain outstanding, to the period before the redemption. (ii) Safe harbor for allocation of qualified guarantee fees for variable yield issues. An allocation of non-level payments for a qualified guarantee for variable yield bonds is treated as meeting the requirements of paragraph (f)(6)(i) of this section if, for each bond year for which the guarantee is in effect, an equal amount (or for any short bond year, a proportionate amount of the equal amount) is treated as paid as of the beginning of that bond year. The present value of the annual amounts must equal the fee for the guarantee allocated to that bond, with present value computed as of the first day the guarantee is in effect by using as the discount rate the yield on the variable yield bonds covered by the guarantee, determined without regard to any fee allocated under this paragraph (f)(6)(ii). (7) Refund or reduction of guarantee payments. If as a result of an investment of proceeds of a refunding issue in a refunding escrow, there will be a reduction in, or refund of, payments for a guarantee (savings), the savings must be treated as a reduction in the payments on the refunding issue. (g) Yield on certain mortgage revenue and student loan bonds. For purposes of section 148 and this section, section 143(g)(2)(C)(ii) applies to the computation of yield on an issue of qualified mortgage bonds or qualified veterans' mortgage bonds. For purposes of applying sections 148 and 143(g) to a variable yield issue of

qualified mortgage bonds or qualified student loan bonds, the yield on that issue is computed over the term of the issue. (h) Qualified hedging transactions-(1) In general. Payments made or received by an issuer under a qualified hedge (as defined in paragraph (h)(2) of this section) relating to bonds of an issue are taken into account (as provided in paragraph (h)(3) of this section) to determine the yield on the issue. Except as provided in paragraph (h)(4) of this section, the issue is treated as a variable yield issue. These hedging rules apply solely for purposes of section 148. (2) Qualified hedge defined. A qualified hedge is a contract that satisfies each of the following requirements: (i) Hedge-(A) In general. The contract is a hedge entered into primarily to reduce the issuer's risk of interest rate changes with respect to a borrowing. For example, the contract may be an interest rate swap, an interest rate cap, a futures contract, a forward contract, or an option. (B) No significant investment element. A contract is not a hedge under paragraph (h)(2)(i)(A) of this section if it contains a significant investment element (i.e., an expected return). For example, variable rate bonds held by the issuer do not meet the requirements of this paragraph (h)(2)(i). A contract may contain a significant investment element if the payments under the contract do not correspond closely in time and amount to the interest payments on the bonds being hedged. For example, an interest rate swap generally contains a significant investment element if it requires any payments other than periodic payments, within the meaning of section 446 and the regulations thereunder (periodic payments) (e.g., an up-front payment for an off-market swap) before its termination date. Similarly, an interest rate cap generally contains a significant investment element if the cap rate is less than the on-market swap rate on the date the cap is entered into. For this purpose, the on-market swap rate is the single fixed rate for which the rate or index that is the subject of the cap could be swapped in an on-market interest rate swap that requires only periodic payments and that has a term equal to the term of the cap. (ii) Parties. The contract is entered into between the issuer or the political subdivision on behalf of which the issuer issues the bonds (collectively referred to in this paragraph (h) as the issuer) and a provider that is not a related party (the hedge provider). (iii) Hedged bonds. The hedge covers all of one or more groups of substantially identical bonds in the issue (i.e., all of the bonds having the same interest rate, maturity, and terms). If the hedge does not cover all interest payments on all of the substantially identical bonds being hedged, it must cover, in whole or in part, the same specific identifiable interest payments on each of the substantially identical bonds. Thus, for example, a qualified hedge may include a hedge of all or a pro rata portion of each interest payment on the variable rate bonds in an issue for the first five years following their issuance. For purposes of this paragraph (h), unless the context clearly requires otherwise, hedged bonds means the specific bonds or portions thereof (i.e., the specific interest payments) covered by a hedge. (iv) Interest based. Changes in the value of the contract are based primarily on interest rate changes. For example, an interest rate swap or a futures contract on

Treasury securities may qualify. A commodity swap or an option on a commodity futures contract, however, is not a qualified hedge. (v) Size. The contract does not hedge an amount larger than the issuer's risk with respect to interest rate changes on the hedged bonds. (vi) Receipts. The payments to the issuer under the contract correspond closely, in both time and amount, to the specific interest payments being hedged on the hedged bonds. (vii) Timing and duration. Payments do not begin to accrue under the contract on a date earlier than the sale date of the hedged bonds and do not accrue longer than the hedged interest payments on the hedged bonds. (viii) Source of payments. Payments to the hedge provider are reasonably expected to be made from the same source of funds that, absent the hedge, would be reasonably expected to be used to pay principal and interest on the hedged bonds. (ix) Identification. The hedge is identified by the actual issuer on its books and records maintained for the hedged bonds on or before the later of the date on which the parties enter into the contract or the issue date of the hedged bonds. The identification specifies the hedge provider, the terms of the hedge, and the hedged bonds. The identification contains sufficient detail to establish that the requirements of this paragraph (h)(2) and, if applicable, paragraph (h)(4) of this section are satisfied. The existence of the hedge is noted on all forms filed with the Internal Revenue Service for the issue after the date on which the hedge is entered into. (3) Accounting for qualified hedges-(i) In general. Except as otherwise provided in paragraph (h)(4) of this section, payments made or received by the issuer under a qualified hedge are treated as payments made or received, as appropriate, on the hedged bonds that are taken into account in determining the yield on those bonds. These payments are reasonably allocated to the hedged bonds in the period to which the payments relate, as determined under paragraph (h)(3)(iii) of this section. Payments made or received by the issuer include payments deemed made or received when a contract is terminated or deemed terminated under this paragraph (h)(3). Payments reasonably allocable to the reduction of risk of interest rate changes and to the hedge provider's overhead under this paragraph (h) are included as payments made or received under a qualified hedge. (ii) Exclusions from hedge. Payments for services or other items under the contract that are not expressly treated as payments under the qualified hedge under paragraph (h)(3)(i) of this section are not payments with respect to a qualified hedge. (iii) Timing and allocation of payments. The period to which a payment made by the issuer relates is determined under general Federal income tax principles, including, without limitation, section 446 and the regulations thereunder on notional principal contracts, and adjusted as necessary to reflect the end of a computation period and the start of a new computation period. Except as provided in paragraph (h)(3)(iv) of this section, a payment received by the issuer is taken into account in the period that the interest payment that the payment hedges is required to be made.

(iv) Termination payments-(A) Termination defined. A termination of a qualified hedge includes any sale, assignment, or other disposition of the hedge by the issuer, or the acquisition by the issuer of an offsetting hedge. A deemed termination occurs when the hedged bonds are redeemed. (B) General rule. A payment made or received by an issuer to terminate a qualified hedge, including gain or loss realized or deemed realized, is treated as a payment made or received on the hedged bonds, as appropriate. The payment is reasonably allocated to the remaining periods originally covered by the terminated hedge in a manner that reflects the economic substance of the hedge. (C) Special rule for terminations when bonds are redeemed. Except as otherwise provided in this paragraph (h)(3)(iv)(C) and in paragraph (h)(3)(iv)(D) of this section, when a qualified hedge is deemed terminated because the hedged bonds are redeemed, the fair market value of the contract on the redemption date is treated as a termination payment made or received on that date. When hedged bonds are redeemed, any payment received by the issuer on termination of a hedge, including a termination payment or a deemed termination payment, reduces, but cannot exceed, the interest payments made by the issuer on the hedged bonds in the computation period ending on the termination date. The excess, if any, is reasonably allocated over the bond years in the immediately preceding computation period or periods to the extent necessary to eliminate the excess. (D) Special rules for refundings. To the extent that the hedged bonds are redeemed using the proceeds of a refunding issue, the termination payment is accounted for under paragraph (h)(3)(iv)(B) by treating it as a payment on the refunding issue, rather than the hedged bonds. In addition, to the extent that the refunding issue, rather than the hedged bonds, has been redeemed, paragraph (h)(3)(iv)(C) applies to the termination payment by treating it as a payment on the redeemed refunding issue. (4) Certain variable yield issues treated as fixed yield issues-(i) In general. Except as otherwise provided in paragraph (h)(4)(ii)(C) of this section, if the issuer of a variable yield issue enters into an interest rate swap that is a qualified hedge, the hedged bonds are treated as fixed yield bonds if- (A) Start date. The date on which payments begin to accrue on the swap is not later than 15 days after the issue date of the hedged bonds; (B) Maturity. The term of the swap is equal to the term of the hedged bonds or the entire period during which the hedged bonds bear interest at variable interest rates. (C) No nonperiodic payments. Payments to be made or received under the swap are reasonably expected to correspond closely, in time and amount, to payments on the hedged bonds (i.e., no nonperiodic payments). Swap payments made within 15 days of the related payments on the hedged bonds generally so correspond. (D) Notional principal amount. The notional principal amount used to compute both fixed and variable payments on the swap equals the principal amount of all the variable yield bonds in the issue.

(E) Payments and interest rate. Under the swap, the issuer makes level payments based on a fixed interest rate and receives payments based on a variable interest rate that is substantially the same as the interest rate on the hedged bonds. These interest rates are treated as substantially the same if they are reasonably expected to be substantially the same throughout the term of the hedge. For example, an objective 30-day tax-exempt variable rate index or other objective index (e.g., LIBOR, J.J. Kenney Index, PSA Municipal swap index) may be adjusted to correspond to an issuer's individual 30-day interest rate. (ii) Accounting-(A) In general. If a hedged bond is treated as a fixed yield bond under this paragraph (h)(4), the fixed-rate payments made by the issuer on the swap are substituted for the actual interest payments on the hedged bonds for purposes of computing yield on that bond. For this purpose, the fixed-rate payments are the amounts determined by multiplying the notional principal amount by the fixed rate (i.e., the amount determined before netting the fixed and variable amounts due under the swap). (B) Effect of termination generally. Except as otherwise provided in paragraph (h)(4)(ii)(C) of this section, for purposes of §1.148-3, as of the termination date of a qualified hedge covered by this paragraph (h)(4), the issue of which the hedged bonds are a part is treated as if it were reissued on the termination date. The redemption price of the retired issue and the issue price of the new issue equal the aggregate values of all the bonds of the issue on the termination date. In computing the yield on the new issue, any termination payment is accounted for under paragraph (h)(3)(iv) of this section, applied by treating the termination payment as made or received on the deemed new issue under this paragraph (h)(4)(ii)(B). (C) Effect of early termination. If the swap is terminated or deemed terminated within 5 years after the issue date of the issue of which the hedged bonds are a part, the general rules under this paragraph (h)(4) do not apply, and, for purposes of §1.148-3, the hedged bonds are treated as variable yield bonds from the issue date. (5) Authority of the Commissioner-(i) In general. A contract is not a qualified hedge if the Commissioner determines, based on all the facts and circumstances, that treating the contract as a qualified hedge would provide a material potential for arbitrage, or a principal purpose for entering into the contract is that arbitrage potential. For example, a contract that requires a substantial nonperiodic payment may constitute, in whole or part, an embedded loan, investment-type property, or other investment. (ii) Other qualified hedges. The Commissioner, by publication of a revenue ruling or revenue procedure, may specify contracts that do not otherwise meet the requirements of paragraph (h)(2) of this section as qualified hedges. (iii) Recomputation of yield. If an issuer enters into a hedge that is not properly identified or otherwise fails to meet the requirements of this section, the Commissioner may recompute the yield on the issue taking the hedge into account if the failure to take the hedge into account distorts that yield or otherwise fails to clearly reflect the economic substance of the transaction.

§1.148-5 Yield and valuation of investments.

(a) In general. This section provides rules for computing the yield and value of investments allocated to an issue for various purposes under section 148. (b) Yield on an investment-(1) In general. Except as otherwise provided, the yield on an investment allocated to an issue is computed under the economic accrual method, using the same compounding interval and financial conventions used to compute the yield on the issue. The yield on an investment allocated to an issue is the discount rate that, when used in computing the present value as of the date the investment is first allocated to the issue of all unconditionally payable receipts from the investment, produces an amount equal to the present value of all unconditionally payable payments for the investment. For this purpose, payments means amounts to be actually or constructively paid to acquire the investment, and receipts means amounts to be actually or constructively received from the investment, such as earnings and return of principal. The yield on a variable rate investment is determined in a manner comparable to the determination of the yield on a variable rate issue. For an issue of qualified mortgage bonds, qualified veterans' mortgage bonds, or qualified student loan bonds on which interest is paid semiannually, all regular monthly loan payments to be received during a semiannual debt service period may be treated as received at the end of that period. In addition, for any conduit financing issue, payments made by the conduit borrower are not treated as paid until the conduit borrower ceases to receive the benefit of earnings on those amounts. (2) Yield on a separate class of investments-(i) In general. For purposes of the yield restriction rules of section 148(a) and §1.148-2, yield is computed separately for each class of investments. For this purpose, in determining the yield on a separate class of investments, the yield on each individual investment within the class is blended with the yield on other individual investments within the class, whether or not held concurrently, by treating those investments as a single investment. The yields on investments that are not within the same class are not blended. (ii) Separate classes of investments. Each of the following is a separate class of investments- (A) Each category of yield restricted purpose investment and program investment that is subject to a different definition of materially higher under §1.148-2(d)(2); (B) Yield-restricted nonpurpose investments; and (C) All other nonpurpose investments; (iii) Permissive application of single investment rules to certain yield restricted investments for all purposes of section 148. Excluding those investments to which paragraph (b)(2)(iv) of this section applies, all yield restricted investments that are part of the same class may be treated as a single investment having a single yield, determined under this paragraph (b)(2), for all purposes of section 148. (iv) Mandatory application of single investment rules for refunding escrows for all purposes of section 148. For all purposes of section 148, in computing the yield on yield restricted investments allocable to proceeds (i.e., sale proceeds, investment proceeds, and transferred proceeds) of a refunding issue that are held in one or more refunding escrows, the individual investments are treated as a single

investment having a single yield, whether or not held concurrently. For example, this single investment includes both the individual investments allocable to sale and investment proceeds of a refunding issue that are held in one refunding escrow for a prior issue and the investments allocable to transferred proceeds of that refunding issue that are held in another refunding escrow. (3) Investments to be held beyond issue's maturity or beyond temporary period. In computing the yield on investments allocable to an issue that are to be held beyond the reasonably expected redemption date of the issue, those investments are treated as sold for an amount equal to their value on that date. In computing the yield on investments that are held beyond an applicable temporary period under §1.148-2, for purposes of §1.148-2 those investments may be treated as purchased for an amount equal to their fair market value as of the end of the temporary period. (4) Consistent redemption assumptions on purpose investments. The yield on purpose investments allocable to an issue is computed using the same redemption assumptions used to compute the yield on the issue. Yield on purpose investments allocable to an issue of qualified mortgage bonds and qualified veterans' mortgage bonds must be determined in a manner that is consistent with, and using the assumptions required by, section 143(g)(2)(B). (5) Student loan special allowance payments included in yield. Except as provided in §1.148-11(e), the yield on qualified student loans is computed by including as receipts any special allowance payments made by the Secretary of Education pursuant to section 438 of the Higher Education Act of 1965. (c) Yield reduction payments to the United States-(1) In general. In determining the yield on an investment to which this paragraph (c) applies, any amount paid to the United States in accordance with this paragraph (c), including a rebate amount, is treated as a payment for that investment that reduces the yield on that investment. (2) Manner of payment-(i) In general. Except as otherwise provided in paragraph (c)(2)(ii) of this section, an amount is paid under this paragraph (c) if it is paid to the United States at the same time and in the same manner as rebate amounts are required to be paid or at such other time or in such manner as the Commissioner may prescribe. The provisions of §1.148-3(i) apply to payments made under this paragraph (c). (ii) Special rule for purpose investments. For purpose investments allocable to an issue- (A) No amounts are required to be paid to satisfy this paragraph (c) until the earlier of the end of the tenth bond year after the issue date of the issue or 60 days after the date on which the issue is no longer outstanding; and (B) For payments made prior to the date on which the issue is retired, the issuer need not pay more than 75 percent of the amount otherwise required to be paid as of the date to which the payment relates. (3) Applicability of special yield reduction rule-(i) Covered investments. This paragraph (c) applies to-

(A) Nonpurpose investments allocable to proceeds of an issue that qualified for one of the temporary periods available for capital projects, restricted working capital expenditures, pooled financings, or investment proceeds under paragraphs §1.148-2 (e)(2), (e)(3), (e)(4), or (e)(6) of this section, respectively; (B) Investments allocable to a variable yield issue during any computation period in which at least 5 percent of the value of the issue is represented by variable yield bonds, unless the issue is an issue of hedge bonds (as defined in section 149(g)(3)(A)); (C) Nonpurpose investments allocable to transferred proceeds of- (1) A current refunding issue to the extent necessary to reduce the yield on those investments to satisfy yield restrictions under section 148(a); or (2) An advance refunding issue to the extent that investment of the refunding escrows allocable to the proceeds, other than transferred proceeds, of the refunding issue in zero-yielding nonpurpose investments is insufficient to satisfy yield restrictions under section 148(a); (D) Purpose investments allocable to qualified student loans under a program described in section 144(b)(1)(A); (E) Nonpurpose investments allocable to gross proceeds of an issue in a fund that, except for its failure to satisfy the size limitation in §1.148-2(f)(2)(ii), would qualify as a reasonably required reserve or replacement fund, but only to the extent that- (1) The value of the nonpurpose investments in the fund is not greater than 15 percent of the stated principal amount of the issue, as computed under §1.148- 2(f)(2)(ii), or (2) The amounts in the fund (other than investment earnings) are not reasonably expected to be used to pay debt service on the issue (e.g., a reserve fund for a revolving fund loan program); (F) Nonpurpose investments allocated to replacement proceeds of a refunded issue as a result of the application of the universal cap to amounts in a refunding escrow (see §1.148-11(c)(1)(ii)); and (G) Investments described in §1.148-11(f). (ii) Exception to yield reduction payments rule for advance refunding issues. Paragraph (c)(1) of this section does not apply to investments allocable to gross proceeds of an advance refunding issue, other than transferred proceeds to which paragraph (c)(3)(i)(C) of this section applies and replacement proceeds to which paragraph (c)(3)(i)(F) of this section applies. (d) Value of investments-(1) In general. Except as otherwise provided, the value of an investment (including a payment or receipt on the investment) on a date must be determined using one of the following valuation methods consistently for all purposes of section 148 to that investment on that date:

(i) Plain par investment-outstanding principal amount. A plain par investment may be valued at its outstanding stated principal amount, plus any accrued unpaid interest on that date. (ii) Fixed rate investment-present value. A fixed rate investment may be valued at its present value on that date. (iii) Any investment-fair market value. An investment may be valued at its fair market value on that date. (2) Mandatory valuation of yield restricted investments at present value. Any yield restricted investment must be valued at present value. For example, a purpose investment or an investment allocable to gross proceeds in a refunding escrow after the expiration of the initial temporary period must be valued at present value. See, however, paragraph (b)(3) of this section. (3) Mandatory valuation of certain investments at fair market value-(i) In general. Except as provided in paragraphs (d)(2), (d)(3)(ii), and (d)(4) of this section, an investment must be valued at fair market value on the date that it is first allocated to an issue or first ceases to be allocated to an issue as a consequence of a deemed acquisition or deemed disposition. For example, if an issuer deposits existing investments into a sinking fund for an issue, those investments must be valued at fair market value as of the date first deposited into the fund. (ii) Exception to fair market value requirement for transferred proceeds allocations, universal cap allocations, and commingled funds. This paragraph (d)(3) does not apply if the investment is allocated to an issue or ceases to be allocated to an issue as a result of the transferred proceeds allocation rule under §1.148-9(b) or the universal cap rule under §1.148-6(b)(2). In addition, this paragraph (d)(3) does not apply to investments in a commingled fund (other than a bona fide debt service fund) unless it is a commingled fund described in §1.148-6(e)(5)(iii). (4) Special transition rule for transferred proceeds. The value of a nonpurpose investment that is allocated to transferred proceeds of a refunding issue on a transfer date may not exceed the value of that investment on the transfer date used for purposes of applying the arbitrage restrictions to the refunded issue. (5) Definition of present value of an investment. Except as otherwise provided, present value of an investment is computed under the economic accrual method, using the same compounding interval and financial conventions used to compute the yield on the issue. The present value of an investment on a date is equal to the present value of all unconditionally payable receipts to be received from and payments to be paid for the investment after that date, using the yield on the investment as the discount rate. (6) Definition of fair market value-(i) In general. The fair market value of an investment is the price at which a willing buyer would purchase the investment from a willing seller in a bona fide, arm's-length transaction. Fair market value generally is determined on the date on which a contract to purchase or sell the nonpurpose investment becomes binding (i.e., the trade date rather than the settlement date). Except as otherwise provided in this paragraph (d)(6), an investment that is not of a type traded on an established securities market, within the meaning of section 1273,

is rebuttably presumed to be acquired or disposed of for a price that is not equal to its fair market value. The fair market value of a United States Treasury obligation that is purchased directly from the United States Treasury is its purchase price. (ii) Safe harbor for establishing fair market value for certificates of deposit. This paragraph (d)(6)(ii) applies to a certificate of deposit that has a fixed interest rate, a fixed payment schedule, and a substantial penalty for early withdrawal. The purchase price of such a certificate of deposit is treated as its fair market value on the purchase date if the yield on the certificate of deposit is not less than- (A) The yield on reasonably comparable direct obligations of the United States; and (B) The highest yield that is published or posted by the provider to be currently available from the provider on reasonably comparable certificates of deposit offered to the public. (iii) Safe harbor for establishing fair market value for guaranteed investment contracts. The purchase price of a guaranteed investment contract is treated as its fair market value on the purchase date if- (A) The issuer makes a bona fide solicitation for a specified guaranteed investment contract and receives at least three bona fide bids from providers that have no material financial interest in the issue (e.g., as underwriters or brokers); (B) The issuer purchases the highest-yielding guaranteed investment contract for which a qualifying bid is made (determined net of broker's fees); (C) The yield on the guaranteed ni vestment contract (determined net of broker's fees) is not less than the yield then available from the provider on reasonably comparable guaranteed investment contracts, if any, offered to other persons from a source of funds other than gross proceeds of tax-exempt bonds; (D) The determination of the terms of the guaranteed investment contract takes into account as a significant factor the issuer's reasonably expected drawdown schedule for the amounts to be invested, exclusive of amounts deposited in debt service funds and reasonably required reserve or replacement funds; (E) The terms of the guaranteed investment contract, including collateral security requirements, are reasonable; and (F) The obligor on the guaranteed investment contract certifies the administrative costs that it is paying (or expects to pay) to third parties in connection with the guaranteed investment contract. (e) Administrative costs of investments-(1) In general. Except as otherwise provided in this paragraph (e), an allocation of gross proceeds of an issue to a payment or a receipt on an investment is not adjusted to take into account any costs or expenses paid, directly or indirectly, to purchase, carry, sell, or retire the investment (administrative costs). Thus, these administrative costs generally do not increase the payments for, or reduce the receipts from, investments.

(2) Qualified administrative costs on nonpurpose investments-(i) In general. In determining payments and receipts on nonpurpose investments, qualified administrative costs are taken into account. Thus, qualified administrative costs increase the payments for, or decrease the receipts from, the investments. Qualified administrative costs are reasonable, direct administrative costs, other than carrying costs, such as separately stated brokerage or selling commissions, but not legal and accounting fees, recordkeeping, custody, and similar costs. General overhead costs and similar indirect costs of the issuer such as employee salaries and office expenses and costs associated with computing the rebate amount under section 148(f) are not qualified administrative costs. In general, administrative costs are not reasonable unless they are comparable to administrative costs that would be charged for the same investment or a reasonably comparable investment if acquired with a source of funds other than gross proceeds of tax-exempt bonds. (ii) Special rule for administrative costs of nonpurpose investments in certain regulated investment companies and commingled funds. Qualified administrative costs include all reasonable administrative costs, without regard to the limitation on indirect costs under paragraph (e)(2)(i) of this section, incurred by: (A) Regulated investment companies. A publicly offered regulated investment company (as defined in section 67(c)(2)(B)); and (B) External commingled funds. A commingled fund in which the issuer and any related parties do not own more than 10 percent of the beneficial interest in the fund. (iii) Special rule for guaranteed investment contracts. For a guaranteed investment contract, a broker's commission paid on behalf of either an issuer or the provider is not a qualified administrative cost to the extent that the commission exceeds 0.05 percent of the amount reasonably expected to be invested per year. This paragraph (e)(2)(iii) does not apply to an issue that satisfies section 148(f)(4)(D)(i). (3) Qualified administrative costs on purpose investments-(i) In general. In determining payments and receipts on purpose investments, qualified administrative costs described in this paragraph (e)(3) paid by the conduit borrower are taken into account. Thus, these costs increase the payments for, or decrease the receipts from, the purpose investments. This rule applies even if those payments merely reimburse the issuer. Although the actual payments by the conduit borrower may be made at any time, for this purpose, a pro rata portion of each payment made by a conduit borrower is treated as a reimbursement of reasonable administrative costs, if the present value of those payments does not exceed the present value of the reasonable administrative costs paid by the issuer, using the yield on the issue as the discount rate. (ii) Definition of qualified administrative costs of purpose investments-(A) In general. Except as otherwise provided in this paragraph (e)(3)(ii), qualified administrative costs of a purpose investment means- (1) Costs or expenses paid, directly or indirectly, to purchase, carry, sell, or retire the investment; and (2) Costs of issuing, carrying, or repaying the issue, and any underwriters' discount.

(B) Limitation on program investments. For a program investment, qualified administrative costs include only those costs described in paragraph (e)(3)(ii)(A)(2) of this section.

§1.148-6 General allocation and accounting rules.

(a) In general-(1) Reasonable accounting methods required. An issuer may use any reasonable, consistently applied accounting method to account for gross proceeds, investments, and expenditures of an issue. (2) Bona fide deviations from accounting method. An accounting method does not fail to be reasonable and consistently applied solely because a different accounting method is used for a bona fide governmental purpose to consistently account for a particular item. Bona fide governmental purposes may include special State law restrictions imposed on specific funds or actions to avoid grant forfeitures. (b) Allocation of gross proceeds to an issue-(1) One-issue rule and general ordering rules. Except as otherwise provided, amounts are allocable to only one issue at a time as gross proceeds, and if amounts simultaneously are proceeds of one issue and replacement proceeds of another issue, those amounts are allocable to the issue of which they are proceeds. Amounts cease to be allocated to an issue as proceeds only when those amounts are allocated to an expenditure for a governmental purpose, are allocated to transferred proceeds of another issue, or cease to be allocated to that issue at retirement of the issue or under the universal cap of paragraph (b)(2) of this section. Amounts cease to be allocated to an issue as replacement proceeds only when those amounts are allocated to an expenditure for a governmental purpose, are no longer used in a manner that causes those amounts to be replacement proceeds of that issue, or cease to be allocated to that issue because of the retirement of the issue or the application of the universal cap under paragraph (b)(2) of this section. Amounts that cease to be allocated to an issue as gross proceeds are eligible for allocation to another issue. Under §1.148-10(a), however, the rules in this paragraph (b)(1) do not apply in certain cases involving abusive arbitrage devices. (2) Universal cap on value of nonpurpose investments allocated to an issue-(i) Application. The rules in this paragraph (b)(2) provide an overall limitation on the amount of gross proceeds allocable to an issue. Although the universal cap generally may be applied at any time in the manner described in this paragraph (b)(2), it need not be applied on any otherwise required date of application if its application on that date would not result in a reduction or reallocation of gross proceeds of an issue. For this purpose, if an issuer reasonably expects as of the issue date that the universal cap will not reduce the amount of gross proceeds allocable to the issue during the term of the issue, the universal cap need not be applied on any date on which an issue actually has all of the following characteristics- (A) No replacement proceeds are allocable to the issue, other than replacement proceeds in a bona fide debt service fund or a reasonably required reserve or replacement fund; (B) The net sale proceeds of the issue-

(1) Qualified for one of the temporary periods available for capital projects, restricted working capital expenditures, or pooled financings under paragraphs §1.148-2 (e)(2), (e)(3), or (e)(4), and those net sales proceeds were in fact allocated to expenditures prior to the expiration of the longest applicable temporary period; or (2) were deposited in a refunding escrow and expended as originally expected; (C) The issue does not refund a prior issue that, on any transfer date, has unspent proceeds allocable to it; (D) None of the bonds are retired prior to the date on which those bonds are treated as retired in computing the yield on the issue; and (E) No proceeds of the issue are invested in qualified student loans or qualified mortgage loans. (ii) General rule. Except as otherwise provided below, amounts that would otherwise be gross proceeds allocable to an issue are allocated (and remain allocated) to the issue only to the extent that the value of the nonpurpose investments allocable to those gross proceeds does not exceed the value of all outstanding bonds of the issue. For this purpose, gross proceeds allocable to cash, tax-exempt bonds that would be nonpurpose investments (absent section 148(b)(3)(A)), qualified student loans, and qualified mortgage loans are treated as nonpurpose investments. The values of bonds and investments are determined under §1.148-4(e) and §1.148- 5(d), respectively. The value of all outstanding bonds of the issue is referred to as the universal cap. Thus, for example, the universal cap for an issue of plain par bonds is equal to the outstanding stated principal amount of those bonds plus accrued interest. (iii) Determination and application of the universal cap. Except as otherwise provided, beginning with the first bond year that commences after the second anniversary of the issue date, the amount of the universal cap and the value of the nonpurpose investments must be determined as of the first day of each bond year. For refunding and refunded issues, the cap and values must be determined as of each date that, but for this paragraph (b)(2), proceeds of the refunded issue would become transferred proceeds of the refunding issue, and need not otherwise be determined in the bond year in which that date occurs. All values are determined as of the close of business on each determination date, after giving effect to all payments on bonds and payments for and receipts on investments on that date. (iv) General ordering rule for allocations of amounts in excess of the universal cap- (A) In general. If the value of all nonpurpose investments allocated to the gross proceeds of an issue exceeds the universal cap for that issue on a date as of which the cap is determined under paragraph (b)(2)(iii) of this section, nonpurpose investments allocable to gross proceeds necessary to eliminate that excess cease to be allocated to the issue, in the following order of priority- (1) First, nonpurpose investments allocable to replacement proceeds; (2) Second, nonpurpose investments allocable to transferred proceeds; and

(3) Third, nonpurpose investments allocable to sale proceeds and investment proceeds. (B) Re-allocation of certain amounts. Except as provided in §1.148-9(b)(3), amounts that cease to be allocated to an issue as a result of the application of the universal cap may only be allocated to another issue as replacement proceeds. (C) Allocations of portions of investments. Portions of investments to which this paragraph (b)(2)(iv) applies are allocated under either the ratable method or the representative method in the same manner as allocations of portions of investments to transferred proceeds under §1.148-9(c). (v) Nonpurpose investments in a bona fide debt service fund not counted. For purposes of this paragraph (b)(2), nonpurpose investments allocated to gross proceeds in a bona fide debt service fund for an issue are not taken into account in determining the value of the nonpurpose investments, and those nonpurpose investments remain allocated to the issue. (c) Fair market value limit on allocations to nonpurpose investments. Upon a purchase or sale of a nonpurpose investment, gross proceeds of an issue are not allocated to a payment for that nonpurpose investment in an amount greater than, or to a receipt from that nonpurpose investment in an amount less than, the fair market value of the nonpurpose investment as of the purchase or sale date. For purposes of this paragraph (c) only, the fair market value of a nonpurpose investment is adjusted to take into account qualified administrative costs allocable to the investment. (d) Allocation of gross proceeds to expenditures-(1) Expenditures in general-(i) General rule. Reasonable accounting methods for allocating funds from different sources to expenditures for the same governmental purpose include any of the following methods if consistently applied: a specific tracing method; a gross proceeds spent first method; a first-in, first-out method; or a ratable allocation method. (ii) General limitation. An allocation of gross proceeds of an issue to an expenditure must involve a current outlay of cash for a governmental purpose of the issue. A current outlay of cash means an outlay reasonably expected to occur not later than 5 banking days after the date as of which the allocation of gross proceeds to the expenditure is made. (2) Treatment of gross proceeds invested in purpose investments-(i) In general. Gross proceeds of an issue invested in a purpose investment are allocated to an expenditure on the date on which the conduit borrower under the purpose investment allocates the gross proceeds to an expenditure in accordance with this paragraph (d). (ii) Exception for qualified mortgage loans and qualified student loans. If gross proceeds of an issue are allocated to a purpose investment that is a qualified mortgage loan or a qualified student loan, those gross proceeds are allocated to an expenditure for the governmental purpose of the issue on the date on which the issuer allocates gross proceeds to that purpose investment.

(iii) Continuing allocation of gross proceeds to purpose investments. Regardless of whether gross proceeds of a conduit financing issue invested in a purpose investment have been allocated to an expenditure under paragraph (d)(2) (i) or (ii) of this section, with respect to the actual issuer those gross proceeds continue to be allocated to the purpose investment until the sale, discharge, or other disposition of the purpose investment. (3) Expenditures for working capital purposes-(i) In general. Except as otherwise provided in this paragraph (d)(3) or paragraph (d)(4) of this section, proceeds of an issue may only be allocated to working capital expenditures as of any date to the extent that those working capital expenditures exceed available amounts (as defined in paragraph (d)(3)(iii) of this section) as of that date (i.e., a "proceeds-spent-last" method). For this purpose, proceeds include replacement proceeds described in §1.148-1(c)(4). (ii) Exceptions-(A) General de minimis exception. Paragraph (d)(3)(i) of this section does not apply to expenditures to pay- (1) Any qualified administrative costs within the meaning of §§1.148-5(e)(2) (i) or (ii), or §1.148-5(e)(3)(ii)(A); (2) Fees for qualified guarantees of the issue or payments for a qualified hedge for the issue; (3) Interest on the issue for a period commencing on the issue date and ending on the date that is the later of three years from the issue date or one year after the date on which the project is placed in service; (4) Amounts paid to the United States under sections 1.148-3, 1.148-5(c), or 1.148- 7 for the issue; (5) Costs, other than those described in paragraphs (d)(3)(ii)(A) (1) through (4) of this section, that do not exceed 5 percent of the sale proceeds of an issue and that are directly related to capital expenditures financed by the issue (e.g., initial operating expenses for a new capital project); (6) Principal or interest on an issue paid from unexpected excess sale or investment proceeds; and (7) Principal or interest on an issue paid from investment earnings on a reserve or replacement fund that are deposited in a bona fide debt service fund. (B) Exception for extraordinary items. Paragraph (d)(3)(i) of this section does not apply to expenditures for extraordinary, nonrecurring items that are not customarily payable from current revenues, such as casualty losses or extraordinary legal judgments in amounts in excess of reasonable insurance coverage. If, however, an issuer or a related party maintains a reserve for such items (e.g., a self-insurance fund) or has set aside other available amounts for such expenses, gross proceeds within that reserve must be allocated to expenditures only after all other available amounts in that reserve are expended.

(C) Exception for payment of principal and interest on prior issues. Paragraph (d)(3)(i) of this section does not apply to expenditures for payment of principal, interest, or redemption prices on a prior issue and, for a crossover refunding issue, interest on that issue. (D) No exceptions if replacement proceeds created. The exceptions provided in this paragraph (d)(3)(ii) do not apply if the allocation merely substitutes gross proceeds for other amounts that would have been used to make those expenditures in a manner that gives rise to replacement proceeds. For example, if a purported reimbursement allocation of proceeds of a reimbursement bond does not result in an expenditure under §1.150-2, those proceeds may not be allocated to pay interest on an issue that, absent this allocation, would have been paid from the issuer's current revenues. (iii) Definition of available amount-(A) In general. For purposes of this paragraph (d)(3), available amount means any amount that is available to an issuer for working capital expenditure purposes of the type financed by an issue. Except as otherwise provided, available amount excludes proceeds of the issue but includes cash, investments, and other amounts held in accounts or otherwise by the issuer or a related party if those amounts may be used by the issuer for working capital expenditures of the type being financed by an issue without legislative or judicial action and without a legislative, judicial, or contractual requirement that those amounts be reimbursed. (B) Reasonable working capital reserve treated as unavailable. A reasonable working capital reserve is treated as unavailable. Any working capital reserve is reasonable if it does not exceed 5 percent of the actual working capital expenditures of the issuer in the fiscal year before the year in which the determination of available amounts is made. For this purpose only, in determining the working capital expenditures of an issuer for a prior fiscal year, any expenditures (whether capital or working capital expenditures) that are paid out of current revenues may be treated as working capital expenditures. (C) Qualified endowment funds treated as unavailable. For a 501(c)(3) organization that is a hospital, university, or similar institution, a qualified endowment fund is treated as unavailable. A fund is a qualified endowment fund if- (1) The fund is derived from gifts or bequests, or the income thereon, that were neither made nor reasonably expected to be used to pay working capital expenditures; (2) Pursuant to reasonable, established practices of the organization, the governing body of the 501(c)(3) organization designates and consistently operates the fund as a permanent endowment fund or quasi-endowment fund restricted as to use; and (3) There is an independent verification (e.g., from an independent certified public accountant) that the fund is reasonably necessary as part of the organization's permanent capital. (D) Application to statutory safe harbor for tax and revenue anticipation bonds. For purposes of section 148(f)(4)(B)(iii)(II), available amount has the same meaning as

in paragraph (d)(3)(iii) of this section, except that the otherwise-permitted reasonable working capital reserve is treated as part of the available amount. (4) Expenditures for grants-(i) In general. Gross proceeds of an issue that are used to make a grant are allocated to an expenditure on the date on which the grant is made. (ii) Characterization of repayments of grants. If any amount of a grant financed by gross proceeds of an issue is repaid to the grantor, the repaid amount is treated as unspent proceeds of the issue as of the repayment date unless expended within 60 days of repayment. (iii) Definition of grant. Grant means a transfer for a governmental purpose of money or property to a transferee that is not a related party to or an agent of the transferor. The transfer must not impose any obligation or condition to directly or indirectly repay any amount to the transferor. Obligations or conditions intended solely to assure expenditure of the transferred moneys in accordance with the governmental purpose of the transfer do not prevent a transfer from being a grant. (5) Expenditures for reimbursement purposes. In allocating gross proceeds of issues of reimbursement bonds (as defined in §1.150-2)) to certain expenditures, §1.150-2 applies. In allocating gross proceeds to an expenditure to reimburse a previously paid working capital expenditure, paragraph (d)(3) of this section applies. Thus, if the expenditure is described in paragraph (d)(3)(ii) of this section or there are no available amounts on the date a working capital expenditure is made and there are no other available amounts on the date of the reimbursement of that expenditure, gross proceeds are allocated to the working capital expenditure as of the date of the reimbursement. (6) Expenditures of certain commingled investment proceeds of governmental issues. This paragraph (d)(6) applies to any issue of governmental bonds, any issue of private activity bonds issued to finance a facility that is required by section 142 to be owned by a governmental unit, and any portion of an issue that is not treated as consisting of private activity bonds under section 141(b)(9). Investment proceeds of the issue (other than investment proceeds held in a refunding escrow) are treated as allocated to expenditures for a governmental purpose when the amounts are deposited in a commingled fund with substantial tax or other revenues from governmental operations of the issuer and the amounts are reasonably expected to be spent for governmental purposes within 6 months from the date of the commingling. In establishing these reasonable expectations, an issuer may use any reasonable accounting assumption and is not bound by the proceeds-spent-last assumption generally required for working capital expenditures under paragraph (d)(3) of this section. (7) Payments to related parties. Any payment of gross proceeds of the issue to a related party of the payor is not an expenditure of those gross proceeds. (e) Special rules for commingled funds-(1) In general. An accounting method for gross proceeds of an issue in a commingled fund, other than a bona fide debt service fund, is reasonable only if it satisfies the requirements of paragraphs (e)(2) through (6) of this section in addition to the other requirements of this section.

(2) Investments held by a commingled fund-(i) Required ratable allocations. Not less frequently than as of the close of each fiscal period, all payments and receipts (including deemed payments and receipts) on investments held by a commingled fund must be allocated (but not necessarily distributed) among the different investors in the fund. This allocation must be based on a consistently applied, reasonable ratable allocation method. (ii) Safe harbors for ratable allocation methods. Reasonable ratable allocation methods include, without limitation, methods that allocate these items in proportion to either- (A) The average daily balances of the amounts in the commingled fund from different investors during a fiscal period (as described in paragraph (e)(4) of this section); or (B) The average of the beginning and ending balances of the amounts in the commingled fund from different investors for a fiscal period that does not exceed one month. (iii) Definition of investor. For purposes of this paragraph (e), the term investor means each different source of funds invested in a commingled fund. For example, if a city invests gross proceeds of an issue and tax revenues in a commingled fund, it is treated as two different investors. (3) Certain expenditures involving a commingled fund. If a ratable allocation method is used under paragraph (d) of this section to allocate expenditures from the commingled fund, the same ratable allocation method must be used to allocate payments and receipts on investments in the commingled fund under paragraph (e)(2) of this section. (4) Fiscal periods. The fiscal year of a commingled fund is the calendar year unless the fund adopts another fiscal year. A commingled fund may use any consistent fiscal period that does not exceed three months (e.g., a daily, weekly, monthly, or quarterly fiscal period). (5) Unrealized gains and losses on investments of a commingled fund-(i) Mark-to-market requirement for internal commingled funds with longer-term investment portfolios. Except as otherwise provided in this paragraph (e), in the case of a commingled fund in which the issuer and any related party own more than 25 percent of the beneficial interests in the fund (an internal commingled fund), the fund must treat all its investments as if sold at fair market value either on the last day of the fiscal year or the last day of each fiscal period. The net gains or losses from these deemed sales of investments must be allocated to all investors of the commingled fund during the period since the last allocation. (ii) Exception for internal commingled funds with shorter-term investment portfolios. If the remaining weighted average maturity of all investments held by a commingled fund during a particular fiscal year does not exceed 18 months, and the investments held by the commingled fund during that fiscal year consist exclusively of obligations, the mark-to-market requirement of paragraph (e)(5)(i) of this section does not apply.

(iii) Exception for commingled reserve funds and sinking funds. The mark-to-market requirement of paragraph (e)(5)(i) of this section does not apply to a commingled fund that operates exclusively as a reserve fund, sinking fund, or replacement fund for two or more issues of the same issuer. (6) Allocations of commingled funds serving as common reserve funds or sinking funds-(i) Permitted ratable allocation methods. If a commingled fund serves as a common reserve fund, replacement fund, or sinking fund for two or more issues (a commingled reserve), after making reasonable adjustments to account for proceeds allocated under paragraph (b)(1) or (b)(2) of this section, investments held by that commingled fund must be allocated ratably among the issues served by the commingled fund in accordance with one of the following methods- (A) The relative values of the bonds of those issues under §1.148-4(e); (B) The relative amounts of the remaining maximum annual debt service requirements on the outstanding principal amounts of those issues; or (C) The relative original stated principal amounts of the outstanding issues. (ii) Frequency of allocations. An issuer must make any allocations required by this paragraph (e)(6) as of a date at least every 3 years and as of each date that an issue first becomes secured by the commingled reserve. If relative original principal amounts are used to allocate, allocations must also be made on the retirement of any issue secured by the commingled reserve.

§1.148-7 Spending exceptions to the rebate requirement.

(a) Scope of section-(1) In general. This section provides guidance on the spending exceptions to the arbitrage rebate requirement of section 148(f)(2). These exceptions are the 6-month exception in section 148(f)(4)(B) (the 6-month exception), the 18-month exception under paragraph (d) of this section (the 18-month exception), and the 2-year construction exception under section 148(f)(4)(C) (the 2-year exception) (collectively, the spending exceptions). (2) Relationship of spending exceptions. Each of the spending exceptions is an independent exception to arbitrage rebate. For example, a construction issue may qualify for the 6-month exception or the 18-month exception even though the issuer makes one or more elections under the 2-year exception with respect to the issue. (3) Spending exceptions not mandatory. Use of the spending exceptions is not mandatory. An issuer may apply the arbitrage rebate requirement to an issue that otherwise satisfies a spending exception. If an issuer elects to pay penalty in lieu of rebate under the 2-year exception, however, the issuer must apply those penalty provisions. (b) Rules applicable for all spending exceptions. The provisions of this paragraph (b) apply for purposes of applying each of the spending exceptions. (1) Special transferred proceeds rules-(i) Application to prior issues. For purposes of applying the spending exceptions to a prior issue only, proceeds of the prior issue

that become transferred proceeds of the refunding issue continue to be treated as unspent proceeds of the prior issue. If the prior issue satisfies one of the spending exceptions, the proceeds of the prior issue that are excepted from rebate under that spending exception are not subject to rebate either as proceeds of the prior issue or as transferred proceeds of the refunding issue. (ii) Application to refunding issues-(A) In general. The only spending exception applicable to refunding issues is the 6-month exception. For purposes of applying the 6-month exception to a refunding issue only, proceeds of the prior issue that become transferred proceeds of the refunding issue generally are not treated as proceeds of the refunding issue and need not be spent for the refunding issue to satisfy that spending exception. Even if the refunding issue qualifies for that spending exception, those transferred proceeds are subject to rebate as proceeds of the refunding issue unless an exception to rebate applied to those proceeds as proceeds of the prior issue. (B) Exception. For purposes of applying the 6-month exception to refunding issues, those transferred proceeds of the refunding issue excluded from the gross proceeds of the prior issue under the special definition of gross proceeds in paragraph (c)(3) of this section, and those that transferred from a prior taxable issue, are generally treated as gross proceeds of the refunding issue. Thus, for the refunding issue to qualify for the 6-month exception, those proceeds must be spent within 6 months of the issue date of the refunding issue, unless those amounts continue to be used in a manner that does not cause those amounts to be gross proceeds under paragraph (c)(3) of this section. (2) Application of multipurpose issue rules. Except as otherwise provided, if any portion of an issue is treated as a separate issue allocable to refunding purposes under §1.148-9(h) (relating to multipurpose issues), for purposes of this section, that portion is treated as a separate issue. (3) Expenditures for governmental purposes of the issue. For purposes of this section, expenditures for the governmental purpose of an issue include payments for interest, but not principal, on the issue, and for principal or interest on another issue of obligations. The preceding sentence does not apply for purposes of the 18-month and 2-year exceptions if those payments cause the issue to be a refunding issue. (4) De minimis rule. Any failure to satisfy the final spending requirement of the 18-month exception or the 2-year exception is disregarded if the issuer exercises due diligence to complete the project financed and the amount of the failure does not exceed the lesser of 3 percent of the issue price of the issue or $250,000. (5) Special definition of reasonably required reserve or replacement fund. For purposes of this section only, a reasonably required reserve or replacement fund also includes any fund to the extent described in §1.148-5(c)(3)(i)(E) or (G). (6) Pooled financing issue-(i) In general. Except as otherwise provided in this paragraph (b)(6), the spending exceptions apply to a pooled financing issue as a whole, rather than to each loan separately. (ii) Election to apply spending exceptions separately to each loan-(A) In general. At the election (made on or before the issue date) of the issuer of a pooled financing

issue, the spending exceptions are applied separately to each conduit loan, and the applicable spending requirements for a loan begin on the earlier of the date the loan is made, or the first day following the 1-year period beginning on the issue date of the pooled financing issue. If this election is made, the rebate requirement applies to, and none of the spending exceptions are available for, gross proceeds of the pooled financing bonds before the date on which the spending requirements for those proceeds begin. (B) Application of spending exceptions. If the issuer makes the election under this paragraph (b)(6)(ii), the rebate requirement is satisfied for proceeds used to finance a particular conduit loan to the extent that the loan satisfies a spending exception or the small issuer exception under §1.148-8, regardless of whether any other conduit loans allocable to the issue satisfy such an exception. A pooled financing issue is an issue of arbitrage bonds, however, unless the entire issue satisfies the requirements of section 148. An issuer may pay rebate for some conduit loans and 11/2 percent penalty for other conduit loans from the same pooled financing issue. The 11/2 percent penalty is computed separately for each conduit loan. (C) Elections under 2-year exception. If the issuer makes the election under this paragraph (b)(6)(ii), the issuer may make all elections under the 2-year exception separately for each loan. Elections regarding a loan that otherwise must be made by the issuer on or before the issue date instead may be made on or before the date the loan is made (but not later than 1 year after the issue date). (D) Example. The operation of this paragraph (b)(6) is illustrated by the following example: Example. Pooled financing issue. On January 1, 1994, Authority J issues bonds. As of the issue date, J reasonably expects to use the proceeds of the issue to make loans to City K, County L, and City M. J does not reasonably expect to use more than 75 percent of the available construction proceeds of the issue for construction expenditures. On or before the issue date, J elects to apply the spending exceptions separately for each loan, with spending requirements beginning on the earlier of the date the loan is made or the first day following the 1-year period beginning on the issue date. On February 1, 1994, J loans a portion of the proceeds to K, and K reasonably expects that 45 percent of those amounts will be used for construction expenditures. On the date this loan is made, J elects under paragraph (j) of this section to treat 60 percent of the amount loaned to K as a separate construction issue, and also elects the 11/2 percent penalty under paragraph (k) of this section for the separate construction issue. On March 1, 1994, J loans a portion of the proceeds to L, and L reasonably expects that more than 75 percent of those amounts will be used for construction expenditures. On March 1, 1995, J loans the remainder of the proceeds to M, and none of those amounts will be used for construction expenditures. J must satisfy the rebate requirement for all gross proceeds before those amounts are loaned. For the loan to K, the spending periods begin on February 1, 1994, and the 11/2 percent penalty must be paid for any failure to meet a spending requirement for the portion of the loan to K that is treated as a separate construction issue. Rebate must be paid on the remaining portion of the loan to K, unless that portion qualifies for the 6-month exception. For the loan to L, the spending periods begin on March 1, 1994, and the rebate requirement must be satisfied unless the 6-month, 18-month, or the 2-year except ion is satisfied with respect to those amounts. For the loan to M, the spending periods begin on January

2, 1995, and the rebate requirement must be satisfied for those amounts unless the 6-month or 18-month exception is satisfied. (c) 6-month exception- (1) General rule. An issue is treated as meeting the rebate requirement if- (i) The gross proceeds (as modified by paragraph (c)(3) of this section) of the issue are allocated to expenditures for the governmental purposes of the issue within the 6-month period beginning on the issue date (the 6-month spending period); and (ii) The rebate requirement is met for amounts not required to be spent within the 6-month spending period (excluding earnings on a bona fide debt service fund). (2) Additional period for certain bonds. The 6-month spending period is extended for an additional 6 months in certain circumstances specified under section 148(f)(4)(B)(ii). (3) Amounts not included in gross proceeds. For purposes of paragraph (c)(1)(i) of this section only, gross proceeds has the meaning used in §1.148-1, except it does not include amounts- (i) In a bona fide debt service fund; (ii) In a reasonably required reserve or replacement fund (see §1.148-7(b)(5)); (iii) That, as of the issue date, are not reasonably expected to be gross proceeds but that become gross proceeds after the end of the 6-month spending period; (iv) Representing sale or investment proceeds derived from payments under any purpose investment of the issue; and (v) Representing repayments of grants (as defined in §1.148-6(d)(4)) financed by the issue. (4) Series of refundings. If a principal purpose of a series of refunding issues is to exploit the difference between taxable and tax-exempt interest rates by investing proceeds during the temporary periods provided in §1.148-9(d), the 6-month spending period for all issues in the series begins on the issue date of the first issue in the series. (d) 18-month exception-(1) General rule. An issue is treated as meeting the rebate requirement if all of the following requirements are satisfied- (i) 18-month expenditure schedule met. The gross proceeds (as defined in paragraph (d)(3) of this section) are allocated to expenditures for a governmental purpose of the issue in accordance with the following schedule (the 18-month expenditure schedule) measured from the issue date- (A) At least 15 percent within 6 months (the first spending period); (B) At least 60 percent within 12 months (the second spending period); and

(C) 100 percent within 18 months (the third spending period). (ii) Rebate requirement met for amounts not required to be spent. The rebate requirement is met for all amounts not required to be spent in accordance with the 18-month expenditure schedule (other than earnings on a bona fide debt service fund). (iii) Issue qualifies for initial temporary period. All of the gross proceeds (as defined in paragraph (d)(3)(i) of this section) of the issue qualify for the initial temporary period under §1.148-2(e)(2). (2) Extension for reasonable retainage. An issue does not fail to satisfy the spending requirement for the third spending period as a result of a reasonable retainage if the reasonable retainage is allocated to expenditures within 30 months of the issue date. Reasonable retainage has the meaning under paragraph (h) of this section, as modified to refer to net sale proceeds on the date 18 months after the issue date. (3) Gross proceeds-(i) Definition of gross proceeds. For purposes of paragraph (d)(1) of this section only, gross proceeds means gross proceeds as defined in paragraph (c)(3) of this section, as modified to refer to "18 months" in paragraph (c)(3)(iii) of this section in lieu of "6 months." (ii) Estimated earnings. For purposes of determining compliance with the first two spending periods under paragraph (d)(1)(i) of this section, the amount of investment proceeds included in gross proceeds of the issue is determined based on the issuer's reasonable expectations on the issue date. (4) Application to multipurpose issues. This paragraph (d) does not apply to an issue any portion of which is treated as meeting the rebate requirement under paragraph (e) of this section (relating to the 2-year exception). (e) 2-year exception-(1) General rule. A construction issue is treated as meeting the rebate requirement for available construction proceeds if those proceeds are allocated to expenditures for governmental purposes of the issue in accordance with the following schedule (the 2-year expenditure schedule), measured from the issue date- (i) At least 10 percent within 6 months (the first spending period); (ii) At least 45 percent within 1 year (the second spending period); (iii) At least 75 percent within 18 months (the third spending period); and (iv) 100 percent within 2 years (the fourth spending period). (2) Extension for reasonable retainage. An issue does not fail to satisfy the spending requirement for the fourth spending period as a result of unspent amounts for reasonable retainage (as defined in paragraph (h) of this section) if those amounts are allocated to expenditures within 3 years of the issue date. (3) Definitions. For purposes of the 2-year exception, the following definitions apply:

(i) Real property means land and improvements to land, such as buildings or other inherently permanent structures, including interests in real property. For example, real property includes wiring in a building, plumbing systems, central heating or air-conditioning systems, pipes or ducts, elevators, escalators installed in a building, paved parking areas, roads, wharves and docks, bridges, and sewage lines. (ii) Tangible personal property means any tangible property other than real property, including interests in tangible personal property. For example, tangible personal property includes machinery that is not a structural component of a building, subway cars, fire trucks, automobiles, office equipment, testing equipment, and furnishings. (iii) Substantially completed. Construction may be treated as substantially completed when the issuer abandons construction or when at least 90 percent of the total costs of the construction reasonably expected, as of that date, to be financed with the available construction proceeds have been allocated to expenditures. (f) Construction issue-(1) Definition. Construction issue means any issue that is not a refunding issue if- (i) The issuer reasonably expects, as of the issue date, that at least 75 percent of the available construction proceeds of the issue will be allocated to construction expenditures (as defined in paragraph (g) of this section) for property owned by a governmental unit or a 501(c)(3) organization; and (ii) Any private activity bonds that are part of the issue are qualified 501(c)(3) bonds or private activity bonds issued to finance property to be owned by a governmental unit or a 501(c)(3) organization. (2) Use of actual facts. For the provisions of paragraphs (e) through (m) of this section that apply based on the issuer's reasonable expectations, an issuer may elect on or before the issue date to apply all of those provisions based on actual facts. (3) Ownership requirement-(i) In general. A governmental unit or 501(c)(3) organization is treated as the owner of property if it would be treated as the owner for Federal income tax purposes. For obligations issued on behalf of a State or local governmental unit, the entity that actually issues the bonds is treated as a governmental unit. (ii) Safe harbor for leases and management contracts. Property leased by a governmental unit or a 501(c)(3) organization is treated as owned by the governmental unit or 501(c)(3) organization if the lessee complies with the requirements of section 142(b)(1)(B). For a bond described in section 142(a)(6), the requirements of section 142(b)(1)(B) apply as modified by section 146(h)(2). (g) Construction expenditures-(1) Definition. Except as otherwise provided, construction expenditures means capital expenditures (as defined in §1.150-1) that are allocable to the cost of real property or constructed personal property (as defined in paragraph (g)(3) of this section). Except as provided in paragraph (g)(2) of this section, construction expenditures do not include expenditures for acquisitions of interests in land or other existing real property.

(2) Certain acquisitions under turnkey contracts treated as construction expenditures. Expenditures are not for the acquisition of an interest in existing real property other than land if the contract between the seller and the issuer requires the seller to build or install the property (e.g., a turnkey contract), but only to the extent that the property has not been built or installed at the time the parties enter into the contract. (3) Constructed personal property. Constructed personal property means tangible personal property (or, if acquired pursuant to a single acquisition contract, properties) or specially developed computer software if- (i) A substantial portion of the property or properties is completed more than 6 months after the earlier of the date construction or rehabilitation commenced and the date the issuer entered into an acquisition contract; (ii) Based on the reasonable expectations of the issuer, if any, or representations of the person constructing the property, with the exercise of due diligence, completion of construction or rehabilitation (and delivery to the issuer) could not have occurred within that 6-month period; and (iii) If the issuer itself builds or rehabilitates the property, not more than 75 percent of the capitalizable cost is attributable to property acquired by the issuer (e.g., components, raw materials, and other supplies). (4) Specially developed computer software. Specially developed computer software means any programs or routines used to cause a computer to perform a desired task or set of tasks, and the documentation required to describe and maintain those programs, provided that the software is specially developed and is functionally related and subordinate to real property or other constructed personal property. (5) Examples. The operation of this paragraph (g) is illustrated by the following examples: Example 1. Purchase of construction materials. City A issues bonds to finance a new office building. A uses proceeds of the bonds to purchase materials to be used in constructing the building, such as bricks, pipes, wires, lighting, carpeting, heating equipment, and similar materials. Expenditures by A for the construction materials are construction expenditures because those expenditures will be capitalizable to the cost of the building upon completion, even though they are not initially capitalizable to the cost of existing real property. This result would be the same if A hires a third-party to perform the construction, unless the office building is partially constructed at the time that A contracts to purchase the building. Example 2. Turnkey contract. City B issues bonds to finance a new office building. B enters into a turnkey contract with developer D under which D agrees to provide B with a completed building on a specified completion date on land currently owned by D. Under the agreement, D holds title to the land and building and assumes any risk of loss until the completion date, at which time title to the land and the building will be transferred to B. No construction has been performed by the date that B and D enter into the agreement. All payments by B to D for construction of the building are construction expenditures because all the payments are properly capitalized to the

cost of the building, but payments by B to D allocable to the acquisition of the land are not construction expenditures. Example 3. Right-of-way. P, a public agency, issues bonds to finance the acquisition of a right-of-way and the construction of sewage lines through numerous parcels of land. The right-of-way is acquired primarily through P's exercise of its powers of eminent domain. As of the issue date, P reasonably expects that it will take approximately 2 years to acquire the entire right-of-way because of the time normally required for condemnation proceedings. No expenditures for the acquisition of the right-of-way are construction expenditures because they are costs incurred to acquire an interest in existing real property. Example 4. Subway cars. City C issues bonds to finance new subway cars. C reasonably expects that it will take more than 6 months for the subway cars to be constructed to C's specifications. The subway cars are constructed personal property. Alternatively, if the builder of the subway cars informs C that it will only take 3 months to build the subway cars to C's specifications, no payments for the subway cars are construction expenditures. Example 5. Fractional interest in property. U, a public agency, issues bonds to finance an undivided fractional interest in a newly constructed power-generating facility. U contributes its ratable share of the cost of building the new facility to the project manager for the facility. U's contributions are construction expenditures in the same proportion that the total expenditures for the facility qualify as construction expenditures. Example 6. Park land. City D issues bonds to finance the purchase of unimproved land and the cost of subsequent improvements to the land, such as grading and landscaping, necessary to transform it into a park. The costs of the improvements are properly capitalizable to the cost of the land, and therefore, are construction expenditures, but expenditures for the acquisition of the land are not. (h) Reasonable retainage definition. Reasonable retainage means an amount, not to exceed 5 percent of available construction proceeds as of the end of the fourth spending period, that is retained for reasonable business purposes relating to the property financed with the proceeds of the issue. For example, a reasonable retainage may include a retention to ensure or promote compliance with a construction contract in circumstances in which the retained amount is not yet payable, or in which the issuer reasonably determines that a dispute exists regarding completion or payment. (i) Available construction proceeds-(1) Definition in general. Available construction proceeds has the meaning used in section 148(f)(4)(C)(vi). For purposes of this definition, earnings include earnings on any tax-exempt bond. Pre-issuance accrued interest and earnings thereon may be disregarded. Amounts that are not gross proceeds as a result of the application of the universal cap under §1.148-6(b)(2) are not available construction proceeds. (2) Earnings on a reasonably required reserve or replacement fund. Earnings on any reasonably required reserve or replacement fund are available construction proceeds only to the extent that those earnings accrue before the earlier of the date construction is substantially completed or the date that is 2 years after the issue

date. An issuer may elect on or before the issue date to exclude from available construction proceeds the earnings on such a fund. If the election is made, the rebate requirement applies to the excluded amounts from the issue date. (3) Reasonable expectations test for future earnings. For purposes of determining compliance with the spending requirements as of the end of each of the first three spending periods, available construction proceeds include the amount of future earnings that the issuer reasonably expected as of the issue date. (4) Issuance costs. Available construction proceeds do not include gross proceeds used to pay issuance costs financed by an issue, but do include earnings on such proceeds. Thus, an expenditure of gross proceeds of an issue for issuance costs does not count toward meeting the spending requirements. The expenditure of earnings on gross proceeds used to pay issuance costs does count toward meeting those requirements. If the spending requirements are met and the proceeds used to pay issuance costs are expended by the end of the fourth spending period, those proceeds and the earnings thereon are treated as having satisfied the rebate requirement. (5) One and one-half percent penalty in lieu of arbitrage rebate. For purposes of the spending requirements of paragraph (e) of this section, available construction proceeds as of the end of any spending period are reduced by the amount of penalty in lieu of arbitrage rebate (under paragraph (k) of this section) that the issuer has paid from available construction proceeds before the last day of the spending period. (6) Payments on purpose investments and repayments of grants. Available construction proceeds do not include- (i) Sale or investment proceeds derived from payments under any purpose investment of the issue; or (ii) Repayments of grants (as defined in §1.148-6(d)(4)) financed by the issue. (7) Examples. The operation of this paragraph (i) is illustrated by the following examples: Example 1. Treatment of investment earnings. City F issues bonds having an issue price of $10,000,000. F deposits all of the proceeds of the issue into a construction fund to be used for expenditures other than costs of issuance. F estimates on the issue date that, based on reasonably expected expenditures and rates of investment, earnings on the construction fund will be $800,000. As of the issue date and the end of each of the first three spending periods, the amount of available construction proceeds is $10,800,000. To qualify as a construction issue, F must reasonably expect on the issue date that at least $8,100,000 (75 percent of $10,800,000) will be used for construction expenditures. In order to meet the 10 percent spending requirement at the end of the first spending period, F must spend at least $1,080,000. As of the end of the fourth spending period, F has received $1,100,000 in earnings. In order to meet the spending requirement at the end of the fourth spending period, however, F must spend all of the $11,100,000 of actual available construction proceeds (except for reasonable retainage not exceeding $555,000).

Example 2. Treatment of investment earnings without a reserve fund. City G issues bonds having an issue price of $11,200,000. G does not elect to exclude earnings on the reserve fund from available construction proceeds. G uses $200,000 of proceeds to pay issuance costs and deposits $1,000,000 of proceeds into a reasonably required reserve fund. G deposits the remaining $10,000,000 of proceeds into a construction fund to be used for construction expenditures. On the issue date, G reasonably expects that, based on the reasonably expected date of substantial completion and rates of investment, total earnings on the construction fund will be $800,000, and total earnings on the reserve fund to the date of substantial completion will be $150,000. G reasonably expects that substantial completion will occur during the fourth spending period. As of the issue date, the amount of available construction proceeds is $10,950,000 ($10,000,000 originally deposited into the construction fund plus $800,000 expected earnings on the construction fund and $150,000 expected earnings on the reserve fund). To qualify as a construction issue, G must reasonably expect on the issue date that at least $8,212,500 will be used for construction expenditures. Example 3. Election to exclude earnings on a reserve fund. The facts are the same as Example 2, except that G elects on the issue date to exclude earnings on the reserve fund from available construction proceeds. The amount of available construction proceeds as of the issue date is $10,800,000. (j) Election to treat portion of issue used for construction as separate issue-(1) In general. For purposes of paragraph (e) of this section, if any proceeds of an issue are to be used for construction expenditures, the issuer may elect on or before the issue date to treat the portion of the issue that is not a refunding issue as two, and only two, separate issues, if- (i) One of the separate issues is a construction issue as defined in paragraph (f) of this section; (ii) The issuer reasonably expects, as of the issue date, that this construction issue will finance all of the construction expenditures to be financed by the issue; and (iii) The issuer makes an election to apportion the issue under this paragraph (j)(1) in which it identifies the amount of the issue price of the issue allocable to the construction issue. (2) Example. The operation of this paragraph (j) is illustrated by the following example. Example. City D issues bonds having an issue price of $19,000,000. On the issue date, D reasonably expects to use $10,800,000 of bond proceeds (including investment earnings) for construction expenditures for the project being financed. D deposits $10,000,000 in a construction fund to be used for construction expenditures and $9,000,000 in an acquisition fund to be used for acquisition of equipment not qualifying as construction expenditures. D estimates on the issue date, based on reasonably expected expenditures and rates of investment, that total earnings on the construction fund will be $800,000 and total earnings on the acquisition fund will be $200,000. Because the total construction expenditures to be financed by the issue are expected to be $10,800,000, the maximum available construction proceeds for a construction issue is $14,400,000 ($10,800,000 divided by 0.75). To determine the

maximum amount of the issue price allocable to a construction issue, the estimated investment earnings allocable to the construction issue are subtracted. The entire $800,000 of earnings on the construction fund are allocable to the construction issue. Only a portion of the $200,000 of earnings on the acquisition fund, however, are allocable to the construction issue. The total amount of the available construction proceeds that is expected to be used for acquisition is $3,600,000 ($14,400,000$10,800,000). The portion of earnings on the acquisition fund that is allocable to the construction issue is $78,261 ($200,000$3,600,000/$9,200,000). Accordingly, D may elect on or before the issue date to treat up to $13,521,739 of the issue price as a construction issue ($14,400,000$800,000$78,261). D's election must specify the amount of the issue price treated as a construction issue. The balance of the issue price is treated as a separate nonconstruction issue that si subject to the rebate requirement unless it meets another exception to arbitrage rebate. Because the financing of a construction issue is a separate governmental purpose under §1.148-9(h), the election causes the issue to be a multipurpose issue under that section. (k) One and one-half percent penalty in lieu of arbitrage rebate-(1) In general. Under section 148(f)(4)(C)(vii), an issuer of a construction issue may elect on or before the issue date to pay a penalty (the 11/2 percent penalty) to the United States in lieu of the obligation to pay the rebate amount on available construction proceeds upon failure to satisfy the spending requirements of paragraph (e) of this section. The 11/2 percent penalty is calculated separately for each spending period, including each semiannual period after the end of the fourth spending period, and is equal to 1.5 percent times the underexpended proceeds as of the end of the spending period. For each spending period, underexpended proceeds equal the amount of available construction proceeds required to be spent by the end of the spending period, less the amount actually allocated to expenditures for the governmental purposes of the issue by that date. The 11/2 percent penalty must be paid to the United States no later than 90 days after the end of the spending period to which it relates. The 11/2 percent penalty continues to apply at the end of each spending period and each semiannual period thereafter until the earliest of the following- (i) The termination of the penalty under paragraph ( ) of this section; (ii) The expenditure of all of the available construction proceeds; or (iii) The last stated final maturity date of bonds that are part of the issue and any bonds that refund those bonds. (2) Application to reasonable retainage. If an issue meets the exception for reasonable retainage except that all retainage is not spent within 3 years of the issue date, the issuer must pay the 11/2 percent penalty to the United States for any reasonable retainage that was not so spent as of the close of the 3-year period and each later spending period. (3) Coordination with rebate requirement. The rebate requirement is treated as met with respect to available construction proceeds for a period if the 11/2 percent penalty is paid in accordance with this section.

(l) Termination of 11/2 percent penalty-(1) Termination after initial temporary period. The issuer may terminate the 11/2 percent penalty after the initial temporary period (a section 148(f)(4)(C)(viii) penalty termination) if- (i) Not later than 90 days after the earlier of the end of the initial temporary period or the date construction is substantially completed, the issuer elects to terminate the 11/2 percent penalty; provided that solely for this purpose, the initial temporary period may be extended by the issuer to a date ending 5 years after the issue date; (ii) Within 90 days after the end of the initial temporary period, the issuer pays a penalty equal to 3 percent of the unexpended available construction proceeds determined as of the end of the initial temporary period, multiplied by the number of years (including fractions of years computed to 2 decimal places) in the initial temporary period; (iii) For the period beginning as of the close of the initial temporary period, the unexpended available construction proceeds are not invested in higher yielding investments; and (iv) On the earliest date on which the bonds may be called or otherwise redeemed, with or without a call premium, the unexpended available construction proceeds as of that date (not including any amount earned after the date on which notice of the redemption was required to be given) must be used to redeem the bonds. Amounts used to pay any call premium are treated as used to redeem bonds. This redemption requirement may be met by purchases of bonds by the issuer on the open market at prices not exceeding fair market value. A portion of the annual principal payment due on serial bonds of a construction issue may be paid from the unexpended amount, but only in an amount no greater than the amount that bears the same ratio to the annual principal due that the total unexpended amount bears to the issue price of the construction issue. (2) Termination before end of initial temporary period. If the construction to be financed by the construction issue is substantially completed before the end of the initial temporary period, the issuer may elect to terminate the 11/2 percent penalty before the end of the initial temporary period (a section 148(f)(4)(C)(ix) penalty termination) if- (i) Before the close of the initial temporary period and not later than 90 days after the date the construction is substantially completed, the issuer elects to terminate the 11/2 percent penalty; (ii) The election identifies the amount of available construction proceeds that will not be spent for the governmental purposes of the issue; and (iii) The issuer has met all of the conditions for a section 148(f)(4)(C)(viii) penalty termination, applied as if the initial temporary period ended as of the date the required election for a section 148(f)(4)(C)(ix) penalty termination is made. That penalty termination election satisfies the required election for a section 148(f)(4)(C)(viii) termination.

(3) Application to reasonable retainage. Solely for purposes of determining whether the conditions for terminating the 11/2 percent penalty are met, reasonable retainage may be treated as spent for a governmental purpose of the construction issue. Reasonable retainage that is so treated continues to be subject to the 11/2 percent penalty. (4) Example. The operation of this paragraph (l) is illustrated by the following example. Example. City I issues a construction issue having a 20-year maturity and qualifying for a 3-year initial temporary period. The bonds are first subject to optional redemption 10 years after the issue date at a premium of 3 percent. I elects, on or before the issue date, to pay the 11/2 percent penalty in lieu of arbitrage rebate. At the end of the 3-year temporary period, the project is not substantially completed, and $1,500,000 of available construction proceeds of the issue are unspent. At that time, I reasonably expects to need $500,000 to complete the project. I may terminate the 11/2 percent penalty in lieu of arbitrage rebate with respect to the excess $1,500,000 by electing to terminate within 90 days of the end of the initial temporary period; paying a penalty to the United States of $135,000 (3 percent of $1,500,000 multiplied by 3 years); restricting the yield on the investment of unspent available construction proceeds for 7 years until the first call date, although any portion of these proceeds may still be spent on the project prior to that call date; and using the available construction proceeds that, as of the first call date, have not been allocated to expenditures for the governmental purposes of the issue to redeem bonds on that call date. If I fails to make the termination election, I is required to pay the 11/2 percent penalty on unspent available construction proceeds every 6 months until the latest maturity date of bonds of the issue (or any bonds of another issue that refund such bonds). (m) Payment of penalties. Each penalty payment under this section must be paid in the manner provided in §1.148-3(g). See §1.148-3(h) for rules on failures to pay penalties under this section.

§1.148-8 Small issuer exception to rebate requirement.

(a) Scope. Under section 148(f)(4)(D), bonds issued to finance governmental activities of certain small issuers are treated as meeting the arbitrage rebate requirement of section 148(f)(2) (the "small issuer exception"). This section provides guidance on the small issuer exception. (b) General taxing powers. The small issuer exception generally applies only to bonds issued by governmental units with general taxing powers. A governmental unit has general taxing powers if it has the power to impose taxes (or to cause another entity to impose taxes) of general applicability which, when collected, may be used for the general purposes of the issuer. The taxing power may be limited to a specific type of tax, provided that the applicability of the tax is not limited to a small number of persons. The governmental unit's exercise of its taxing power may be subject to procedural limitations, such as voter approval requirements, but may not be contingent on approval by another governmental unit. See, also, section 148(f)(4)(D)(iv).

(c) Size limitation-(1) In general. An issue (other than a refunding issue) qualifies for the small issuer exception only if the issuer reasonably expects, as of the issue date, that the aggregate face amount of all tax-exempt bonds (other than private activity bonds) issued by it during that calendar year will not exceed $5,000,000; or the aggregate face amount of all tax-exempt bonds of the issuer (other than private activity bonds) actually issued during that calendar year does not exceed $5,000,000. For this purpose, if an issue has more than a de minimis amount of original issue discount or premium, aggregate face amount means the aggregate issue price of that issue (determined without regard to pre-issuance accrued interest). (2) Aggregation rules. The following aggregation rules apply for purposes of applying the $5,000,000 size limitation under paragraph (c)(1) of this section. (i) On-behalf-of issuers. An issuer and all entities (other than political subdivisions) that issue bonds on behalf of that issuer are treated as one issuer. (ii) Subordinate entities-(A) In general. Except as otherwise provided in paragraph (d) of this section and section 148(f)(4)(D)(iv), all bonds issued by a subordinate entity are also treated as issued by each entity to which it is subordinate. An issuer is subordinate to another governmental entity if it is directly or indirectly controlled by the other entity within the meaning of §1.150-1(e). (B) Exception for allocations of size limitation. If an entity properly makes an allocation of a portion of its $5,000,000 size limitation to a subordinate entity (including an on behalf of issuer) under section 148(f)(4)(D)(iv), the portion of bonds issued by the subordinate entity under the allocation is treated as issued only by the allocating entity and not by any other entity to which the issuing entity is subordinate. These allocations are irrevocable and must bear a reasonable relationship to the benefits received by the allocating unit from issues issued by the subordinate entity. The benefits to be considered include the manner in which- (1) Proceeds are to be distributed; (2) The debt service is to be paid; (3) The facility financed is to be owned; (4) The use or output of the facility is to be shared; and (5) Costs of operation and maintenance are to be shared. (iii) Avoidance of size limitation. An entity formed or availed of to avoid the purposes of the $5,000,000 size limitation and all entities that would benefit from the avoidance are treated as one issuer. Situations in which an entity is formed or availed of to avoid the purposes of the $5,000,000 size limitation include those in which the issuer- (A) Issues bonds which, but for the $5,000,000 size limitation, would have been issued by another entity; and

(B) Does not receive a substantial benefit from the project financed by the bonds. (3) Certain refunding bonds not taken into account. In applying the $5,000,000 size limitation, there is not taken into account the portion of an issue that is a current refunding issue to the extent that the stated principal amount of the refunding bond does not exceed the portion of the outstanding stated principal amount of the refunded bond paid with proceeds of the refunding bond. For this purpose, principal amount means, in reference to a plain par bond, its stated principal amount plus accrued unpaid interest, and in reference to any other bond, its present value. (d) Pooled financings-(1) Treatment of pool issuer. To the extent that an issuer of a pooled financing is not an ultimate borrower in the financing and the conduit borrowers are governmental units with general taxing powers and not subordinate to the issuer, the pooled financing is not counted towards the $5,000,000 size limitation of the issuer for purposes of applying the small issuer exception to its other issues. The issuer of the pooled financing issue is, however, subject to the rebate requirement for any unloaned gross proceeds. (2) Treatment of conduit borrowers. A loan to a conduit borrower in a pooled financing qualifies for the small issuer exception, regardless of the size of either the pooled financing or of any loan to other conduit borrowers, only if- (i) The bonds of the pooled financing are not private activity bonds; (ii) None of the loans to conduit borrowers are private activity bonds; and (iii) The loan to the conduit borrower meets all the requirements of the small issuer exception. (e) Refunding issues-(1) In general. Sections 148(f)(4)(D) (v) and (vi) provide restrictions on application of the small issuer exception to refunding issues. (2) Multipurpose issues. The multipurpose issue allocation rules of §1.148-9(h) apply for purposes of determining whether refunding bonds meet the requirements of section 148(f)(4)(D)(v).

§1.148-9 Arbitrage rules for refunding issues.

(a) Scope of application. This section contains special arbitrage rules for refunding issues. These rules apply for all purposes of section 148 and govern allocations of proceeds, bonds, and investments to determine transferred proceeds, temporary periods, reasonably required reserve or replacement funds, minor portions, and separate issue treatment of certain multipurpose issues. (b) Transferred proceeds allocation rule-(1) In general. When proceeds of the refunding issue discharge any of the outstanding principal amount of the prior issue, proceeds of the prior issue become transferred proceeds of the refunding issue and cease to be proceeds of the prior issue. The amount of proceeds of the prior issue that becomes transferred proceeds of the refunding issue is an amount equal to the proceeds of the prior issue on the date of that discharge multiplied by a fraction-

(i) The numerator of which is the principal amount of the prior issue discharged with proceeds of the refunding issue on the date of that discharge; and (ii) The denominator of which is the total outstanding principal amount of the prior issue on the date immediately before the date of that discharge. (2) Special definition of principal amount. For purposes of this section, principal amount means, in reference to a plain par bond, its stated principal amount, and in reference to any other bond, its present value. (3) Relation of transferred proceeds rule to universal cap rule-(i) In general. Paragraphs (b)(1) and (c) of this section apply to allocate transferred proceeds and corresponding investments to a refunding issue on any date required by those paragraphs before the application of the universal cap rule of §1.148-6(b)(2) to reallocate any of those amounts. To the extent nonpurpose investments allocable to proceeds of a refunding issue exceed the universal cap for the issue on the date that amounts become transferred proceeds of the refunding issue, those transferred proceeds and corresponding investments are reallocated back to the issue from which they transferred on that same date to the extent of the unused universal cap on that prior issue. (ii) Example. The following example illustrates the application of this paragraph of (b)(3): Example. On January 1, 1995, $100,000 of nonpurpose investments allocable to proceeds of issue A become transferred proceeds of issue B under §1.148-9, but the unused portion of issue B's universal cap is $75,000 as of that date. On January 1, 1995, issue A has unused universal cap in excess of $25,000. Thus, $25,000 of nonpurpose investments representing the transferred proceeds are immediately reallocated back to issue A on January 1, 1995, and are proceeds of issue A. On the next transfer date under §1.148-9, the $25,000 receives no priority in determining transferred proceeds as of that date but is treated the same as all other proceeds of issue A subject to transfer. (4) Limitation on multi-generational transfers. This paragraph (b)(4) contains limitations on the manner in which proceeds of a first generation issue that is refunded by a refunding issue (a second generation issue) become transferred proceeds of a refunding issue (a third generation issue) that refunds the second generation issue. Proceeds of the first generation issue that become transferred proceeds of the third generation issue are treated as having a yield equal to the yield on the refunding escrow allocated to the second generation issue (i.e., as determined under §1.148-5(b)(2)(iv)). The determination of the transferred proceeds of the third generation issue does not affect compliance with the requirements of section 148, including the determination of the amount of arbitrage rebate with respect to or the yield on the refunding escrow, of the second generation issue. (c) Special allocation rules for refunding issues-(1) Allocations of investments-(i) In general. Except as otherwise provided in this paragraph (c), investments purchased with sale proceeds or investment proceeds of a refunding issue must be allocated to those proceeds, and investments not purchased with those proceeds may not be allocated to those proceeds (i.e., a specific tracing method).

(ii) Allocations to transferred proceeds. When proceeds of a prior issue become transferred proceeds of a refunding issue, investments (and the related payments and receipts) of proceeds of the prior issue that are held in a refunding escrow for another issue are allocated to the transferred proceeds under the ratable allocation method described in paragraph (c)(1)(iii) of this section. Investments of proceeds of the prior issue that are not held in a refunding escrow for another issue are allocated to the transferred proceeds by application of the allocation methods described in paragraph (c)(1) (iii) or (iv) of this section, consistently applied to all investments on a transfer date. (iii) Ratable allocation method. Under the ratable allocation method, a ratable portion of each nonpurpose and purpose investment of proceeds of the prior issue is allocated to transferred proceeds of the refunding issue. (iv) Representative allocation method-(A) In general. Under the representative allocation method, representative portions of the portfolio of nonpurpose investments and the portfolio of purpose investments of proceeds of the prior issue are allocated to transferred proceeds of the refunding issue. Unlike the ratable allocation method, this representative allocation method permits an allocation of particular whole investments. Whether a portion is representative is based on all the facts and circumstances, including, without limitation, whether the current yields, maturities, and current unrealized gains or losses on the particular allocated investments are reasonably comparable to those of the unallocated investments in the aggregate. In addition, if a portion of nonpurpose investments is otherwise representative, it is within the issuer's discretion to allocate the portion from whichever source of funds it deems appropriate, such as a reserve fund or a construction fund for a prior issue. (B) Mark-to-market safe harbor for representative allocation method. In addition to other representative allocations, a specific allocation of a particular nonpurpose investment to transferred proceeds (e.g., of lower yielding investments) is treated as satisfying the representative allocation method if that investment is valued at fair market value on the transfer date in determining the payments and receipts on that date, but only if the portion of the nonpurpose investments that transfers is based on the relative fair market value of all nonpurpose investments. (2) Allocations of mixed escrows to expenditures for principal, interest, and redemption prices on a prior issue-(i) In general. Except for amounts required or permitted to be accounted for under paragraph (c)(2)(ii) of this section, proceeds of a refunding issue and other amounts that are not proceeds of a refunding issue that are deposited in a refunding escrow (a mixed escrow) must be accounted for under this paragraph (c)(2)(i). Those proceeds and other amounts must be allocated to expenditures for principal, interest, or stated redemption prices on the prior issue so that the expenditures of those proceeds do not occur faster than ratably with expenditures of the other amounts in the mixed escrow. If, however, the prior issue has unspent proceeds, these allocations must be ratable both between sources for expenditures (i.e., proceeds and other amounts) and between uses (i.e., principal, interest, and stated redemption prices on the prior issue). (ii) Exceptions-(A) Mandatory allocation of certain non-proceeds to earliest expenditures. If amounts other than proceeds of the refunding issue are deposited in a mixed escrow, but before the issue date of the refunding issue those amounts had

been held in a bona fide debt service fund or a fund to carry out the governmental purpose of the prior issue (e.g., a construction fund), those amounts must be allocated to the earliest expenditures from the mixed escrow. (B) Permissive allocation of non-proceeds to earliest expenditures. Excluding amounts covered by paragraph (c)(2)(ii)(A) of this section and subject to any required earlier expenditure of those amounts, any amounts in a mixed escrow that are not proceeds of a refunding issue may be allocated to the earliest expenditures from the mixed escrow, provided that those expenditures occur before the date of any expenditure from the mixed escrow to pay any principal of the prior issue. (d) Temporary periods in refundings-(1) In general. Proceeds of a refunding issue may be invested in higher yielding investments under section 148(c) only during the temporary periods described in paragraph (d)(2) of this section. (2) Types of temporary periods in refundings. The available temporary periods for proceeds of a refunding issue are as follows: (i) General temporary period for refunding issues. Except as otherwise provided in this paragraph (d)(2), the temporary period for proceeds (other than transferred proceeds) of a refunding issue is the period ending 30 days after the issue date of the refunding issue. (ii) Temporary periods for current refunding issues-(A) In general. Except as otherwise provided in paragraph (d)(2)(ii)(B) of this section, the temporary period for proceeds (other than transferred proceeds) of a current refunding issue is 90 days. (B) Temporary period for short-term current refunding issues. The temporary period for proceeds (other than transferred proceeds) of a current refunding issue that has an original term to maturity of 270 days or less may not exceed 30 days. The aggregate temporary periods for proceeds (other than transferred proceeds) of all current refunding issues described in the preceding sentence that are part of the same series of refundings is 90 days. An issue is part of a series of refundings if it finances or refinances the same expenditures for a particular governmental purpose as another issue. (iii) Temporary periods for transferred proceeds-(A) In general. Except as otherwise provided in paragraph (d)(2)(iii)(B) of this section, each available temporary period for transferred proceeds of a refunding issue begins on the date those amounts become transferred proceeds of the refunding issue and ends on the date that, without regard to the discharge of the prior issue, the available temporary period for those proceeds would have ended had those proceeds remained proceeds of the prior issue. (B) Termination of initial temporary period for prior issue in an advance refunding. The initial temporary period under §1.148-2(e) (2) and (3) for the proceeds of a prior issue that is refunded by an advance refunding issue (including transferred proceeds) terminates on the issue date of the advance refunding issue.

(iv) Certain short-term gross proceeds. Except for proceeds of a refunding issue held in a refunding escrow, proceeds otherwise reasonably expected to be used to pay principal or interest on the prior issue, replacement proceeds not held in a bona fide debt service fund, and transferred proceeds, the temporary period for gross proceeds of a refunding issue is the 13-month period beginning on the date of receipt. (e) Reasonably required reserve or replacement funds in refundings. In addition to the requirements of §1.148-2(f), beginning on the issue date of a refunding issue, a reserve or replacement fund for a refunding issue or a prior issue is a reasonably required reserve or replacement fund under section 148(d) that may be invested in higher yielding investments only if the aggregate amount invested in higher yielding investments under this paragraph (e) for both the refunding issue and the prior issue does not exceed the size limitations under §1.148-2 (f)(2) and (f)(3), measured by reference to the refunding issue only (regardless of whether proceeds of the prior issue have become transferred proceeds of the refunding issue). (f) Minor portions in refundings. Beginning on the issue date of the refunding issue, gross proceeds not in excess of a minor portion of the refunding issue qualify for investment in higher yielding investments under section 148(e), and gross proceeds not in excess of a minor portion of the prior issue qualify for investment in higher yielding investments under either section 148(e) or section 149(d)(3)(A)(v), whichever is applicable. Minor portion is defined in §1.148-2(g). (g) Certain waivers permitted. On or before the issue date, an issuer may waive the right to invest in higher yielding investments during any temporary period or as part of a reasonably required reserve or replacement fund. At any time, an issuer may waive the right to invest in higher yielding investments as part of a minor portion. (h) Multipurpose issue allocations-(1) Application of multipurpose issue allocation rules. The portion of the bonds of a multipurpose issue reasonably allocated to any separate purpose under this paragraph (h) is treated as a separate issue for all purposes of section 148 except the following- (i) Arbitrage yield. Except to the extent that the proceeds of an issue are allocable to two or more conduit loans that are tax-exempt bonds, determining the yield on a multipurpose issue and the yield on investments for purposes of the arbitrage yield restrictions of section 148 and the arbitrage rebate requirement of section 148(f); (ii) Rebate amount. Except as provided in paragraph (h)(1)(i) of this section, determining the rebate amount for a multipurpose issue, including subsidiary matters with respect to that determination, such as the computation date credit under §1.148-3(d)(1), the due date for payments, and the $100,000 bona fide debt service fund exception under section 148(f)(4)(A)(ii); (iii) Minor portion. Determining the minor portion of an issue under section 148(e); (iv) Reasonably required reserve or replacement fund. Determining the portion of an issue eligible for investment in higher yielding investments as part of a reasonably required reserve fund under section 148(d); and

(v) Effective date. Applying the provisions of §1.148-11(b) (relating to elective retroactive application of §§1.148-1 through 1.148-10 to certain issues). (2) Rules on allocations of multipurpose issues-(i) In general. This paragraph (h) applies to allocations of multipurpose issues, including allocations involving the refunding purposes of the issue. Except as otherwise provided in this paragraph (h), proceeds, investments, and bonds of a multipurpose issue may be allocated among the various separate purposes of the issue using any reasonable, consistently applied allocation method. An allocation is not reasonable if it achieves more favorable results under section 148 or 149(d) than could be achieved with actual separate issues. An allocation under this paragraph (h) may be made at any time, but once made may not be changed. (ii) Allocations involving certain common costs. A ratable allocation of common costs (as described in paragraph (h)(3)(ii) of this section) among the separate purposes of the multipurpose issue is generally reasonable. If another allocation method more accurately reflects the extent to which any separate purpose of a multipurpose issue enjoys the economic benefit or bears the economic burden of certain common costs, that allocation method may be used. (3) Separate purposes of a multipurpose issue-(i) In general. Separate purposes of a multipurpose issue include refunding a separate prior issue, financing a separate purpose investment, financing a construction issue (as defined in §1.148-7(f)), and any clearly discrete governmental purpose reasonably expected to be financed by that issue. In general, all integrated or functionally related capital projects that qualify for the same initial temporary period under §1.148-2(e)(2) are treated as having a single governmental purpose. The separate purposes of a refunding issue include the separate purposes of the prior issue, if any. Separate purposes may be treated as a single purpose if the proceeds used to finance those purposes are eligible for the same initial temporary period under section 148(c). For example, the use of proceeds of a multipurpose issue to finance separate qualified mortgage loans may be treated as a single purpose. (ii) Financing common costs. Common costs of a multipurpose issue are not separate purposes. Common costs include issuance costs, accrued interest, capitalized interest on the issue, a reserve or replacement fund, qualified guarantee fees, and similar costs properly allocable to the separate purposes of the issue. (iii) Example. The following example illustrates the application of this paragraph (h)(3). Example. On January 1, 1994, Housing Authority of State A issues a $10 million issue (the 1994 issue) at an interest rate of 10 percent to finance qualified mortgage loans for owner-occupied residences under section 143. During 1994, A originates $5 million in qualified mortgage loans at an interest rate of 10 percent. In 1995, the market interest rates for housing loans falls to 8 percent and A is unable to originate further loans from the 1994 issue. On January 1, 1996, A issues a $5 million issue (the 1996 issue) at an interest rate of 8 percent to refund partially the 1994 issue. Under paragraph (h) of this section, A treats the portion of the 1994 issue used to originate $5 million in loans as a separate issue comprised of that group of purpose investments. A allocates those purpose investments representing those loans to that separate unrefunded portion of the issue. In addition, A treats the unoriginated

portion of the 1994 issue as a separate issue and allocates the nonpurpose investments representing the unoriginated proceeds of the 1994 issue to the refunded portion of the issue. Thus, when proceeds of the 1996 issue are used to pay principal on the refunded portion of the 1994 issue that is treated as a separate issue under paragraph (h) of this section, only the portion of the 1994 issue representing unoriginated loan funds invested in nonpurpose investments transfer to become transferred proceeds of the 1996 issue. (4) Allocations of bonds of a multipurpose issue-(i) Reasonable allocation of bonds to portions of issue. After reasonable adjustment of the issue price of a multipurpose issue to account for common costs, the portion of the bonds of a multipurpose issue allocated to a separate purpose must have an issue price that bears the same ratio to the aggregate issue price of the multipurpose issue as the portion of the sale proceeds of the multipurpose issue used for that separate purpose bears to the aggregate sale proceeds of the multipurpose issue. For a refunding issue used to refund two or more prior issues, the portion of the sales proceeds allocated to the refunding of a separate prior issue is based on the present value of the refunded debt service on that prior issue, using the yield on investments in the refunding escrow allocable to the entire refunding issue as the discount rate. (ii) Safe harbor for pro rata allocation method for bonds. The use of the relative amount of sales proceeds used for each separate purpose to ratably allocate each bond or a ratable number of substantially identical whole bonds is a reasonable method for allocating bonds of a multipurpose issue. (iii) Safe harbor for allocations of bonds used to finance separate purpose investments. An allocation of a portion of the bonds of a multipurpose issue to a particular purpose investment is generally reasonable if that purpose investment has principal and interest payments that reasonably coincide in time and amount to principal and interest payments on the bonds allocated to that purpose investment. (iv) Rounding of bond allocations to next whole bond denomination permitted. An allocation that rounds each resulting fractional bond up or down to the next integral multiple of a permitted denomination of bonds of that issue not in excess of $100,000 does not prevent the allocation from satisfying this paragraph (h)(4). (v) Restrictions on allocations of bonds to refunding purposes. For each portion of a multipurpose issue that is used to refund a separate prior issue, a method of allocating bonds of that issue is reasonable under this paragraph (h) only if, in addition to the requirements of paragraphs (h)(1) and (h)(2) of this section, the portion of the bonds allocated to the refunding of that prior issue- (A) Results from a pro rata allocation under paragraph (h)(4)(ii) of this section; (B) Reflects aggregate principal and interest payable in each bond year that is less than, equal to, or proportionate to, the aggregate principal and interest payable on the prior issue in each bond year; (C) Results from an allocation of all the bonds of the entire multipurpose issue in proportion to the remaining weighted average economic life of the capital projects financed or refinanced by the issue, determined in the same manner as under section 147(b); or

(D) Results from another reasonable allocation method, but only to the extent that the application of the allocation methods provided in this paragraph (h)(4)(v) is not permitted under state law restrictions applicable to the bonds, reasonable terms of bonds issued before, or subject to a master indenture that became effective prior to, July 1, 1993, or other similar restrictions or circumstances. This paragraph (h)(4)(v)(D) shall be strictly construed and is available only if it does not result in a greater burden on the market for tax-exempt bonds than would occur using one of the other allocation methods provided in this paragraph (h)(4)(v). (See also §1.148- 11(c)(2).) (5) Limitation on multi-generation allocations. This paragraph (h) does not apply to allocations of a multipurpose refunded issue unless that refunded issue is refunded directly by an issue to which this paragraph (h) applies. For example, if a 1994 issue refunds a 1984 multipurpose issue, which in turn refunded a 1980 multipurpose issue, this paragraph (h) applies to allocations of the 1984 issue for purposes of allocating the refunding purposes of the 1994 issue, but does not permit allocations of the 1980 issue. (i) Operating rules for separation of prior issue into refunded and unrefunded portions-(1) In general. For purposes of paragraph (h)(3)(i) of this section, the separate purposes of a prior issue include the refunded and unrefunded portions of the prior issue. Thus, the refunded and unrefunded portions are treated as separate issues under paragraph (h)(1) of this section. Those separate issues must satisfy the requirements of paragraphs (h) and (i) of this section. The refunded portion of the bonds of a prior issue is based on a fraction the numerator of which is the principal amount of the prior issue to be paid with proceeds of the refunding issue and the denominator of which is the outstanding principal amount of the bonds of the prior issue, each determined as of the issue date of the refunding issue. (See also paragraph (b)(2) of this section.) (2) Allocations of proceeds and investments in a partial refunding. As of the issue date of a partial refunding issue under this paragraph (i), unspent proceeds of the prior issue are allocated ratably between the refunded and unrefunded portions of the prior issue and the investments allocable to those unspent proceeds are allocated in the manner required for the allocation of investments to transferred proceeds under paragraph (c)(1)(ii) of this section. (3) References to prior issue. If the refunded and unrefunded portions of a prior issue are treated as separate issues under this paragraph (i), then, except to the extent that the context clearly requires otherwise (e.g., references to the aggregate prior issue in the mixed escrow rule in paragraph (c)(2) of this section), all references in this section to a prior issue refer only to the refunded portion of that prior issue.

§1.148-10 Anti-abuse rules and authority of Commissioner.

(a) Abusive arbitrage device-(1) In general. Bonds of an issue are arbitrage bonds under section 148 if an abusive arbitrage device under paragraph (a)(2) of this section is used in connection with the issue. This paragraph (a) is to be applied and interpreted broadly to carry out the purposes of section 148, as further described in

§1.148-0. Except as otherwise provided in paragraph (c) of this section, any action

that is expressly permitted by section 148 or §§1.148-1 through 1.148-11 is not an

abusive arbitrage device (e.g., investment in higher yielding investments during a permitted temporary period under section 148(c)). (2) Abusive arbitrage device defined. Any action is an abusive arbitrage device if the action has the effect of- (i) Enabling the issuer to exploit the difference between tax-exempt and taxable interest rates to obtain a material financial advantage; and (ii) Overburdening the tax-exempt bond market. (3) Exploitation of tax-exempt interest rates. An action may exploit tax-exempt interest rates under paragraph (a)(2) of this section as a result of an investment of any portion of the gross proceeds of an issue over any period of time, notwithstanding that, in the aggregate, the gross proceeds of the issue are not invested in higher yielding investments over the term of the issue. (4) Overburdening the tax-exempt market. An action overburdens the tax-exempt bond market under paragraph (a)(2)(ii) of this section if it results in issuing more bonds, issuing bonds earlier, or allowing bonds to remain outstanding longer than is otherwise reasonably necessary to accomplish the governmental purposes of the bonds, based on all the facts and circumstances. Whether an action is reasonably necessary to accomplish the governmental purposes of the bonds depends on whether the primary purpose of the transaction is a bona fide governmental purpose (e.g., an issue of refunding bonds to achieve a debt service restructuring that would be issued independent of any arbitrage benefit). An important factor bearing on this determination is whether the action would reasonably be taken to accomplish the governmental purpose of the issue if the interest on the issue were not excludable from gross income under section 103(a) (assuming that the hypothetical taxable interest rate would be the same as the actual tax-exempt interest rate). Factors evidencing an overissuance include the issuance of an issue the proceeds of which are reasonably expected to exceed by more than a minor portion the amount necessary to accomplish the governmental purposes of the issue, or an issue the proceeds of which are, in fact, substantially in excess of the amount of sale proceeds allocated to expenditures for the governmental purposes of the issue. One factor evidencing an early issuance is the sisuance of bonds that do not qualify for a temporary period under §1.148-2(e)(2), (e)(3), or (e)(4). One factor evidencing that bonds may remain outstanding longer than necessary is a term that exceeds the safe harbors against the creation of replacement proceeds under §1.148-1(c)(4)(i)(B). These factors may be outweighed by other factors, however, such as bona fide cost underruns or long-term financial distress. (b) Consequences of overburdening the tax-exempt bond market-(1) In general. An issue that overburdens the tax-exempt bond market (within the meaning of paragraph (a)(4) of this section) is subject to the following special limitations- (i) Special yield restriction. Investments are subject to the definition of materially higher yield under §1.148-2(d) that is equal to one-thousandth of 1 percent. In addition, each investment is treated as a separate class of investments under §1.148-5(b)(2)(ii), the yield on which may not be blended with that of other investments.

(ii) Certain regulatory provisions inapplicable. The provisions of §1.148-5(c) (relating to yield reduction payments) and §1.148-5(e) (2) and (3) (relating to recovery of qualified administrative costs) do not apply. (iii) Restrictive expenditure rule. Proceeds are not allocated to expenditures unless the proceeds-spent-last rule under §1.148-6(d)(3)(i) is satisfied, applied by treating those proceeds as proceeds to be used for restricted working capital expenditures. For this purpose, available amount includes a reasonable working capital reserve as defined in §1.148-6(d)(3)(iii)(B). (2) Application. The provisions of this paragraph (b) only apply to the portion of the issue that overburdens the market for tax-exempt bonds, except that, for an issue that is reasonably expected as of the issue date to overburden the market, these provisions apply to all of the gross proceeds of the issue. (c) Anti-abuse rules on excess gross proceeds of advance refunding issues-(1) In general. Except as otherwise provided in this paragraph (c), an abusive arbitrage device is used and bonds of an advance refunding issue are arbitrage bonds if the issue has excess gross proceeds. (2) Definition of excess gross proceeds. Excess gross proceeds means all gross proceeds of an advance refunding issue that exceed an amount equal to 1 percent of sale proceeds of the issue, other than gross proceeds allocable to- (i) Payment of principal, interest, or call premium on the prior issue; (ii) Payment of pre-issuance accrued interest on the refunding issue, and interest on the refunding issue that accrues for a period up to the completion date of any capital project for which the prior issue was issued, plus one year; (iii) A reasonably required reserve or replacement fund for the refunding issue or investment proceeds of such a fund; (iv) Payment of costs of issuance of the refunding issue; (v) Payment of administrative costs allocable to repaying the prior issue, carrying and repaying the refunding issue, or investments of the refunding issue; (vi) Transferred proceeds allocable to expenditures for the governmental purpose of the prior issue; (vii) Interest on purpose investments; (viii) Replacement proceeds in a sinking fund for the refunding issue; and (ix) Qualified guarantee fees for the refunding issue or the prior issue. (3) Special treatment of transferred proceeds. For purposes of this paragraph (c), all unspent proceeds of the prior issue as of the issue date of the refunding issue are treated as transferred proceeds of the advance refunding issue.

(4) Special rule for crossover refundings. An advance refunding issue is not an issue of arbitrage bonds under this paragraph (c) if all excess gross proceeds of the refunding issue are used to pay interest that accrues on the refunding issue before the prior issue is discharged, and no gross proceeds of any refunding issue are used to pay interest on the prior issue or to replace funds used directly or indirectly to pay such interest (other than transferred proceeds used to pay interest on the prior issue that accrues for a period up to the completion date of the project for which the prior issue was issued, plus one year, or proceeds used to pay principal that is attributable to accrued original issue discount). (5) Special rule for gross refundings. This paragraph (c)(5) applies if an advance refunding issue (the series B issue) is used together with one or more other advance refunding issues (the series A issues) in a gross refunding of a prior issue, but only if the use of a gross refunding method is required under bond documents that were effective prior to November 6, 1992. These advance refunding issues are not arbitrage bonds under this paragraph (c) if- (i) All excess gross proceeds of the series B issue and each series A issue are investment proceeds used to pay principal and interest on the series B issue; (ii) At least 99 percent of all principal and interest on the series B issue is paid with proceeds of the series B and series A issues or with the earnings on other amounts in the refunding escrow for the prior issue; (iii) The series B issue is discharged not later than the prior issue; and (iv) As of any date, the amount of gross proceeds of the series B issue allocated to expenditures does not exceed the aggregate amount of expenditures before that date for principal and interest on the series B issue, and administrative costs of carrying and repaying the series B issue, or of investments of the series B issue. (d) Examples. The provisions of this section are illustrated by the following examples: Example 1. Mortgage sale. In 1982, City issued its revenue issue (the 1982 issue) and lent the proceeds to Developer to finance a low-income housing project under former section 103(b)(4)(A) of the 1954 Code. In 1994, Developer encounters financial difficulties and negotiates with City to refund the 1982 issue. City issues $10 million in principal amount of its 8 percent bonds (the 1994 issue). City lends the proceeds of the 1994 issue to Developer. To evidence Developer's obligation to repay that loan, Developer, as obligor, issues a note to City (the City note). Bank agrees to provide Developer with a direct-pay letter of credit pursuant to which Bank will make all payments to the trustee for the 1994 issue necessary to meet Developer's obligations under the City note. Developer pays Bank a fee for the issuance of the letter of credit and issues a note to Bank (the Bank note). The Bank note is secured by a mortgage on the housing project and is guaranteed by FHA. The Bank note and the 1982 issue have different prepayment terms. The City does not reasonably expect to treat prepayments of the Bank note as gross proceeds of the 1982 issue. At the same time or pursuant to a series of related transactions, Bank sells the Bank note to Investor for $9.5 million. Bank invests these monies together with its other funds. In substance, the transaction is a loan by City to Bank, under which Bank enters into a series of transactions that, in effect, result in Bank retaining

$9.5 million in amounts treated as proceeds of the 1994 issue. Those amounts are invested in materially higher yielding investments that provide funds sufficient to equal or exceed the Bank's liability under the letter of credit. Alternatively, the letter of credit is investment property in a sinking fund for the 1994 issue provided by Developer, a substantial beneficiary of the financing. Because, in substance, Developer acquires the $10 million prin cipal amount letter of credit for a fair market value purchase price of $9.5 million, the letter of credit is a materially higher yielding investment. Neither result would change if Developer's obligation under the Bank note is contingent on Bank performing its obligation under the letter of credit. Each characterization causes the bonds to be arbitrage bonds. Example 2. Bonds outstanding longer than necessary for yield-blending device. (i) Longer bond maturity to create sinking fund. In 1994, Authority issues an advance refunding issue (the refunding issue) to refund a 1982 prior issue (the prior issue). Under current market conditions, Authority will have to invest the refunding escrow at a yield significantly below the yield on the refunding issue. Authority issues its refunding issue with a longer weighted average maturity than otherwise necessary primarily for the purpose of creating a sinking fund for the refunding issue that will be invested in a guaranteed investment contract. The weighted average maturity of the refunding issue is less than 120 percent of the remaining average economic life of the facilities financed with the proceeds of the prior issue. The guaranteed investment contract has a yield that is higher than the yield on the refunding issue. The yield on the refunding escrow blended with the yield on the guaranteed investment contract does not exceed the yield on the issue. The refunding issue uses an abusive arbitrage device and the bonds of the issue are arbitrage bonds under section 148(a). (ii) Refunding of noncallable bonds. The facts are the same as in paragraph (i) of this Example 2 except that instead of structuring the refunding issue to enable it to take advantage of sinking fund investments, Authority will also refund other long-term, non-callable bonds in the same refunding issue. There are no savings attributable to the refunding of the non-callable bonds (e.g., a low-to-high refunding). The Authority invests the portion of the proceeds of the refunding issue allocable to the refunding of the non-callable bonds in the refunding escrow at a yield that is higher than the yield on the refunding issue, based on the relatively long escrow period for this portion of the refunding. The Authority invests the other portion of the proceeds of the refunding issue in the refunding escrow at a yield lower than the yield on the refunding issue. The blended yield on all the investments in the refunding escrow for the prior issues does not exceed the yield on the refunding issue. The portion of the refunding issue used to refund the noncallable bonds, however, was not otherwise necessary and was issued primarily to exploit the difference between taxable and tax-exempt rates for that long portion of the refunding escrow to minimize the effect of lower yielding investments in the other portion of the escrow. The refunding issue uses an abusive arbitrage device and the bonds of the issue are arbitrage bonds. (iii) Governmental purpose. In paragraphs (i) and (ii) of this Example 2, the existence of a governmental purpose for the described financing structures would not change the conclusions unless Authority clearly established that the primary purpose for the use of the particular structure was a bona fide governmental purpose. The fact that each financing structure had the effect of eliminating significant amounts of negative arbitrage is strong evidence of a primary purpose that is not a bona fide governmental purpose. Moreover, in paragraph (i) of this Example 2, the structure of

the refunding issue coupled with the acquisition of the guaranteed investment contract to lock in the investment yield associated with the structure is strong evidence of a primary purpose that is not a bona fide governmental purpose. Example 3. Window refunding. (i) Authority issues its 1994 refunding issue to refund a portion of the principal and interest on its outstanding 1985 issue. The 1994 refunding issue is structured using zero-coupon bonds that pay no interest or principal for the 5-year period following the issue date. The proceeds of the 1994 refunding issue are deposited in a refunding escrow to be used to pay only the interest requirements of the refunded portion of the 1985 issue. Authority enters into a guaranteed investment contract with a financial institution, G, under which G agrees to provide a guaranteed yield on revenues invested by Authority during the 5-year period following the issue date. The guaranteed investment contract has a yield that is no higher than the yield on the refunding issue. The revenues to be invested under this guaranteed investment contract consist of the amounts that Authority otherwise would have used to pay principal and interest on the 1994 refunding issue. The guaranteed investment contract is structured to generate receipts at times and in amounts sufficient to pay the principal and redemption requirements of the refunded portion of the 1985 issue. A principal purpose of these transactions is to avoid transferred proceeds. Authority will continue to invest the unspent proceeds of the 1985 issue that are on deposit in a refunding escrow for its 1982 issue at a yield equal to the yield on the 1985 issue and will not otherwise treat those unspent proceeds as transferred proceeds of the 1994 refunding issue. The 1994 refunding issue is an issue of arbitrage bonds since those bonds involve a transaction or series of transactions that overburdens the market by leaving bonds outstanding longer than is necessary to obtain a material financial advantage based on arbitrage. Specifically, Authority has structured the 1994 refunding issue to make available for the refunding of the 1985 issue replacement proceeds rather than proceeds so that the unspen t proceeds of the 1985 issue will not become transferred proceeds of the 1994 refunding issue. (ii) The result would be the same in each of the following circumstances: (A) The facts are the same as in paragraph (i) of this Example 3 except that Authority does not enter into the guaranteed investment contract but instead, as of the issue date of the 1994 refunding issue, reasonably expects that the released revenues will be available for investment until used to pay principal and interest on the 1985 issue. (B) The facts are the same as in paragraph (i) of this Example 3 except that there are no unspent proceeds of the 1985 issue and Authority invests the released revenues at a yield materially higher than the yield on the 1994 issue. (C) The facts are the same as in paragraph (i) of this Example 3 except that Authority uses the proceeds of the 1994 issue for capital projects instead of to refund a portion of the 1985 issue. Example 4. Sale of conduit loan. On January 1, 1994, Authority issues a conduit financing issue (the 1994 conduit financing issue) and uses the proceeds to purchase from City, an unrelated party, a tax-exempt bond of City (the City note). The proceeds of the 1994 conduit financing issue are to be used to advance refund a prior conduit financing issue that was issued in 1988 and used to make a loan to

City. The 1994 conduit financing issue and the City note each have a yield of 8 percent on January 1, 1994. On June 30, 1996, interest rates have decreased and Authority sells the City note to D, a person unrelated to either City or Authority. Based on the sale price of the City note and treating June 30, 1996 as the issue date of the City note, the City note has a 6 percent yield. Authority deposits the proceeds of the sale of the City note into an escrow to redeem the bonds of the 1994 conduit financing issue on January 1, 2001. The escrow is invested in nonpurpose investments having a yield of 8 percent. For purposes of section 149(d), City and Authority are related parties and, therefore, the issue date of the City note is treated as being June 30, 1996. Thus, the City note is an advance refunding of Authority's 1994 conduit financing issue. Interest on the City note is not exempt from Federal income tax from the date it is sold to D under section 149(d), because, by investing the escrow investments at a yield of 8 percent instead of a yield not materially higher than 6 percent, the sale of the City note employs a device to obtain a material financial advantage, based on arbitrage, apart from the savings attributable to lower interest rates. In addition, the City note is not a tax-exempt bond because the note is the second advance refunding of the original bond under section 149(d)(3). The City note also employs an abusive arbitrage device and is an arbitrage bond under section 148. Example 5. Re-refunding. (i) On January 1, 1984, City issues a tax-exempt issue (the 1984 issue) to finance the cost of constructing a prison. The 1984 issue has a 7 percent yield and a 30-year maturity. The 1984 issue is callable at any time on or after January 1, 1994. On January 1, 1990, City issues a refunding issue (the 1990 issue) to advance refund the 1984 issue. The 1990 issue has an 8 percent yield and a 30-year maturity. The 1990 issue is callable at any time on or after January 1, 2000. The proceeds of the 1990 issue are invested at an 8 percent yield in a refunding escrow for the 1984 issue (the original 1984 escrow) in a manner sufficient to pay debt service on the 1984 issue until maturity (i.e., an escrow to maturity). On January 1, 1994, City issues a refunding issue (the 1994 issue). The 1994 issue has a 6 percent yield and a 30-year maturity. City does not invest the proceeds of the 1994 issue in a refunding escrow for the 1990 issue in a manner sufficient to pay a portion of the debt service until, and redeem a portion of that issue on, January 1, 2000. Instead, City invests those proceeds at a 6 percent yield in a new refunding escrow for a portion of the 1984 issue (the new 1984 escrow) in a manner sufficient to pay debt service on a portion of the 1984 issue until maturity. City also liquidates the investments allocable to the proceeds of the 1990 issue held in the original 1984 escrow and reinvests those proceeds in an escrow to pay a portion of the debt service on the 1990 issue itself until, and redeem a portion of that issue on, January 1, 2000 (the 1990 escrow). The 1994 bonds are arbitrage bonds and employ an abusive device under section 149(d)(4). Although, in form, the proceeds of the 1994 issue are used to pay principal on the 1984 issue, this accounting for the use of the proceeds of the 1994 issue is an unreasonable, inconsistent accounting method under §1.148-6(a). Moreover, since the proceeds of the 1990 issue were set a side in an escrow to be used to retire the 1984 issue, the use of proceeds of the 1994 issue for that same purpose involves a replacement of funds invested in higher yielding investments under section 148(a)(2). Thus, using a reasonable, consistent accounting method and giving effect to the substance of the transaction, the proceeds of the 1994 issue are treated as used to refund the 1990 issue and are allocable to the 1990 escrow. The proceeds of the 1990 issue are treated as used to refund the 1984 issue and are allocable to the investments in the new 1984 escrow. The proceeds of the 1990 issue allocable to the nonpurpose investments in the new 1984 escrow become transferred proceeds of the 1994 issue as principal is paid on

the 1990 issue from amounts on deposit in the 1990 escrow. As a result, the yield on nonpurpose investments allocable to the 1994 issue is materially higher than the yield on the 1994 issue, causing the bonds of the 1994 issue to be arbitrage bonds. In addition, the transaction employs a device under section 149(d)(4) to obtain a material financial advantage based on arbitrage, other than savings attributable to lower interest rates. (ii) The following changes in the facts do not affect the conclusion that the 1994 issue consists of arbitrage bonds- (1) The 1990 issue is a taxable issue; (2) The original 1984 escrow is used to pay the 1994 issue (rather than the 1990 issue); or (3) The 1994 issue is used to retire the 1984 issue within 90 days of January 1, 1994. (e) Authority of the Commissioner to clearly reflect the economic substance of a transaction. If an issuer enters into a transaction for a principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the purposes of section 148, the Commissioner may exercise her discretion to depart from the rules of

§1.148-1 through §1.148-11 as necessary to clearly reflect the economic substance

of the transaction. For this purpose, the Commissioner may recompute yield on an issue or on investments, reallocate payments and receipts on investments, recompute the rebate amount on an issue, or otherwise adjust any item whatsoever bearing upon the investments and expenditures of gross proceeds of an issue. (f) Authority of the Commissioner to require an earlier date for payment of rebate. If the Commissioner determines that an issue is likely to fail to meet the requirements of §1.148-3 and that a failure to serve a notice of demand for payment on the issuer will jeopardize the assessment or collection of tax on interest paid or to be paid on the issue, the date that the Commissioner serves notice on the issuer is treated as a required computation date for payment of rebate for that issue. (g) Authority of the Commissioner to waive regulatory limitations. Notwithstanding any specific provision in §§1.148-1 through 1.148-11, the Commissioner may prescribe extensions of temporary periods, larger reasonably required reserve or replacement funds, or consequences of failures or remedial action under section 148 in lieu of or in addition to other consequences of those failures, or take other action, if the Commissioner finds that good faith or other similar circumstances so warrant, consistent with the purposes of section 148.

§1.148-11 Effective dates.

(a) In general. Except as otherwise provided in this section, the provisions of

§1.148-1 through §1.148-11 apply to all issues issued after June 30, 1993.

(b) Elective retroactive application in whole-(1) In general. Except as otherwise provided in this section and subject to the applicable effective dates of the

corresponding statutory provisions, an issuer may apply the provisions of §1.148-1 through §1.148-11 in whole, but not in part, to any issue that is outstanding on June 30, 1993, and is subject to section 148(f) or to sections 103(c)(6) or 103A(i) of the Internal Revenue Code of 1954, in lieu of otherwise applicable regulations under those sections. (2) No elective retroactive application for 18-month spending exception. The provisions of §1.148-7(d) (relating to the 18-month spending exception) may not be applied to any issue issued on or before June 30, 1993. (c) Elective retroactive application of certain provisions and special rules-(1) In general. An issuer may apply any of the following individual provisions of §1.148-1 through §1.148-11 to outstanding issues issued on or before August 15, 1993, in the indicated manner- (i) Certain commingled funds. If paragraph (a) of this section applies to an issue, and that issue has a commingled fund to which the provisions of §1.148-6(e)(6) (relating to commingled reserves) apply, that provision may be applied to all issues secured by that commingled reserve. (ii) Certain applications of the universal cap. The provisions of §1.148-5(c)(3)(i)(F) (and related provisions) may be applied to satisfy the requirements of section 148 (or applicable prior law) if the application of the universal cap results in amounts in a refunding escrow becoming replacement proceeds of an issue issued on or before June 30, 1993. (2) Certain allocations of multipurpose issues. An allocation of bonds to a refunding purpose under §1.148-9(h) may be adjusted as necessary to reflect allocations made between May 18, 1992, and August 15, 1993, in connection with the issuance of a refunding issue issued during that period if the allocations satisfied the corresponding prior provision of §1.148-11(j)(4) under applicable prior regulations. (3) Special limitation. The provisions of §1.148-9 apply to issues issued before August 15, 1993, only if the issuer in good faith estimates the present value savings, if any, associated with the effect of the application of that section on refunding escrows, using any reasonable accounting method, and applies those savings, if any, to redeem outstanding tax-exempt bonds of the applicable issue at the earliest possible date on which those bonds may be redeemed or otherwise retired. These savings are not reduced to take into account any administrative costs associated with applying these provisions retroactively. (d) Transition rule excepting certain state guarantee funds from the definition of replacement proceeds-(1) Certain perpetual trust funds. A guarantee by a fund created and controlled by a State and established pursuant to its constitution does not cause the amounts in the fund to be pledged funds treated as replacement proceeds if- (i) Substantially all of the corpus of the fund consists of nonfinancial assets, revenues derived from these assets, gifts, and bequests;

(ii) The corpus of the guarantee fund may be invaded only to support specifically designated essential governmental functions (designated functions) carried on by political subdivisions with general taxing powers; (iii) Substantially all of the available income of the fund is required to be applied annually to support designated functions; (iv) The issue guaranteed consists of general obligations that are not private activity bonds substantially all of the proceeds of which are to be used for designated functions; (v) The fund satisfied each of the requirements of paragraphs (d)(1)(i) through (d)(1)(iii) of this section on August 16, 1986; and (vi) The guarantee is not attributable to a deposit to the fund made after May 14, 1989, unless- (A) The deposit is attributable to the sale or other disposition of fund assets; or (B) Prior to the deposit, the outstanding amount of the bonds guaranteed by the fund did not exceed 250 percent of the lower of the cost or fair market value of the fund. (2) Permanent University Fund. Replacement proceeds do not include amounts allocable to investments of the fund described in section 648 of Public Law 98-369. (e) Transition rule regarding special allowance payments. Section 1.148-5(b)(5) applies to any bond issued after January 5, 1990, except a bond issued exclusively to refund a bond issued before January 6, 1990, if the amount of the refunding bond does not exceed 101 percent of the amount of the refunded bond, and the maturity date of the refunding bond is not later than the date that is 17 years after the date on which the refunded bond was issued (or, in the case of a series of refundings, the date on which the original bond was issued). (f) Transition rule regarding applicability of yield reduction rule. Section 1.148-5(c) applies to nonpurpose investments allocable to replacement proceeds of an issue that are held in a reserve or replacement fund to the extent that- (1) Amounts must be paid into the fund under a constitutional provision, statute, or ordinance adopted before May 3, 1978; (2) Under that provision, amounts paid into the fund (and investment earnings thereon) can be used only to pay debt service on the issues; and (3) The size of the payments made into the fund is independent of the size of the outstanding issues or the debt service thereon. (g) Extension of due date for rebate payments. Payments of rebate under section 148(f) that are otherwise due after June 30, 1993, and before September 1, 1993, may be paid by September 1, 1993.

(h) Elective application of existing regulations. For an issue issued after June 30, 1993 and before August 15, 1993, an issuer may apply the provisions of T.D. 7627, sections 1.103-13, 1.103-14, 1.103-15, 1979-2 C.B. 45, (see §601.601(d)(2)(ii)(b)) of this chapter, as amended by T.D. 8418, 1992-1 C.B. 29; T.D. 8345, section 1.103-13T, 1991-1 C.B. 33; and T.D. 8418, sections 1.148-0 through 1.148-11, 1.149(d)-1 and 1.150-1, 1992-1 C.B. 29, in whole, but not in part, in lieu of applying these regulations under paragraph (a) of this section, without regard to §1.148- 0(b)(2)(ii)(D) of those provisions. §§1.148-12T and 1.148-13T (Removed) Par. 5a. Sections 1.148-12T and 1.148-13T are removed. Par. 6. Section 1.149(b)-1 is added to read as follows: §1.149(b)-1 Federally guaranteed bonds. (a) General rule. Under section 149(b) and this section, nothing in section 103(a) or in any other provision of law shall be construed to provide an exemption from Federal income tax for interest on any bond issued as part of an issue that is federally guaranteed. (b) Exceptions. Pursuant to section 149(b)(3)(B), section 149(b)(1) and paragraph (a) of this section do not apply to- (1) Investments in obligations issued pursuant to §21B(d)(3) of the Federal Home Loan Bank Act, as amended by §511 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, or any successor provision; or (2) Any investments that are held in a refunding escrow (as defined in §1.148-1). (c) Effective date. This section applies to investments made after June 30, 1993. §1.149(b)(3)-1T (Removed) Par. 7. Section §1.149(b)(3)-1T is removed. Par. 8. Section 1.149(d)-1 is revised to read as follows: §1.149(d)-1 Limitations on advance refundings. (a) General rule. Under section 149(d) and this section, nothing in section 103(a) or in any other provision of law shall be construed to provide an exemption from Federal income tax for interest on any bond issued as part of an issue described in paragraphs (2), (3), or (4) of section 149(d). (b) Advance refunding issues that employ abusive devices-(1) In general. An advance refunding issue employs an abusive device and is described in section 149(d)(4) if the issue violates any of the anti-abuse rules under §1.148-10.

(2) Failure to pay required rebate. An advance refunding issue is described in section 149(d)(4) if the issue fails to meet the requirements of §1.148-3. This paragraph (b)(2) applies to any advance refunding issue issued after August 31, 1986. (3) Mixed escrows invested in tax-exempt bonds. An advance refunding issue is described in section 149(d)(4) if- (i) Any of the proceeds of the issue are invested in a refunding escrow in which a portion of the proceeds are invested in tax-exempt bonds and a portion of the proceeds are invested in nonpurpose investments; (ii) The yield on the tax-exempt bonds in the refunding escrow exceeds the yield on the issue; (iii) The yield on all the investments (including investment property and tax-exempt bonds) in the refunding escrow exceeds the yield on the issue; and (iv) The weighted average maturity of the tax-exempt bonds in the refunding escrow is more than 25 percent greater or less than the weighted average maturity of the nonpurpose investments in the refunding escrow, and the weighted average maturity of nonpurpose investments in the refunding escrow is greater than 60 days. (4) Tax-exempt conduit loans. For purposes of applying section 149(d) to a conduit financing issue that finances any conduit loan that is a tax-exempt bond, the actual issuer of a conduit financing issue and the conduit borrower of that conduit financing issue are treated as related parties. Thus, the issue date of the conduit loan does not occur prior to the date on which the actual issuer of the conduit financing issue sells, exchanges, or otherwise disposes of that conduit loan, and the use of the proceeds of the disposition to pay debt service on the conduit financing issue causes the conduit loan to be a refunding issue. See §1.148-10(d), Example 4. (c) Unrefunded debt service remains eligible for future advance refunding. For purposes of section 149(d)(3)(A)(i), any principal or interest on a prior issue that has not been paid or provided for by any advance refunding issue is treated as not having been advance refunded. (d) Application of arbitrage regulations-(1) Application of multipurpose issue rules. For purposes of sections 149(d)(2) and (3)(A)(i), (ii), and (iii), the provisions of the multipurpose issue rule in §1.148-9(h) apply. (2) General mixed escrow rules. For purposes of section 149(d), the provisions of §1.148-9(c) (relating to mixed escrows) apply, except that those provisions do not apply for purposes of section 149(d)(2) and (d)(3)(A) (i) and (ii) to amounts that were not gross proceeds of the prior issue before the issue date of the refunding issue. (3) Temporary periods and minor portions. Section 1.148-9(d) and (f) contains rules applicable to temporary periods and minor portions for advance refunding issues. (4) Definitions. Section 1.148-1 applies for purposes of section 149(d).

(e) Taxable refundings-(1) In general. Except as provided in paragraph (e)(2) of this section, for purposes of section 149(d)(3)(A)(i), an advance refunding issue the interest on which is not excludable from gross income under section 103(a) (i.e., a taxable advance refunding issue) is not taken into account. In addition, for this purpose, an advance refunding of a taxable issue is not taken into account unless the taxable issue is a conduit loan of a tax-exempt conduit financing issue. (2) Use to avoid section 149(d)(3)(A)(i). A taxable issue is taken into account under section 149(d)(3)(A)(i) if it is issued to avoid the limitations of that section. For example, in the case of a refunding of a tax-exempt issue with a taxable advance refunding issue that is, in turn, currently refunded with a tax-exempt issue, the taxable advance refunding issue is taken into account under section 149(d)(3)(A)(i) if the two tax-exempt issues are outstanding concurrently for more than 90 days. (f) Redemption at first call date-(1) General rule. Under sections 149(d)(3)(A) (ii) and (iii) (the first call requirement), bonds refunded by an advance refunding must be redeemed on their first call date if the savings test under section 149(d)(3)(B)(i) (the savings test) is satisfied. The savings test is satisfied if the issuer may realize present value debt service savings (determined without regard to administrative expenses) in connection with the issue of which the refunding bond is a part. (2) First call date. First call date means the earliest date on which a bond may be redeemed (or, if issued before 1986, on the earliest date on which that bond may be redeemed at a redemption price not in excess of 103 percent of par). If, however, the savings test is not met with respect to the date described in the preceding sentence (i.e., there are no present value savings if the refunded bonds are retired on that date), the first call date is the first date thereafter on which the bonds can be redeemed and on which the savings test is met. (3) Savings test. Except as provided below, the multipurpose issue allocation rules apply for purposes of the savings test. The savings test is satisfied and the first call requirement applies to a bond if the refunding of that bond increases the aggregate present value debt service savings on the entire refunding issue when compared with the aggregate present value debt service savings if that bond were not refunded. (g) Effective date-(1) In general. Except as provided in paragraph (g)(2) of this section, this section applies to bonds issued after June 30, 1993, to which §§1.148-1 through 1.148-11 apply, including conduit loans that are treated as issued after June 30, 1993, under paragraph (b)(4) of this section. In addition, this section applies to any issue to which the election described in §1.148-11(b)(1) is made. (2) Special effective date for paragraph (b)(3). Paragraph (b)(3) of this section applies to any advance refunding issue issued after May 28, 1991. Par. 9. Section 1.149(g)-1 is added to read as follows: §1.149(g)-1 Hedge bonds. (a) Certain definitions. Except as otherwise provided, the definitions set forth in

§1.148-1 apply for purposes of section 149(g) and this section. In addition, the

following terms have the following meanings:

Reasonable expectations means reasonable expectations (as defined in §1.148-1), as modified to take into account the provisions of section 149(f)(2)(B). Spendable proceeds means net sale proceeds (as defined in §1.148-1). (b) Applicability of arbitrage allocation and accounting rules. Section 1.148-6 applies for purposes of section 149(g), except that an expenditure that results in the creation of replacement proceeds (other than amounts in a bona fide debt service fund or a reasonably required reserve or replacement fund) is not an expenditure for purposes of section 149(g). (c) Refundings-(1) Investment in tax-exempt bonds. A bond issued to refund a bond that is a tax-exempt bond by virtue of the rule in section 149(g)(3)(B) is not a tax-exempt bond unless the gross proceeds of that refunding bond (other than proceeds in a refunding escrow for the refunded bond) satisfy the requirements of section 149(g)(3)(B). (2) Anti-abuse rule. A refunding bond is treated as a hedge bond unless there is a significant governmental purpose for the issuance of that bond (e.g., an advance refunding bond issued to realize debt service savings or to relieve the issuer of significantly burdensome document provisions, but not to otherwise hedge against future increases in interest rates). (d) Effective date. This section applies to bonds issued after June 30, 1993 to which §§1.148-1 through 1.148-11 apply. In addition, this section applies to any issue to which the election described in §1.148-11(b)(1) is made. Par. 10. Section 1.150-1 is revised to read as follows:

§1.150-1 Definitions.

(a) Scope and effective date-(1) In general. Except as otherwise provided, the definitions in this section apply for all purposes of sections 103 and 141 through 150. (2) Effective date. This section applies to issues issued after June 30, 1993 to which §§1.148-1 through 1.148-11 apply. In addition, this section (other than paragraph (c)(3) of this section) applies to any issue to which the election described in §1.148- 11(b)(1) is made. (b) Certain general definitions. The following definitions apply: Bond means any obligation of a State or political subdivision thereof under section 103(c)(1). Capital expenditure means any cost of a type that is properly chargeable to capital account (or would be so chargeable with a proper election or with the application of the definition of placed in service under §1.150-2(c)) under general Federal income tax principles. For example, costs incurred to acquire, construct, or improve land, buildings, and equipment generally are capital expenditures. Whether an expenditure is a capital expenditure is determined at the time the expenditure is paid with

respect to the property. Future changes in law do not affect whether an expenditure is a capital expenditure. Conduit borrower means the obligor on a purpose investment (as defined in §1.148- 1). For example, if an issuer invests proceeds in a purpose investment in the form of a loan, lease, installment sale obligation, or similar obligation to another entity and the obligor uses the proceeds to carry out the governmental purpose of the issue, the obligor is a conduit borrower. Conduit financing issue means an issue the proceeds of which are used or are reasonably expected to be used to finance at least one purpose investment representing at least one conduit loan to one conduit borrower. Conduit loan means a purpose investment (as defined in §1.148-1). Governmental bond means any bond of an issue of tax-exempt bonds in which none of the bonds are private activity bonds. Issuance costs means costs to the extent incurred in connection with, and allocable to, the issuance of an issue within the meaning of section 147(g). For example, issuance costs include the following costs but only to the extent incurred in connection with, and allocable to, the borrowing: underwriters' spread; counsel fees; financial advisory fees; rating agency fees; trustee fees; paying agent fees; bond registrar, certification, and authentication fees; accounting fees; printing costs for bonds and offering documents; public approval process costs; engineering and feasibility study costs; guarantee fees, other than for qualified guarantees (as defined in §1.148-4(f)); and similar costs. Issue date means, in reference to an issue, the first date on which the issuer receives the purchase price in exchange for delivery of the evidence of indebtedness representing any bond included in the issue. Issue date means, in reference to a bond, the date on which the issuer receives the purchase price in exchange for that bond. In no event is the issue date earlier than the first day on which interest begins to accrue on the bond or bonds for Federal income tax purposes. Obligation means any valid evidence of indebtedness under general Federal income tax principles. Pooled financing issue means an issue the proceeds of which are to be used to finance purpose investments representing conduit loans to two or more conduit borrowers, unless those conduit loans are to be used to finance a single capital project. Private activity bond means a private activity bond (as defined in section 141). Qualified mortgage loan means a mortgage loan with respect to an owner-occupied residence acquired with the proceeds of an obligation described in section 143(a)(1) or 143(b) (or applicable prior law). Qualified student loan means a student loan acquired with the proceeds of an obligation described in section 144(b)(1).

Related party means, in reference to a governmental unit or a 501(c)(3) organization, any member of the same controlled group, and, in reference to any person that is not a governmental unit or 501(c)(3) organization, a related person (as defined in section 144(a)(3)). Taxable bond means any obligation the interest on which is not excludable from gross income under section 103. Tax-exempt bond means any bond the interest on which is excludable from gross income under section 103(a). Tax-exempt bond includes an interest in a regulated investment company to the extent that at least 95 percent of the income to the holder of the interest is interest that is excludable from gross income under section 103(a). Working capital expenditure means any cost that is not a capital expenditure. Generally, current operating expenses are working capital expenditures. (c) Definition of issue-(1) In general. The provisions of this paragraph (c) apply for all purposes of sections 103 and 141 through 150. Except as otherwise provided in this paragraph (c), two or more bonds are treated as part of the same issue if all of the following factors are present: (i) Sold at substantially the same time. The bonds are sold at substantially the same time. Bonds are treated and sold at substantially the same time if they are sold less than 15 days apart. For this purpose only, a variable yield bond is treated and sold on its issue date. (ii) Sold pursuant to the same plan of financing. The bonds are sold pursuant to the same plan of financing. Factors material to the plan of financing include the purposes for the bonds and the structure of the financing. For example, generally- (A) Bonds to finance a single facility or related facilities are part of the same plan of financing; (B) Short-term bonds to finance working capital expenditures and long-term bonds to finance capital projects are not part of the same plan of financing; and (C) Certificates of participation in a lease and general obligation bonds secured by tax revenues are not part of the same plan of financing. (iii) Payable from same source of funds. The bonds are reasonably expected to be paid from substantially the same source of funds, determined without regard to guarantees from unrelated parties. (2) Exception for taxable bonds. Taxable bonds and tax-exempt bonds are not part of the same issue under this paragraph (c). The issuance of tax-exempt bonds in a transaction (or series of related transactions) that includes taxable bonds, however, may constitute an abusive arbitrage device under §1.148-10(a) or a device to avoid other limitations in sections 103 and 141 through 150 (for example, structures involving windows or unreasonable allocations of bonds).

(3) Exception for certain bonds financing separate purposes-(i) In general. Bonds may be treated as part of separate issues if the requirements of this paragraph (c)(3) are satisfied. Each of these separate issues must finance a separate purpose (e.g., refunding a separate prior issue, financing a separate purpose investment, financing integrated or functionally related capital projects, and financing any clearly discrete governmental purpose). Each of these separate issues independently must be a tax-exempt bond (e.g., a governmental bond or a qualified mortgage bond). The aggregate proceeds, investments, and bonds in such a transaction must be allocated between each of the separate issues using a reasonable, consistently applied allocation method. If any separate issue consists of refunding bonds, the allocation rules in §1.148-9(h) must be satisfied. An allocation is not reasonable if it achieves more favorable results under sections 103 and 141 to 150 than could be achieved with actual separate issues. All allocations under this paragraph (c)(3) must be made in writing on or before the issue date. (ii) Exceptions. This paragraph (c)(3) does not apply for purposes of sections 141(b)(5), 141(c)(1), 141(d)(1), 144(a), 148, 149(d), and 149(g). (4) Special rules for draw-down loans and commercial paper-(i) Draw-down loans. Bonds issued pursuant to a draw-down loan are treated as part of a single issue. The issue date of that issue is the first date on which the aggregate draws under the loan exceed the lesser of $50,000 or 5 percent of the issue price. (ii) Commercial paper-(A) In general. Short-term bonds having a maturity of 270 days or less (commercial paper) issued pursuant to the same commercial paper program may be treated as part of a single issue, the issue date of which is the first date the aggregate amount of commercial paper issued under the program exceeds the lesser of $50,000 or 5 percent of the aggregate issue price of the commercial paper in the program. A commercial paper program is a program to issue commercial paper to finance or refinance the same governmental purpose pursuant to a single master legal document. Commercial paper is not part of the same commercial paper program unless issued during an 18-month period, beginning on the deemed issue date. In addition, commercial paper issued after the end of this 18-month period may be treated as part of the program to the extent issued to refund commercial paper that is part of the program, but only to the extent that- (1) There is no increase in the principal amount outstanding; and (2) The program does not have a term in excess of- (i) 30 years; or (ii) The period reasonably necessary for the governmental purposes of the program. (B) Safe harbor. The requirement of paragraph (c)(4)(ii)(A)(2) of this section is treated as satisfied if the weighted average maturity of the issue does not exceed 120 percent of the weighted average expected economic life of the property financed by the issue. (5) Anti-abuse rule. In order to prevent the avoidance of sections 103 and 141 through 150 and the general purposes thereof, the Commissioner may treat bonds

as part of the same issue or as part of separate issues to clearly reflect the economic substance of a transaction. (d) Definition of refunding issue and related definitions-(1) General definition of refunding issue. Refunding issue means an issue of obligations the proceeds of which are used to pay principal, interest, or redemption price on another issue (a prior issue, as more particularly defined in paragraph (d)(5) of this section), including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund, or similar costs, if any, properly allocable to that refunding issue. (2) Exceptions and special rules. For purposes of paragraph (d)(1) of this section, the following exceptions and special rules apply- (i) Payment of certain interest. An issue is not a refunding issue if the only principal and interest that is paid with proceeds of the issue (determined without regard to the multipurpose issue rules of §1.148-9(h)) is interest on another issue that- (A) Accrues on the other issue during a one-year period including the issue date of the issue that finances the interest; (B) Is a capital expenditure; or (C) Is a working capital expenditure to which the de minimis rule of §1.148- 6(d)(3)(ii)(A) applies. (ii) Certain issues with different obligors-(A) In general. An issue is not a refunding issue to the extent that the obligor (as defined in paragraph (d)(2)(ii)(B) of this section) of one issue is neither the obligor of the other issue nor a related party with respect to the obligor of the other issue. (B) Definition of obligor. The obligor of an issue means the actual issuer of the issue, except that the obligor of the portion of an issue properly allocable to an investment in a purpose investment means the conduit borrower under that purpose investment. The obligor of an issue used to finance qualified mortgage loans, qualified student loans, or similar program investments (as defined in §1.148-1) does not include the ultimate recipient of the loan (e.g., the homeowner, the student). (iii) Certain special rules for purpose investments. For purposes of this paragraph (d), the following special rules apply: (A) Refunding of a conduit financing issue by a conduit loan refunding issue. Except as provided in paragraph (d)(2)(iii)(B) of this section, the use of the proceeds of an issue that is used to refund an obligation that is a purpose investment (a conduit refunding issue) by the actual issuer of the conduit financing issue determines whether the conduit refunding issue is a refunding of the conduit financing issue (in addition to a refunding of the obligation that is the purpose investment). (B) Recycling of certain payments under purpose investments. A conduit refunding issue is not a refunding of a conduit financing issue to the extent that the actual issuer of the conduit financing issue reasonably expects as of the date of receipt of

the proceeds of the conduit refunding issue to use those amounts within 6 months (or, if greater, during the applicable temporary period for those amounts under section 148(c) or under applicable prior law) to acquire a new purpose investment. Any new purpose investment is treated as made from the proceeds of the conduit financing issue. (C) Application to tax-exempt loans. For purposes of this paragraph (d), obligations that would be purpose investments (absent section 148(b)(3)(A)) are treated as purpose investments. (iv) Substance of transaction controls. In the absence of other applicable controlling rules under this paragraph (d), the determination of whether an issue is a refunding issue is based on the substance of the transaction in light of all the facts and circumstances. (v) Certain integrated transactions in connection with asset acquisition not treated as refunding issues. If, within six months before or after a person assumes (including taking subject to) obligations of an unrelated party in connection with an asset acquisition (other than a transaction to which section 381(a) applies if the person assuming the obligation is the acquiring corporation within the meaning of section 381(a)), the assumed issue is refinanced, the refinancing issue is not treated as a refunding issue. (3) Current refunding issue. Current refunding issue means: (i) Except as provided in paragraph (d)(3)(ii) of this section, a refunding issue that is issued not more than 90 days before the last expenditure of any proceeds of the refunding issue for the payment of principal or interest on the prior issue; and (ii) In the case of a refunding issue issued before 1986- (A) A refunding issue that is issued not more than 180 days before the last expenditure of any proceeds of the refunding issue for the payment of principal or interest on the prior issue; or (B) A refunding issue if the prior issue had a term of less than 3 years and was sold in anticipation of permanent financing, but only if the aggregate term of all prior issues sold in anticipation of permanent financing was less than 3 years. (4) Advance refunding issue. Advance refunding issue means a refunding issue that is not a current refunding issue. (5) Prior issue. Prior issue means an issue of obligations all or a portion of the principal, interest, or call premium on which is paid or provided for with proceeds of a refunding issue. A prior issue may be issued before, at the same time as, or after a refunding issue. If the refunded and unrefunded portions of a prior issue are treated as separate issues under §1.148-9(i), for the purposes for which that section applies, except to the extent that the context clearly requires otherwise, references to a prior issue refer only to the refunded portion of that prior issue.

(e) Controlled group means a group of entities controlled directly or indirectly by the same entity or group of entities within the meaning of this paragraph (e). (1) Direct control. The determination of direct control is made on the basis of all the relevant facts and circumstances. One entity or group of entities (the controlling entity) generally controls another entity or group of entities (the controlled entity) for purposes of this paragraph if the controlling entity possesses either of the following rights or powers and the rights or powers are discretionary and non-ministerial- (i) The right or power both to approve and to remove without cause a controlling portion of the governing body of the controlled entity; or (ii) The right or power to require the use of funds or assets of the controlled entity for any purpose of the controlling entity. (2) Indirect control. If a controlling entity controls a controlled entity under the test in paragraph (e)(1) of this section, then the controlling entity also controls all entities controlled, directly or indirectly, by the controlled entity or entities. (3) Exception for general purpose governmental entities. An entity is not a controlled entity under this paragraph (e) fi the entity possesses substantial taxing, eminent domain, and police powers. For example, a city possessing substantial amounts of each of these sovereign powers is not a controlled entity of the state. Par. 11. Section 1.150-2 is added to read as follows:

§1.150-2 Proceeds of bonds used for reimbursement.

(a) Table of contents. This table of contents contains a listing of the headings contained in §1.150-2. (a) Table of contents. (b) Scope. (c) Definitions. (d) General operating rules for reimbursement expenditures. (1) Official intent. (2) Reimbursement period. (3) Nature of expenditure. (e) Official intent rules. (1) Form of official intent. (2) Project description in official intent. (3) Reasonableness of official intent. (f) Exceptions to general operating rules. (1) De minimis exception. (2) Preliminary expenditures exception. (g) Special rules on refundings. (1) In general-once financed, not reimbursed. (2) Certain proceeds of prior issue used for reimbursement treated as unspent. (h) Anti-abuse rules. (1) General rule. (2) One-year step transaction rule. (i) Authority of the Commissioner to prescribe rules. (j) Effective date. (1) In general. (2) Transitional rules. (b) Scope. This section applies to reimbursement bonds (as defined in paragraph (c) of this section) for all purposes of sections 103 and 141 to 150. (c) Definitions. The following definitions apply: Issuer means- (1) For any private activity bond (excluding a qualified 501(c)(3) bond, qualified student loan bond, qualified mortgage bond, or qualified veterans' mortgage bond), the entity that actually issues the reimbursement bond; and

(2) For any bond not described in paragraph (1) of this definition, either the entity that actually issues the reimbursement bond or, to the extent that the reimbursement bond proceeds are to be loaned to a conduit borrower, that conduit borrower. Official intent means an issuer's declaration of intent to reimburse an original expenditure with proceeds of an obligation. Original expenditure means an expenditure for a governmental purpose that is originally paid from a source other than a reimbursement bond. Placed in service means, with respect to a facility, the date on which, based on all the facts and circumstances- (1) The facility has reached a degree of completion which would permit its operation at substantially its design level; and (2) The facility is, in fact, in operation at such level. Reimbursement allocation means an allocation in writing that evidences an issuer's use of proceeds of a reimbursement bond to reimburse an original expenditure. An allocation made within 30 days after the issue date of a reimbursement bond may be treated as made on the issue date. Reimbursement bond means the portion of an issue allocated to reimburse an original expenditure that was paid before the issue date. (d) General operating rules for reimbursement expenditures. Except as otherwise provided, a reimbursement allocation is treated as an expenditure of proceeds of a reimbursement bond for the governmental purpose of the original expenditure on the date of the reimbursement allocation only if: (1) Official intent. Not later than 60 days after payment of the original expenditure, the issuer adopts an official intent for the original expenditure that satisfies paragraph (e) of this section. (2) Reimbursement period-(i) In general. The reimbursement allocation is made not later than 18 months after the later of- (A) The date the original expenditure is paid; or (B) The date the project is placed in service or abandoned, but in no event more than 3 years after the original expenditure is paid. (ii) Special rule for small issuers. In applying paragraph (d)(2)(i) of this section to an issue that satisfies section 148(f)(4)(D)(i) (I) through (IV), the "18 month" limitation is changed to "3 years" and the "3-year" maximum reimbursement period is disregarded. (iii) Special rule for long-term construction projects. In applying paragraph (d)(2)(i) to a construction project for which both the issuer and a licensed architect or

engineer certify that at least 5 years is necessary to complete construction of the project, the maximum reimbursement period is changed from "3 years" to "5 years." (3) Nature of expenditure. The original expenditure is a capital expenditure, a cost of issuance for a bond, an expenditure described in §1.148-6(d)(3)(ii)(B) (relating to certain extraordinary working capital items), a grant (as defined in §1.148-6(d)(4)), a qualified student loan, a qualified mortgage loan, or a qualified veterans' mortgage loan. (e) Official intent rules. An official intent satisfies this paragraph (e) if: (1) Form of official intent. The official intent is made in any reasonable form, including issuer resolution, action by an appropriate representative of the issuer (e.g., a person authorized or designated to declare official intent on behalf of the issuer), or specific legislative authorization for the issuance of obligations for a particular project. (2) Project description in official intent-(i) In general. The official intent generally describes the project for which the original expenditure is paid and states the maximum principal amount of obligations expected to be issued for the project. A project includes any property, project, or program (e.g., highway capital improvement program, hospital equipment acquisition, or school building renovation). (ii) Fund accounting. A project description is sufficient if it identifies, by name and functional purpose, the fund or account from which the original expenditure is paid (e.g., parks and recreation fund-recreational facility capital improvement program). (iii) Reasonable deviations in project description. Deviations between a project described in an official intent and the actual project financed with reimbursement bonds do not invalidate the official intent to the extent that the actual project is reasonably related in function to the described project. For example, hospital equipment is a reasonable deviation from hospital building improvements. In contrast, a city office building rehabilitation is not a reasonable deviation from highway improvements. (3) Reasonableness of official intent. On the date of the declaration, the issuer must have a reasonable expectation (as defined in §1.148-1(b)) that it will reimburse the original expenditure with proceeds of an obligation. Official intents declared as a matter of course or in amounts substantially in excess of the amounts expected to be necessary for the project (e.g., blanket declarations) are not reasonable. Similarly, a pattern of failure to reimburse actual original expenditures covered by official intents (other than in extraordinary circumstances) is evidence of unreasonableness. An official intent declared pursuant to a specific legislative authorization is rebuttably presumed to satisfy this paragraph (e)(3). (f) Exceptions to general operating rules-(1) De minimis exception. Paragraphs (d)(1) and (d)(2) of this section do not apply to costs of issuance of any bond or to an amount not in excess of the lesser of $100,000 or 5 percent of the proceeds of the issue.

(2) Preliminary expenditures exception. Paragraphs (d)(1) and (d)(2) of this section do not apply to any preliminary expenditures, up to an amount not in excess of 20 percent of the aggregate issue price of the issue or issues that finance or are reasonably expected by the issuer to finance the project for which the preliminary expenditures were incurred. Preliminary expenditures include architectural, engineering, surveying, soil testing, reimbursement bond issuance, and similar costs that are incurred prior to commencement of acquisition, construction, or rehabilitation of a project, other than land acquisition, site preparation, and similar costs incident to commencement of construction. (g) Special rules on refundings-(1) In general-once financed, not reimbursed. Except as provided in paragraph (g)(2) of this section, paragraph (d) of this section does not apply to an allocation to pay principal or interest on an obligation to reimburse an original expenditure paid by another obligation. Instead, such an allocation is analyzed under rules on refunding issues. See §1.148-9. (2) Certain proceeds of prior issue used for reimbursement treated as unspent. In the case of a refunding issue (or series of refunding issues), proceeds of a prior issue purportedly used to reimburse original expenditures are treated as unspent proceeds of the prior issue unless the purported reimbursement was a valid expenditure under applicable law on reimbursement expenditures on the issue date of the prior issue. (h) Anti-abuse rules-(1) General rule. A reimbursement allocation is not an expenditure of proceeds of an issue under this section if the allocation employs an abusive arbitrage device under §1.148-10 to avoid the arbitrage restrictions or to avoid the restrictions under sections 142 through 147. (2) One-year step transaction rule-(i) Creation of replacement proceeds. A purported reimbursement allocation is invalid and thus is not an expenditure of proceeds of an issue if, within 1 year after the allocation, funds corresponding to the proceeds of a reimbursement bond for which a reimbursement allocation was made are used in a manner that results in the creation of replacement proceeds (as defined in §1.148-1) of that issue or another issue. The preceding sentence does not apply to amounts deposited in a bona fide debt service fund (as defined in §1.148-1). (ii) Example. The provisions of paragraph (h)(2)(i) of this section are illustrated by the following example. Example. On January 1, 1994, County A issues an issue of 7 percent tax-exempt bonds (the 1994 issue) and makes a purported reimbursement allocation to reimburse an original expenditure for specified capital improvements. A immediately deposits funds corresponding to the proceeds subject to the reimbursement allocation in an escrow fund to provide for payment of principal and interest on its outstanding 1991 issue of 9 percent tax-exempt bonds (the prior issue). The use of amounts corresponding to the proceeds of the reimbursement bonds to create a sinking fund for another issue within 1 year after the purported reimbursement allocation invalidates the reimbursement allocation. The proceeds retain their character as unspent proceeds of the 7 percent issue upon deposit in the escrow fund. Accordingly, the proceeds are subject to the 7 percent yield restriction of the 1994 issue instead of the 9 percent yield restriction of the prior issue.

(i) Authority of the Commissioner to prescribe rules. The Commissioner may by revenue ruling or revenue procedure (see §601.601(d)(2)(ii)(b) of this chapter) prescribe rules for the expenditure of proceeds of reimbursement bonds in circumstances that do not otherwise satisfy this section. (j) Effective date-(1) In general. The provisions of this section apply to all allocations of proceeds of reimbursement bonds issued after June 30, 1993. (2) Transitional rules-(i) Official intent. An official intent is treated as satisfying the official intent requirement of paragraph (d)(1) of this section if it- (A) Satisfied the applicable provisions of §1.103-8(a)(5) as in effect prior to July 1, 1993, (as contained in 26 CFR part 1 revised as of April 1, 1993) and was made prior to that date, or (B) Satisfied the applicable provisions of §1.103-18 as in effect between January 27, 1992, and June 30, 1993, (as contained in 26 CFR part 1 revised as of April 1, 1993) and was made during that period. (ii) Certain expenditures of private activity bonds. For any expenditure that was originally paid prior to August 15, 1993, and that would have qualified for expenditure by reimbursement from the proceeds of a private activity bond under T.D. 7199, section 1.103-8(a)(5), 1972-2 C.B. 45 (see §601.601(d)(2)(ii)(b)) of this chapter, the requirements of that section may be applied in lieu of this section. PART 6a-TEMPORARY REGULATIONS UNDER TITLE II OF THE OMNIBUS RECONCILIATION ACT OF 1980 Par. 12. The authority for part 6a is revised to read as follows:

Authority

26 U.S.C. 7805. Sections 6a.103A-2(k), (l), and (m) also issued under 26 U.S.C. 103A(j) (3), (4), and (5). Par. 13. Section 6a.103A-2 is amended by adding a new paragraph (i)(3)(v) to read as follows:

§6a.103A-2 Qualified mortgage bond.

(i) (3) (v) Bonds issued after June 30, 1993. Section 1.148-2(f)(2)(iv) applies to bonds issued after June 30, 1993, in lieu of this paragraph (i)(3).

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

ACT Par. 14. The authority citation for part 602 continues to read as follows:

Authority

26 U.S.C. 7805. Par. 15. Section 602.101(c) is amended by adding the following entries in numerical order to the table to read as follows:

§602.101 OMB Control Numbers.

(c) ------------------------------------------------------------------------------ CFR part or section where identified and described Current OMB control number ---------------- -------------------------------------------------------------- 1.148-2 ............................................................. 1545-1347 1.148-3 ............................................................. 1545-1347 1.148-4 ............................................................. 1545-1347 1.148-7 ............................................................. 1545-1347 1.148-11 ............................................................ 1545-1347 ---------------------- -------------------------------------------------------- Margaret Milner Richardson, Commissioner of Internal Revenue. Approved: June 4, 1993. Leslie Samuels, Assistant Secretary of the Treasury (Tax Policy).

AGENCY

Internal Revenue Service (IRS), Treasury.

ACTION

Final regulations.

SUMMARY

This document contains final regulations concerning the low-income housing credit under section 42 of the Internal Revenue Code. The regulations provide guidance with respect to: Eligibility for a carryover allocation; procedures for electing an appropriate percentage month; the general public use requirement; utility allowances to be used in determining gross rent; and the inclusion of the cost of certain services in gross rent. The regulations incorporate and expand upon the guidance provided by Notice 89-1, 1989-1 C.B. 620, and Notice 89-6, 1989-1 C.B. 625. This information will assist State and local housing credit agencies and taxpayers in complying with the requirements of section 42. The regulations affect taxpayers that apply for or claim the low-income housing tax credit and State and local housing credit agencies.

DATES

These regulations are effective May 2, 1994. For dates of applicability of these regulations, see §1.42-12.

FOR FURTHER INFORMATION CONTACT

Christopher J. Wilson (202) 622-3040 (not a toll-free call).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collections of information contained in this final regulation have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1102. The estimated annual burden per State or local government respondent/recordkeeper varies from 18.60 hours to 51.63 hours, with an estimated average of 39.61 hours. The estimated annual burden for all other respondent/recordkeepers varies from 1.90 hours to 6.20 hours, with an estimated average of 4.50 hours. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of

Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Background

On December 29, 1992, the IRS published a notice of proposed rulemaking in the Federal Register (57 FR 61852) proposing amendments to the Income Tax Regulations (26 CFR part 1) under section 42 of the Internal Revenue Code of 1986, as amended. These amendments provide guidance on several requirements of the low-income housing tax credit and incorporate and expand upon the guidance provided by Notices 89-1 and 89-6. Written comments responding to the notice of proposed rulemaking were received. A public hearing was scheduled for February 16, 1993, pursuant to a notice of public hearing published simultaneously with the notice of proposed rulemaking. However, the IRS received no requests to speak at the public hearing by the designated date. On February 8, 1993, the IRS published a notice (58 FR 7497) cancelling the public hearing on the proposed regulations. After consideration of the comments received, the proposed regulations are adopted as revised by this Treasury decision.

Explanation of Provisions

Carryover Allocations Section 42 provides for a low-income housing credit that may be claimed as part of the general business credit under section 38. In general, the credit is allowable only to the extent that the owner of a qualified low-income building receives a housing credit allocation from a State or local housing credit agency (Agency). Under section 42(h)(1)(E), an allocation may be made to a qualified building that has not yet been placed in service, provided the building is placed in service not later than the close of the second calendar year following the calendar year of the allocation (a carryover allocation). Section 42(h)(1)(E)(ii) defines a qualified building as any building that is part of a project if the taxpayer's basis in the project (as of the close of the calendar year of the allocation) is more than 10 percent of the taxpayer's reasonably expected basis in the project (as of the close of the second calendar year following the calendar year of the allocation). For these purposes, the taxpayer's basis equals the taxpayer's basis in land and depreciable property. See 2 H.R. Conf. Rep. No. 1104, 100th Cong., 2d Sess. II-82 (1988), 1988-3 C.B. 572. A carryover allocation may also be made to a multiple-building project under section 42(h)(1)(F). Commentators requested clarification on when a carryover allocation is treated as if it had never been made. The final regulations clarify that only a failure to satisfy a requirement of section 42(h)(1) (E) or (F) that must be satisfied by the close of the calendar year of allocation will cause a carryover allocation to be treated as if it had not been made. The proposed regulations provide that a taxpayer does not have carryover-allocation basis in a project unless, by the close of the calendar year of allocation, the taxpayer is the owner, for federal income tax purposes, of land or depreciable real property

expected to be part of the project. The final regulations do not explicitly contain this requirement. After further consideration, the IRS believes that satisfaction of the requirements of §1.42-6 is sufficient to ensure that a taxpayer intends to complete a qualified low-income housing project. For example, if a taxpayer has basis in land or depreciable property that is reasonably expected to be part of a project and the requirements of §1.42-6 are otherwise satisfied, the taxpayer has carryover-allocation basis with respect to the land or depreciable property. This basis includes all items that are properly capitalizable with respect to the land or depreciable property. Thus, notwithstanding the rule in Notice 89-1 to the contrary, a nonrefundable downpayment for, or an amount paid to acquire an option to purchase, land or depreciable property may be included in carryover-allocation basis if properly capitalizable into the basis of land or depreciable property that is reasonably expected to be part of a project. Commentators objected to the exclusion of credit application fees from carryover-allocation basis and requested that the final regulations permit these fees to be included in carryover-allocation basis. On further consideration, it appears that an absolute prohibition against the inclusion of application fees (and compliance monitoring fees, which were also not included) in carryover-allocation basis is not warranted. Accordingly, the final regulations subject credit application and compliance monitoring fees to the same standards imposed upon other fees under the regulations. For example, if a fee is properly capitalizable as part of the taxpayer's basis in land or depreciable property that is reasonably expected to be part of a project, the fee is included in carryover-allocation basis. Verification of Basis The proposed regulations provide verification requirements and procedures that an Agency must follow to ensure that the minimum basis requirement that is required to be met by the close of the year of allocation is, in fact, met. A commentator suggested that the basis verification requirements are too burdensome to Agencies and that Agencies lack the expertise to verify the costs includible in basis. The IRS does not expect Agencies to audit projects or make legal determinations. Rather, the proposed regulations provide that an Agency may verify the basis requirement by requiring the taxpayer to obtain a certification from an attorney or certified public accountant that the taxpayer has incurred the minimum required basis by the close of the calendar year of allocation. Accordingly, the final regulations adopt the basis verification requirement of the proposed regulations. Requirements for Making Carryover Allocations The proposed regulations provide guidance on the information needed for carryover allocation documents. A commentator suggested that the final regulations clarify whether a newly constructed building that receives an allocation of credit in different calendar years must have a separate Form 8609 for each allocation and, if so, whether the same building identification number (B.I.N.) should be used. The final regulations clarify that, in this and similar situations, a separate Form 8609 is necessary for both allocations and that the B.I.N. assigned to the building for the first allocation also is used for the subsequent allocation. Use by the General Public

The legislative history of section 42 provides that residential rental units must be for use by the general public. Residential rental units are not for use by the general public, for example, if the units are provided only for members of a social organization or provided by an employer for its employees. The proposed regulations provide an exception for an employer-provided resident manager unit that is a facility reasonably required by a project. Commentators suggested that the exception for a resident manager unit be expanded to include a unit occupied by a full-time maintenance person. After further review, IRS the Service and the Treasury have concluded that the reference to a resident manager unit in the proposed regulations was inappropriate because the general public use requirement only applies to residential rental units. A unit that is occupied by a full-time resident manager or a full-time maintenance person is not a residential rental unit but is a facility reasonably required by a project. See Rev. Rul. 92-61, 1992-2 C.B. 7. Accordingly, the final regulations remove the reference to a resident manager unit. Utility Allowances A commentator suggested that the final regulations provide that in areas where there is a utility allowance increase without a corresponding increase in area median gross income, an owner may adjust the rent upwards so that rent receipts do not decrease below the minimum rent floor of section 42(g)(2)(A). Because a change of this nature requires an amendment to the statute, the final regulations do not adopt this suggestion.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of the proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Christopher J. Wilson, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 602

Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1-INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

Authority

26 U.S.C. 7805 Sections 1.42-6, 1.42-8, 1.42-9, 1.42-10, 1.42-11, and 1.42-12 also issued under 26 U.S.C. 42(n); Par. 2. Section 1.42-6 is added, §1.42-7 is added and reserved, and §§1.42-8 through 1.42-12 are added to read as follows:

§1.42-6 Buildings qualifying for carryover allocations.

(a) Carryover allocations. A carryover allocation is an allocation that meets the requirements of section 42(h)(1) (E) or (F). If the requirements of section 42(h)(1) (E) or (F) that are required to be satisfied by the close of the calendar year are not satisfied, the allocation is treated as if it had not been made. For example, if the taxpayer's basis in the project as of the close of the calendar year of allocation is not more than 10 percent of the taxpayer's reasonably expected basis in the project as of the close of the second calendar year following the year of allocation, the carryover allocation is not valid and is treated as if it had not been made. (b) Carryover-allocation basis-(1) In general. Subject to the limitations of paragraph (b)(2) of this section, a taxpayer's basis in a project for purposes of section 42(h)(1) (E)(ii) or (F) (carryover-allocation basis) is the taxpayer's adjusted basis in land or depreciable property that is reasonably expected to be part of the project, whether or not these amounts are includible in eligible basis under section 42(d). Thus, for example, if the project is to include property that is not residential rental property, such as commercial space, the basis attributable to the commercial space, although not includible in eligible basis, is includible in carryover-allocation basis. The adjusted basis of land and depreciable property is determined under sections 1012 and 1016, and generally includes the direct and indirect costs of acquiring, constructing, and rehabilitating the property. Costs otherwise includible in carryover-allocation basis are not excluded by reason of having been incurred prior to the calendar year in which the carryover allocation is made. (2) Limitations-For purposes of determining carryover-allocation basis under paragraph (b)(1) of this section, the following limitations apply. (i) Taxpayer must have basis in land or depreciable property related to the project. A taxpayer has carryover-allocation basis to the extent that it has basis in land or

depreciable property and the land or depreciable property is reasonably expected to be part of the project for which the carryover allocation is made. This basis includes all items that are properly capitalizable with respect to the land or depreciable property. For example, a nonrefundable downpayment for, or an amount paid to acquire an option to purchase, land or depreciable property may be included in carryover-allocation basis if properly capitalizable into the basis of land or depreciable property that is reasonably expected to be part of a project. (ii) High cost areas. Any increase in eligible basis that may result under section 42(d)(5)(C) from a building's location in a qualified census tract or difficult development area is not taken into account in determining carryover-allocation basis or reasonably expected basis. (iii) Amounts not treated as paid or incurred. An amount is not includible in carryover-allocation basis unless it is treated as paid or incurred under the method of accounting used by the taxpayer. For example, a cash method taxpayer cannot include construction costs in carryover-allocation basis unless the costs have been paid, and an accrual method taxpayer cannot include construction costs in carryover-allocation basis unless they have been properly accrued. See paragraph (b)(2)(iv) of this section for a special rule for fees. (iv) Fees. A fee is includible in carryover-allocation basis only to the extent the requirements of paragraph (b)(2)(iii) of this section are met and- (A) The fee is reasonable; (B) The taxpayer is legally obligated to pay the fee; (C) The fee is capitalizable as part of the taxpayer's basis in land or depreciable property that is reasonably expected to be part of the project; (D) The fee is not paid (or to be paid) by the taxpayer to itself; and (E) If the fee is paid (or to be paid) by the taxpayer to a related person, and the taxpayer uses the cash method of accounting, the taxpayer could properly accrue the fee under the accrual method of accounting (considering, for example, the rules of section 461(h)). A person is a related person if the person bears a relationship to the taxpayer specified in sections 267(b) or 707(b)(1), or if the person and the taxpayer are engaged in trades or businesses under common control (within the meaning of subsections (a) and (b) of section 52). (3) Reasonably expected basis. Rules similar to the rules of paragraphs (a) and (b) of this section apply in determining the taxpayer's reasonably expected basis in a project (land and depreciable basis) as of the close of the second calendar year following the calendar year of the allocation. (4) Examples. The following examples illustrate the rules of paragraphs (a) and (b) of this section. Example 1. (i) Facts. C, an accrual-method taxpayer, receives a carryover allocation from Agency, the state housing credit agency, in September of 1993. As of that date,

C has not begun construction of the low-income housing building C plans to build. However, C has owned the land on which C plans to build the building since 1985. C's basis in the land is $100,000. C reasonably expects that by the end of 1995, C's basis in the project of which the building is to be a part will be $2,000,000. C also expects that because the project is located in a qualified census tract, C will be able to increase its basis in the project to $2,600,000. Before the close of 1993, C incurs $150,000 of costs for architects' fees and site preparation. C properly accrues these costs under its method of accounting and capitalizes the costs. (ii) Determination of carryover-allocation basis. C's $100,000 basis in the land is includible in carryover-allocation basis even though C has owned the land since 1985. The $150,000 of costs C has incurred for architects' fees and site preparation are also includible in carryover-allocation basis. The expected increase in basis due to the project's location in a qualified census tract is not taken into account in determining C's carryover-allocation basis. Accordingly, C's carryover-allocation basis in the project of which the building is a part is $250,000. (iii) Determination of whether building is qualified. C's reasonably expected basis in the project at the close of the second calendar year following the calendar year of allocation is $2,000,000. The expected increase in eligible basis due to the project's location in a qualified census tract is not taken into account in determining this amount. Because C's carryover-allocation basis is more than 10 percent of C's reasonably expected basis in the project of which the building is a part, the building for which C received the carryover allocation is a qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph (a) of this section. Example 2. (i) Facts. D, an accrual-method taxpayer, receives a carryover allocation from Agency, the state housing credit agency, on September 11, 1993. As of that date, D has not begun construction of the low-income housing building D plans to build and D does not have basis in the land on which D plans to build the building. In 1993, D incurs some costs related to the planned building, including architects' fees. However, at the close of 1993, these costs do not exceed 10 percent of D's reasonably expected basis in the project. (ii) Determination of whether building is qualified. Because D's carryover-allocation basis is not more than 10 percent of D's reasonably expected basis in the project of which the building is a part, the building for which D received a carryover allocation is not a qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph (a) of this section. The carryover allocation to D is not valid, and is treated as if it had not been made. (c) Verification of basis by Agency-(1) Verification requirement. An Agency that makes a carryover allocation to a taxpayer must verify that, as of the close of the calendar year of allocation, the taxpayer has incurred more than 10 percent of the reasonably expected basis in the project (land and depreciable basis). (2) Manner of verification. An Agency may verify that a taxpayer has incurred more than 10 percent of its reasonably expected basis in a project by obtaining a certification from the taxpayer, in writing and under penalty of perjury, that the taxpayer has incurred by the close of the calendar year of the allocation more than 10 percent of the reasonably expected basis in the project. The certification must be accompanied by supporting documentation that the Agency must review. Supporting

documentation may include, for example, copies of checks or other records of payments. Alternatively, an Agency may verify that the taxpayer has incurred adequate basis by requiring that the taxpayer obtain from an attorney or certified public accountant a written certification to the Agency, that the attorney or accountant has examined all eligible costs incurred with respect to the project and that, based upon this examination, it is the attorney's or accountant's belief that the taxpayer has incurred more than 10 percent of its reasonably expected basis in the project by the close of the calendar year of the allocation. (3) Time of verification. An Agency may require that the basis certification be submitted to or received by the Agency prior to the close of the calendar year of allocation or within a reasonable time after the close of the calendar year of allocation. The Agency will need to verify basis in order to accurately complete the Form 8610, Annual Low-Income Housing Credit Agencies Report, for the calendar year. If certification is not timely made, or supporting documentation is lacking, inadequate, or does not actually support the certification, the Agency should notify the taxpayer and try to get adequate documentation. If the Agency cannot verify before the Form 8610 is filed that the taxpayer has satisfied the basis requirement for a carryover allocation, the allocation is treated as if it had not been made and the carryover allocation document should not be filed with the Form 8610. (d) Requirements for making carryover allocations-(1) In general. Generally, an allocation is made when an Agency issues the Form 8609, Low-Income Housing Credit Allocation Certification, for a building. See §1.42-1T(d)(8)(ii). An Agency does not issue the Form 8609 for a building until the building is placed in service. However, in cases where allocations of credit are made pursuant to section 42(h)(1)(E) (relating to carryover allocations for buildings) or section 42(h)(1)(F) (relating to carryover allocations for multiple-building projects), Form 8609 is not used as the allocating document because the buildings are not yet in service. When an allocation is made pursuant to section 42(h)(1) (E) or (F), the allocating document is the document meeting the requirements of paragraph (d)(2) of this section. In addition, when an allocation is made pursuant to section 42(h)(1)(F), the requirements of paragraph (d)(3) of this section must be met for the allocation to be valid. An allocation pursuant to section 42(h)(1) (E) or (F) reduces the state housing credit ceiling for the year in which the allocation is made, whether or not the Form 8609 is also issued in that year. (2) Requirements for allocation. An allocation pursuant to section 42(h)(1) (E) or (F) is made when an allocation document containing the following information is completed, signed, and dated by an authorized official of the Agency- (i) The address of each building in the project, or if none exists, a specific description of the location of each building; (ii) The name, address, and taxpayer identification number of the taxpayer receiving the allocation; (iii) The name and address of the Agency; (iv) The taxpayer identification number of the Agency; (v) The date of the allocation;

(vi) The housing credit dollar amount allocated to the building or project, as applicable; (vii) The taxpayer's reasonably expected basis in the project (land and depreciable basis) as of the close of the second calendar year following the calendar year in which the allocation is made; (viii) The taxpayer's basis in the project (land and depreciable basis) as of the close of the calendar year in which the allocation is made and the percentage that basis bears to the reasonably expected basis in the project (land and depreciable basis) as of the close of the second following calendar year; (ix) The date that each building in the project is expected to be placed in service; and (x) The Building Identification Number (B.I.N.) to be assigned to each building in the project. The B.I.N. must reflect the year an allocation is first made to the building, regardless of the year that the building is placed in service. This B.I.N. must be used for all allocations of credit for the building. For example, rehabilitation expenditures treated as a separate new building under section 42(e) should not have a separate B.I.N. if the building to which the rehabilitation expenditures are made has a B.I.N. In this case, the B.I.N. used for the rehabilitation expenditures shall be the B.I.N. previously assigned to the building, although the rehabilitation expenditures must have a separate Form 8609 for the allocation. Similarly, a newly constructed building that receives an allocation of credit in different calendar years must have a separate Form 8609 for each allocation. The B.I.N. assigned to the building for the first allocation must be used for the subsequent allocation. (3) Special rules for project-based allocations-(i) In general. An allocation pursuant to section 42(h)(1)(F) (a project-based allocation) must meet the requirements of this section as well as the requirements of section 42(h)(1)(F), including the minimum basis requirement of section 42(h)(1)(E)(ii). (ii) Requirement of section 42(h)(1)(F)(i)(III). An allocation satisfies the requirement of section 42(h)(1)(F)(i)(III) if the Form 8609 that is issued for each building that is placed in service in the project states the portion of the project-based allocation that is applied to that building. (4) Recordkeeping requirements-(i) Taxpayer. When an allocation is made pursuant to section 42(h)(1) (E) or (F), the taxpayer must retain a copy of the allocation document and file an additional copy with the Form 8609 that is issued to the taxpayer for a building after the building is placed in service. The taxpayer need only file a copy of the allocation document with the Form 8609 for the building for the first year the credit is claimed. However, the Form 8609 must be filed for the first taxable year in which the credit is claimed and for each taxable year thereafter throughout the compliance period, whether or not a credit is claimed for the taxable year. (ii) Agency. The Agency must retain a copy of the allocation document and file the original with the Agency's Form 8610 that accounts for the year the allocation is made. The Agency must also retain a copy of the Form 8609 that is issued to the

taxpayer and file the original with the Agency's Form 8610 that reflects the year the form is issued. (5) Separate procedure for election of appropriate percentage month. If a taxpayer receives an allocation under section 42(h)(1) (E) or (F) and wishes to elect under section 42(b)(2)(A)(ii) to use the appropriate percentage for a month other than the month in which a building is placed in service, the requirements specified in §1.42-8 must be met for the election to be effective. (e) Special rules. The following rules apply for purposes of this section. (1) Treatment of partnerships and other flow-through entities. With respect to taxpayers that own projects through partnerships or other flow-through entities (e.g., S corporations, estates, or trusts), carryover-allocation basis is determined at the entity level using the rules provided by this section. In addition, the entity is responsible for providing to the Agency the certification and documentation required under the basis verification requirement in paragraph (c) of this section. (2) Transferees. If land or depreciable property that is expected to be part of a project is transferred after a carryover allocation has been made for a building that is reasonably expected to be part of the project, but before the close of the calendar year of the allocation, the transferee's carryover-allocation basis is determined under the principles of this section and section 42(d)(7). See also Rev. Rul. 91-38, 1991-2 C.B. 3 (see §601.601(d)(2)(ii)(b) of this chapter). In addition, the transferee is treated as the taxpayer for purposes of the basis verification requirement of this section, and therefore, is responsible for providing to the Agency the required certifications and documentation.

§1.42-7 Substantially bond-financed buildings. (Reserved)

§1.42-8 Election of appropriate percentage month.

(a) Election under section 42(b)(2)(A)(ii)(I) to use the appropriate percentage for the month of a binding agreement-(1) In general. For purposes of section 42(b)(2)(A)(ii)(I), an agreement between a taxpayer and an Agency as to the housing credit dollar amount to be allocated to a building is considered binding if it- (i) Is in writing; (ii) Is binding under state law on the Agency, the taxpayer, and all successors in interest; (iii) Specifies the type(s) of building(s) to which the housing credit dollar amount applies (i.e., a newly constructed or existing building, or substantial rehabilitation treated as a separate new building under section 42(e)); (iv) Specifies the housing credit dollar amount to be allocated to the building(s); and (v) Is dated and signed by the taxpayer and the Agency during the month in which the requirements of paragraphs (a)(1) (i) through (iv) of this section are met.

(2) Effect on state housing credit ceiling. Generally, a binding agreement described in paragraph (a)(1) of this section is an agreement by the Agency to allocate credit to the taxpayer at a future date. The binding agreement may include a reservation of credit or a binding commitment (under section 42(h)(1)(C)) to allocate credit in a future taxable year. A reservation or a binding commitment to allocate credit in a future year has no effect on the state housing credit ceiling until the year the Agency actually makes an allocation. However, if the binding agreement is also a carryover allocation under section 42(h)(1) (E) or (F), the state housing credit ceiling is reduced by the amount allocated by the Agency to the taxpayer in the year the carryover allocation is made. For a binding agreement to be a valid carryover allocation, the requirements of paragraph (a)(1) of this section and §1.42-6 must be met. (3) Time and manner of making election. An election under section 42(b)(2)(A)(ii)(I) may be made either as part of the binding agreement under paragraph (a)(1) of this section to allocate a specific housing credit dollar amount or in a separate document that references the binding agreement. In either case, the election must- (i) Be in writing; (ii) Reference section 42(b)(2)(A)(ii)(I); (iii) Be signed by the taxpayer; (iv) If it is in a separate document, reference the binding agreement that meets the requirements of paragraph (a)(1) of this section; and (v) Be notarized by the 5th day following the end of the month in which the binding agreement was made. (4) Multiple agreements-(i) Rescinded agreements. A taxpayer may not make an election under section 42(b)(2)(A)(ii)(I) for a building if an election has previously been made for the building for a different month. For example, assume a taxpayer entered into a binding agreement for allocation of a specific housing credit dollar amount to a building and made the election under section 42(b)(2)(A)(ii)(I) to apply the appropriate percentage for the month of the binding agreement. If the binding agreement subsequently is rescinded under state law, and the taxpayer enters into a new binding agreement for allocation of a specific housing credit dollar amount to the building, the taxpayer must apply to the building the appropriate percentage for the elected month of the rescinded binding agreement. However, if no prior election was made with respect to the rescinded binding agreement, the taxpayer may elect the appropriate percentage for the month of the new binding agreement. (ii) Increases in credit. The election under section 42(b)(2)(A)(ii)(I), once made, applies to any increase in the credit amount allocated for a building, whether the increase occurs in the same or in a subsequent year. However, in the case of a binding agreement (or carryover allocation that is treated as a binding agreement) to allocate a credit amount under section 42(e)(1) for substantial rehabilitation treated as a separate new building, a taxpayer may make the election under section 42(b)(2)(A)(ii)(I) notwithstanding that a prior election under section 42(b)(2)(A)(ii)(I) is in effect for a prior allocation of credit for a substantial rehabilitation that was previously placed in service under section 42(e).

(5) Amount allocated. The housing credit dollar amount eventually allocated to a building may be more or less than the amount specified in the binding agreement. Depending on the Agency's determination pursuant to section 42(m)(2) as to the financial feasibility of the building (or project), the Agency may allocate a greater housing credit dollar amount to the building (provided that the Agency has additional housing credit dollar amounts available to allocate for the calendar year of the allocation) or the Agency may allocate a lesser housing credit dollar amount. Under section 42(h)(7)(D), in allocating a housing credit dollar amount, the Agency must specify the applicable percentage and maximum qualified basis of the building. The applicable percentage may be less, but not greater than, the appropriate percentage for the month the building is placed in service, or the month elected by the taxpayer under section 42(b)(2)(A)(ii)(I). Whether the appropriate percentage is the appropriate percentage for the 70-percent present value credit or the 30-percent present value credit is determined under section 42(i)(2) when the building is placed in service. (6) Procedures-(i) Taxpayer. The taxpayer must give the original notarized election statement to the Agency before the close of the 5th calendar day following the end of the month in which the binding agreement is made. The taxpayer must retain a copy of the binding agreement and the election statement and must file an additional copy of each with the taxpayer's Form 8609, Low-Income Housing Credit Allocation Certification, for the first taxable year in which credit is claimed for the building. (ii) Agency. The Agency must file with the Internal Revenue Service the original of the binding agreement and the election statement with the Agency's Form 8610, Annual Low-Income Housing Credit Agencies Report, that accounts for the year the allocation is actually made. The Agency must also retain a copy of the binding agreement and the election statement. (7) Examples. The following examples illustrate the provisions of this section. In each example, X is the taxpayer, Agency is the state housing credit agency, and the carryover allocations meet the requirements of §1.42-6 and are otherwise valid. Example 1. (i) In August 1993, X and Agency enter into an agreement that Agency will allocate $100,000 of housing credit dollar amount for the low-income housing building X is constructing. The agreement is binding and meets all the requirements of paragraph (a)(1) of this section. The agreement is a reservation of credit, not an allocation, and therefore, has no effect on the state housing credit ceiling. On or before September 5, 1993, X signs and has notarized a written election statement that meets the requirements of paragraph (a)(3) of this section. The applicable percentage for the building is the appropriate percentage for the month of August 1993. (ii) Agency makes a carryover allocation of $100,000 of housing credit dollar amount for the building on October 2, 1993. The carryover allocation reduces Agency's state housing credit ceiling for 1993. Due to unexpectedly high construction costs, when X places the building in service in July 1994, the product of the building's qualified basis and the applicable percentage for the building (the appropriate percentage for the month of August 1993) is $150,000, rather than $100,000. Notwithstanding that only $100,000 of credit was allocated for the building in 1993, Agency may allocate an additional $50,000 of housing credit dollar amount for the building from its state housing credit ceiling for 1994. The appropriate percentage for the month of August

1993 is the applicable percentage for the building for the entire $150,000 of credit allocated for the building, even though separate allocations were made in 1993 and 1994. Because allocations were made for the building in two separate calendar years, Agency must issue two Forms 8609 to X. One Form 8609 must reflect the $100,000 allocation made in 1993, and the other Form 8609 must reflect the $50,000 allocation made in 1994. (iii) X gives the original notarized statement to Agency on or before September 5, 1993, and retains a copy of the binding agreement, election statement, and carryover allocation document. X files a copy of the binding agreement, election statement, and carryover allocation document with X's Form 8609 for the first taxable year in which X claims credit for the building. (iv) Agency files the original of the binding agreement, election statement, and 1993 carryover allocation document with its 1993 Form 8610. Agency retains a copy of the binding agreement, election statement, and carryover allocation document. After the building is placed in service in 1994, Agency issues to X a copy of the Form 8609 reflecting the 1993 carryover allocation of $100,000 and files the original of that form with its 1994 Form 8610. Agency also files the original of the 1994 Form 8609 reflecting the $50,000 allocation with its 1994 Form 8610 and issues to X a copy of the 1994 Form 8609. Agency retains copies of the Forms 8609 that are issued to X. Example 2. (i) In September 1993, X and Agency enter into an agreement that Agency will allocate $70,000 of housing credit dollar amount for rehabilitation expenditures that X is incurring and that X will treat as a new low-income housing building under section 42(e)(1). The agreement is binding and meets all the requirements of paragraph (a)(1) of this section. The agreement is a reservation of credit, not an allocation, and therefore, has no effect on Agency's state housing credit ceiling. On or before October 5, 1993, X signs and has notarized a written election statement that meets the requirements of paragraph (a)(3) of this section. The applicable percentage for the building is the appropriate percentage for the month of September 1993. Agency makes a carryover allocation of $70,000 of housing credit dollar amount for the building on November 15, 1993. The carryover allocation reduces by $70,000 Agency's state housing credit ceiling for 1993. (ii) In October 1994, X and Agency enter into another binding agreement meeting the requirements of paragraph (a)(1) of this section. Under the agreement, Agency will allocate $50,000 of housing credit dollar amount for additional rehabilitation expenditures by X that qualify as a second separate new building under section 42(e)(1). On or before November 5, 1994, X signs and has notarized a written election statement meeting the requirements of paragraph (a)(3) of this section. On December 1, 1994, X receives a carryover allocation under section 42(h)(1)(E) for $50,000. The carryover allocation reduces by $50,000 Agency's state housing credit ceiling for 1994. The applicable percentage for the rehabilitation expenditures treated as the second separate new building is the appropriate percentage for the month of October 1994, not September 1993. The appropriate percentage for the month of September 1993 still applies to the allocation of $70,000 for the rehabilitation expenditures treated as the first separate new building. Because allocations were made for the building in two separate calendar years, Agency must issue two Forms 8609 to X. One Form 8609 must reflect the $70,000 allocation made in 1993, and the other Form 8609 must reflect the $50,000 allocation made in 1994.

(iii) X gives the first original notarized statement to Agency on or before October 5, 1993, and retains a copy of the first binding agreement, election statement, and carryover allocation document issued in 1993. X gives the second original notarized statement to Agency on or before November 5, 1994, and retains a copy of the second binding agreement, election statement, and carryover allocation document issued in 1994. X files a copy of the binding agreements, election statements, and carryover allocation documents with X's Forms 8609 for the first taxable year in which X claims credit for the buildings. (iv) Agency retains a copy of the binding agreements, election statements, and carryover allocation documents. Agency files the original of the first binding agreement, election statement, and 1993 carryover allocation document with its 1993 Form 8610. Agency files the original of the second binding agreement, election statement, and 1994 carryover allocation document with its 1994 Form 8610. After X notifies Agency of the date each building is placed in service, the Agency will issue copies of the respective Forms 8609 to X, and file the originals of those forms with the Agency's Form 8610 that reflects the year each form is issued. The Agency also retains copies of the Forms 8609. (b) Election under section 42(b)(2)(A)(ii)(II) to use the appropriate percentage for the month tax-exempt bonds are issued-(1) Time and manner of making election. In the case of any building to which section 42(h)(4)(B) applies, an election under section 42(b)(2)(A)(ii)(II) to use the appropriate percentage for the month tax-exempt bonds are issued must- (i) Be in writing; (ii) Reference section 42(b)(2)(A)(ii)(II); (iii) Specify the percentage of the aggregate basis of the building and the land on which the building is located that is financed with the proceeds of obligations described in section 42(h)(4)(A) (tax-exempt bonds); (iv) State the month in which the tax-exempt bonds are issued; (v) State that the month in which the tax-exempt bonds are issued is the month elected for the appropriate percentage to be used for the building; (vi) Be signed by the taxpayer; and (vii) Be notarized by the 5th day following the end of the month in which the bonds are issued. (2) Bonds issued in more than one month. If a building described in section 42(h)(4)(B) (substantially bond-financed building) is financed with tax-exempt bonds issued in more than one month, the taxpayer may elect the appropriate percentage for any month in which the bonds are issued. Once the election is made, the appropriate percentage elected applies for the building even if all bonds are not issued in that month. The requirements of this paragraph (b), including the time limitation contained in paragraph (b)(1)(vii) of this section, must also be met.

(3) Limitations on appropriate percentage. Under section 42(m)(2)(D), the credit allowable for a substantially bond- financed building is limited to the amount necessary to assure the project's feasibility. Accordingly, in making the determination under section 42(m)(2), an Agency may use an applicable percentage that is less, but not greater than, the appropriate percentage for the month the building is placed in service, or the month elected by the taxpayer under section 42(b)(2)(A)(ii)(II). (4) Procedures-(i) Taxpayer. The taxpayer must provide the original notarized election statement to the Agency before the close of the 5th calendar day following the end of the month in which the bonds are issued. If an authority other than the Agency issues the tax-exempt bonds, the taxpayer must also give the Agency a signed statement from the issuing authority that certifies the information described in paragraphs (b)(1)(iii) and (iv) of this section. The taxpayer must file a copy of the election statement with the taxpayer's Form 8609 for the first taxable year in which credit is claimed for the building. The taxpayer must also retain a copy of the election statement. (ii) Agency. The Agency must file with the Internal Revenue Service the original of the election statement and the corresponding Form 8609 for the building with the Agency's Form 8610 that reflects the year the Form 8609 is issued. The Agency must also retain a copy of the election statement and the Form 8609.

§1.42-9 For use by the general public.

(a) General rule. If a residential rental unit in a building is not for use by the general public, the unit is not eligible for a section 42 credit. A residential rental unit is for use by the general public if the unit is rented in a manner consistent with housing policy governing non-discrimination, as evidenced by rules or regulations of the Department of Housing and Urban Development (HUD) (24 CFR subtitle A and chapters I through XX). See HUD Handbook 4350.3 (or its successor). A copy of HUD Handbook 4350.3 may be requested by writing to: HUD, Directives Distribution Section, room B-100, 451 7th Street, SW., Washington, DC 20410. (b) Limitations. Notwithstanding paragraph (a) of this section, if a residential rental unit is provided only for a member of a social organization or provided by an employer for its employees, the unit is not for use by the general public and is not eligible for credit under section 42. In addition, any residential rental unit that is part of a hospital, nursing home, sanitarium, lifecare facility, trailer park, or intermediate care facility for the mentally and physically handicapped is not for use by the general public and is not eligible for credit under section 42. (c) Treatment of units not for use by the general public. The costs attributable to a residential rental unit that is not for use by the general public are not excludable from eligible basis by reason of the unit's ineligibility for the credit under this section. However, in calculating the applicable fraction, the unit is treated as a residential rental unit that is not a low-income unit.

§1.42-10 Utility allowances.

(a) Inclusion of utility allowances in gross rent. If the cost of any utilities (other than telephone) for a residential rental unit are paid directly by the tenant(s), the gross

rent for that unit includes the applicable utility allowance determined under this section. This section only applies for purposes of determining gross rent under section 42(g)(2)(B)(ii) as to rent-restricted units. (b) Applicable utility allowances-(1) FmHA-assisted buildings. If a building receives assistance from the Farmers Home Administration (FmHA-assisted building), the applicable utility allowance for all rent-restricted units in the building is the utility allowance determined under the method prescribed by the Farmers Home Administration (FmHA) for the building. For example, if a building receives assistance under FmHA's section 515 program (whether or not the building or its tenants also receive other state or federal assistance), the applicable utility allowance for all rent-restricted units in the building is determined using Exhibit A-6 of 7 CFR part 1944, subpart E (or a successor method of determining utility allowances). (2) Buildings with FmHA assisted tenants. If any tenant in a building receives FmHA rental assistance payments (FmHA tenant assistance), the applicable utility allowance for all rent-restricted units in the building (including any units occupied by tenants receiving HUD rental assistance payments) is the applicable FmHA utility allowance. (3) HUD-regulated buildings. If neither a building nor any tenant in the building receives FmHA housing assistance, and the rents and utility allowances of the building are reviewed by HUD on an annual basis (HUD-regulated building), the applicable utility allowance for all rent-restricted units in the building is the applicable HUD utility allowance. (4) Other buildings. If a building is neither an FmHA-assisted nor a HUD-regulated building, and no tenant in the building receives FmHA tenant assistance, the applicable utility allowance for rent-restricted units in the building is determined under the following methods. (i) Tenants receiving HUD rental assistance. The applicable utility allowance for any rent-restricted units occupied by tenants receiving HUD rental assistance payments (HUD tenant assistance) is the applicable Public Housing Authority (PHA) utility allowance established for the Section 8 Existing Housing Program. (ii) Other tenants-(A) General rule. If none of the rules of paragraphs (b)(1), (2), (3), and (4)(i) of this section apply to any rent-restricted units in a building, the appropriate utility allowance for the units is the applicable PHA utility allowance. However, if a local utility company estimate is obtained for any unit in the building in accordance with paragraph (b)(4)(ii)(B) of this section, that estimate becomes the appropriate utility allowance for all rent-restricted units of similar size and construction in the building. This local utility company estimate procedure is not available for and does not apply to units to which the rules of paragraphs (b) (1), (2), (3), or (4)(i) of this section apply. (B) Utility company estimate. Any interested party (including a low-income tenant, a building owner, or an Agency) may obtain a local utility company estimate for a unit. The estimate is obtained when the interested party receives, in writing, information from a local utility company providing the estimated cost of that utility for a unit of similar size and construction for the geographic area in which the building containing the unit is located. The local utility company estimate may be obtained by an

interested party at any time during the building's extended use period (see section 42(h)(6)(D)) or, if the building does not have an extended use period, during the building's compliance period (see section 42(i)(1)). Unless the parties agree otherwise, costs incurred in obtaining the estimate are borne by the initiating party. The interested party that obtains the local utility company estimate (the initiating party) must retain the original of the utility company estimate and must furnish a copy of the local utility company estimate to the owner of the building (where the initiating party is not the owner), and the Agency that allocated credit to the building (where the initiating party is not the Agency). The owner of the building must make available copies of the utility company estimate to the tenants in the building. (c) Changes in applicable utility allowance. If at any time during the building's extended use period (or, if the building does not have an extended use period, the building's compliance period), the applicable utility allowance for a unit changes, the new utility allowance must be used to compute gross rents of rent-restricted units due 90 days after the change. For example, if rent must be lowered because a local utility company estimate is obtained that shows a higher utility cost than the otherwise applicable PHA utility allowance, the lower rent must be in effect for rent due more than 90 days after the date of the local utility company estimate.

§1.42-11 Provision of services.

(a) General rule. The furnishing to tenants of services other than housing (whether or not the services are significant) does not prevent the units occupied by the tenants from qualifying as residential rental property eligible for credit under section 42. However, any charges to low-income tenants for services that are not optional generally must be included in gross rent for purposes of section 42(g). (b) Services that are optional-(1) General rule. A service is optional if payment for the service is not required as a condition of occupancy. For example, for a qualified low-income building with a common dining facility, the cost of meals is not included in gross rent for purposes of section 42(g)(2)(A) if payment for the meals in the facility is not required as a condition of occupancy and a practical alternative exists for tenants to obtain meals other than from the dining facility. (2) Continual or frequent services. If continual or frequent nursing, medical, or psychiatric services are provided, it is presumed that the services are not optional and the building is ineligible for the credit, as is the case with a hospital, nursing home, sanitarium, lifecare facility, or intermediate care facility for the mentally and physically handicapped. See also §1.42-9(b). (3) Required services-(i) General rule. The cost of services that are required as a condition of occupancy must be included in gross rent even if federal or state law requires that the services be offered to tenants by building owners. (ii) Exceptions-(A) Supportive services. Section 42(g)(2)(B)(iii) provides an exception for certain fees paid for supportive services. For purposes of section 42(g)(2)(B)(iii), a supportive service is any service provided under a planned program of services designed to enable residents of a residential rental property to remain independent and avoid placement in a hospital, nursing home, or intermediate care facility for the mentally or physically handicapped. For a building described in section 42(i)(3)(B)(iii) (relating to transitional housing for the

homeless), a supportive service includes any service provided to assist tenants in locating and retaining permanent housing. (B) Specific project exception. Gross rent does not include the cost of mandatory meals in any federally-assisted project for the elderly and handicapped (in existence on or before January 9, 1989) that is authorized by 24 CFR 278 to provide a mandatory meals program.

§1.42-12 Effective dates and transitional rules.

(a) Effective date. The rules set forth in §§1.42-6 and 1.42-8 through 1.42-12 are effective May 2, 1994. However, binding agreements, election statements, and carryover allocation documents entered into before May 2, 1994 that follow the guidance set forth in Notice 89-1, 1989-1 C.B. 620 (see § 601.601(d)(2)(ii)(b) of this chapter) need not be changed to conform to the rules set forth in §§1.42-6 and 1.42-9 through 1.42-12. (b) Prior periods. Notice 89-1, 1989-1 C.B. 620 and Notice 89-6, 1989-1 C.B. 625 (see §601.601(d)(2)(ii)(b) of this chapter) may be applied for periods prior to May 2, 1994.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION

ACT Par. 3. Part 602 is amended as follows: 1. The authority citation continues to read as follows:

Authority

26 U.S.C. 7805. 2. Section 602.101(c) is amended by adding entries in numerical order to the table to read as follows:

§602.101 OMB control numbers.

(c) ---------------------------------------------------------------------------- CFR part or section where identified and described Current OMB control no. ------------------------ ---------------------------------------------------- 1.42-6 ............................................................ 1545-1102 1.42-8 ............................................................ 1545-1102 1.42-10 ........................................................... 1545-1102 ----------------------- ----------------------------------------------------- Margaret Milner Richardson, Commissioner of Internal Revenue. Approved: January 25, 1994.

Samuel Y. Sessions, Acting Assistant Secretary of the Treasury.

Treasury Decision 8521 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations concerning the Secretary's authority to provide guidance necessary or appropriate to carry out the purposes of section 42, the low-income housing credit. This document also contains final regulations allowing State and local housing credit agencies to correct administrative errors and omissions made in connection with allocations of low-income housing credit dollar amounts and recordkeeping within a reasonable period after their discovery. The final regulations affect State and local housing credit agencies, owners of buildings or projects for which the low-income housing credit is allocated, and taxpayers claiming the low-income housing credit.

Dates: These final regulations are effective Febuary 24, 1994. For applicability of these regulations, see §1.42-13(d) of these regulations.

For Further Information Contact: Jeffrey A. Erickson, 202-622-3040 (not a toll-free number).

Paperwork Reduction Act

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1357. The estimated annual burden per respondent varies from 1 hour to 2 hours, depending on individual circumstances, with an estimated average of 1.5 hours. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attention: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Background

On January 4, 1993, a notice of proposed rulemaking (PS-50-92) was published in the Federal Register (58 FR 44) proposing amendments to the Income Tax Regulations (26 CFR part 1) under section 42 of the Internal Revenue Code. Written comments responding to the notice were received, and a public hearing was held on April 5, 1993. After consideration of all written and oral comments regarding the proposed amendments, those amendments are adopted as revised by this Treasury decision. Expla nation of Provisions

Changes Made by the Final Regulations

The proposed regulations generally describe an administrative error and omission and include illustrative examples. Commentators have requested that the final regulations include an "accounting error" as an administrative error or omission. The Service and the Treasury Department are concerned that the term "accounting error" is too vague. However, in order to address the commentators' concerns, the final regulations clarify that an administrative error or omission includes an error in tracking the housing credit dollar amount an Agency has allocated (or that remains to be allocated) in a calendar year. For example, assume an Agency, believing that it has $100 of credit remaining in its credit ceiling for the current calendar year, allocates $100 to a project and agrees to allocate an additional $30 from the next calendar year's credit ceiling. Later, in the current calendar year, the Agency discovers that it failed to include in its credit ceiling for the current calendar year $50 of credits that were returned in the current calendar year. The error in tracking the $50 of credits that were returned is an administrative error or omission. One commentator asked for clarification of the correction procedure an Agency should use when correcting a document without the Secretary's prior approval. Under the final regulations, a document that corrects a document containing an error or omission that has not yet been filed with the Internal Revenue Service should be filed as the original. If a document containing an error has already been filed with the Internal Revenue Service, the Agency should refile a copy of the document containing the error that prominently and clearly notes the correction. The Agency should indicate at the top of the document(s) that the correction is being made under §1.42-13 of the Income Tax Regulations. The proposed regulations require that an Agency obtain the prior approval of the Secretary to correct an administrative error or omission if (1) the correction is not made before the close of the calendar year of the error or omission, and (2) the correction is a numerical change to the housing credit dollar amount allocated for the building or project. One commentator suggested that an Agency should have until February 28, the date by which an Agency must file its Form 8610, to correct an administrative error or omission that changes the housing credit dollar amount allocated to a building or project without obtaining the Secretary's prior approval. Another commentator made a similar suggestion solely for credits returned in the same year in which they were allocated. These suggestions have not been adopted. Section 42(h)(1) requires that an allocation for a certain calendar year be made by the close of that calendar year. Consistent with that approach, these regulations do not permit an Agency to make a post-year allocation without the Secretary's prior approval. Of course, for a correction of an administrative error or omission that an

Agency cannot correct on its own, an Agency, or the Agency and the affected taxpayer, may seek the Secretary's prior approval.

Special Analyses

It has been determined that this Treasury Decision is not a significant regulatory action as defined in Executive Order 12866. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, a copy of the proposed regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Jeffrey A. Erickson, Office of Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 602 Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows: PART 1-INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows: Authority: 26 U.S.C. 7805 . Section 1.42-13 also issued under 26 U.S.C. 42(n); . Par. 2. Section 1.42-13 is added to read as follows: §1.42-13 Rules necessary and appropriate; housing correction of administrative errors and omissions.

credit

agencies'

(a) Publication of guidance. Under section 42(n), the Secretary has authority to prescribe regulations as may be necessary or appropriate to carry out the purposes of section 42. The Secretary may also provide guidance through various publications in the Internal Revenue Bulletin. (See § 601.601(d)(2)(ii)(b) of this chapter.) (b) Correcting administrative errors and omissions-(1) In general. An Agency may correct an administrative error or omission with respect to allocations and recordkeeping, as described in paragraph (b)(2) of this section, within a reasonable period after the Agency discovers the administrative error or omission. Whether a correction is made within a reasonable period depends on the facts and circumstances of each situation. Except as provided in paragraph (b)(3)(iii) of this section, an Agency need not obtain the prior approval of the Secretary to correct an administrative error or omission, if the correction is made in accordance with paragraph (b)(3)(i) of this section. The administrative errors and omissions to which this paragraph (b) applies are strictly limited to those described in paragraph (b)(2) of this section, and, thus, do not include, for example, any misinterpretation of the applicable rules and regulations under section 42. Accordingly, an Agency's allocation of a particular calendar year's low-income housing credit dollar amount made after the close of that calendar year, or the use of an incorrect population amount in calculating a State's housing credit ceiling for a calendar year are not administrative errors that can be corrected under this paragraph (b). (2) Administrative errors and omissions described. An administrative error or omission is a mistake that results in a document that inaccurately reflects the intent of the Agency at the time the document is originally completed or, if the mistake affec ts a taxpayer, a document that inaccurately reflects the intent of the Agency and the affected taxpayer at the time the document is originally completed. Administrative errors and omissions described in this paragraph (b)(2) include the following(i) A ma thematical error; (ii) An entry on a document that is inconsistent with another entry on the same or another document regarding the same property, or taxpayer; (iii) A failure in tracking the housing credit dollar amount an Agency has allocated (or that remains to be allocated) in the current calendar year (e.g., a failure to include in its State housing credit ceiling a previously allocated credit dollar amount that has been returned by a taxpayer); (iv) An omission of information that is required on a document; and (v) Any other type of error or omission identified by guidance published in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter) as an administrative error or omission covered by this paragraph (b). (3) Procedures for correcting administrative errors or omissions-(i) In general. An Agency's correction of an administrative error or omission, as described in paragraph (b)(2) of this section, must amend the document so that the corrected document reflects the original intent of the Agency, or the Agency and the affected taxpayer, and complies with applicable rules and regulations under section 42.

(ii) Specific procedures. If a document corrects a document containing an administrative error or omission that has not yet been filed with the Internal Revenue Service, the Agency, or the Agency and the affected taxpayer, should complete and file the corrected document as the original. When a document containing an administrative error or omission has already been filed with the Service, the Agency, or the Agency and the affected taxpayer, should refile a copy of the document containing the administrative error or omission, and prominently and clearly note the correction thereon or on an attached new document. The Agency should indicate at the top of the document(s) that the correction is being made under §1.42-13 of the Income Tax Regulations. (iii) Secretary's prior approval required. An Agency must obtain the Secretary's prior approval to correct an administrative error or omission, as described in paragraph (b)(2) of this section, if the correction is not made before the close of the calendar year of the error or omission and the correction(A) Is a numerical change to the housing credit dollar amount allocated for the building or pro ject; (B) Affects the determination of any component of the State's housing credit ceiling under section 42(h)(3)(C); or (C) Affects the State's unused housing credit carryover that is assigned to the Secretary under section 42(h)(3)(D). (iv) Requesting the Secretary's approval. To obtain the Secretary's approval under paragraph (b)(3)(iii) of this section, an Agency must submit a request for the Secretary's approval within a reasonable period after discovering the administrative error or omission, and must agree to any conditions that may be required by the Secretary under paragraph (b)(3)(v) of this section. When requesting the Secretary's approval, the Agency, or the Agency and the affected taxpayer, must file an application that complies with the require ments of this paragraph (b)(3)(iv). For further information on the application procedure see Rev. Proc. 93-1, 1993-1 I.R.B. 10 (or any subsequent applicable revenue procedure). (See §601.601(d)(2)(ii)(b) of this chapter.) The application requesting the Secretary's approval must contain the following information(A) The name, address, and identification number of each affected taxpayer; (B) The Building Identification Number (B.I.N.) and address of each building or project affected by the administrative error or omission; (C) A statement explaining the administrative error or omission and the intent of the Agency, or of the Agency and the affected taxpayer, when the document was originally completed; (D) Copies of any supporting documentation; (E) A statement explaining the effect, if any, that a correction of the administrative error or omission would have on the housing credit dollar amount allocated for any building or project; and

(F) A statement explaining the effect, if any, that a correction of the administrative error or omission would have on the determination of the components of the State's housing credit ceiling under section 42(h)(3)(C) or on the State's unused housing credit carryover that is assigned to the Secretary under section 42(h)(3)(D). (v) Agreement to conditions. To obtain the Secretary's approval under paragraph (b)(3)(iii) of this section, an Agency, or the Agency and the affected taxpayer, must agree to the conditions the Secretary considers appropriate. (c) Examples. The following examples illustrate the scope of this section: Example 1. Individual B applied to Agency X for a reservation of a low-income housing credit dollar amount for a building that is part of a low-income housing project. When applying for the low-income housing credit dollar amount, B informed Agency X that B intended to form Partnership Y to finance the project. After receiving the reservation letter and prior to receiving an allocation, B formed Partnership Y and sold partnership interests to a number of limited partners. B contributed the lowincome housing project to Partnership Y in exchange for a partnership interest. B and Partnership Y informed Agency X of the ownership change. When actually allocating the housing credit dollar amount, Agency X sent Partnership Y a document listing B, rather than Partnership Y, as the building's owner. Partnership Y promptly notified Agency X of the error. After reviewing related documents, Agency X determined that it had incorrectly listed B as the building's owner on the allocation document. Since the parties originally intended that Partnership Y would receive the allocation as the owner of the building, Agency X may correct the error without obtaining the Secretary's approval, and insert Partnership Y as the building's owner on the allocation document. Example 2. Agency Y allocated a lower low-income housing credit dollar amount for a low-income housing building than Agency Y originally intended. After the close of the calendar year of the allocation, B, the building's owner, discovered the error and promptly notified Agency Y. Agency Y reviewed relevant documents and agreed that an error had occurred. Agency Y and B must apply, as provided in paragraph (b)(3)(iv) of this section, for the Secretary's approval before Agency Y may correct the error. (d) Effective date. This section is effective February 24, 1994. However, an Agency may elect to apply these regulations to administrative errors or omissions that occurred before the publication of these regulations. Any reasonable method used by a State or local housing credit agency to correct an administrative error or omission prior to February 24, 1994, will be considered proper, provided that the method is consistent with the rules of section 42. PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT Par. 3. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805.

§602.101 (Amended) Par. 4. Section 602.101(c) is amended by adding in numerical order the entry "1.4213......1545-1357" to the table. Margaret Milner Richardson, Commissioner of Internal Revenue. Approved: January 25, 1994. Samuel Y. Sessions, Acting Assistant Secretary of the Treasury.

Treasury Decision 8563 | Internal Revenue Service (IRS), Treasury

---

Headnote: Final regs issued under Code Sec. 42(h)(3) relating to the order for allocating housing credit dollar amounts from each state's housing credit ceiling, and the determination of which states qualify to receive credits from a national pool of unused carryovers. Reference(s): Code Sec(s). Code Sec. 42 FULL TEXT:

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations concerning the low-income housing credit under section 42 of the Internal Revenue Code. The regulations provide rules relating to the order in which housing credit dollar amounts are allocated from each State's housing credit ceiling under section 42(h)(3)(C) and the determination of which States qualify to receive credit from a national pool of credit under section 42(h)(3)(D). The regulations affect State and local housing credit agencies and taxpayers receiving credit allocations, and provide them with guidance for complying with section 42. The final regulations also amend §1.42-5 to provide a cross reference to section 42(g)(8)(B). Effective Date: These regulations are effective January 1, 1994.

For Further Information Contact: Christopher J. Wilson 202-622-3040 (not a tollfree call). Supplementary Information:

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1423. The estimated annual burden per State or local government respondent varies from 2 hours to 6 hours, with an estimated average of 4 hours. The estimated annual burden for all other respondents varies from .5 hours to 1.5 hours, with an estimated average of 1 hour. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the IRS, Attn: IRS Reports Clearance Officer,

PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503. Background On December 29, 1993, the IRS published a notice of proposed rulemaking in the Federal Register (58 FR 68799) proposing amendments to the Income Tax Regulations (26 CFR part 1) under section 42 of the Internal Revenue Code of 1986, as amended. These amendments provide guidance on several requirements of the low-income housing tax credit relating to determinations of the housing credit dollar amount available to housing credit agencies for allocation in any given year. Written comments responding to the notice of proposed rulemaking were received. A public hearing was scheduled for April 26, 1994, pursuant to a notice of public hearing published simultaneously with the notice of proposed rulemaking. The IRS received one request to speak at the public hearing. This request was withdrawn before the hearing date. On April 14, 1994, the IRS published a notice (59 FR 17747) cancelling the public hearing on the proposed regulations. After consideration of the comments received, the proposed regulations are adopted as revised by this Treasury decision. Explanation of Provisions Section 42 provides for a low-income housing credit that may be claimed as part of the general business credit under section 38. In general, the credit is allowable only if the owner of a qualified low-income building receives a housing credit allocation from a State or local housing credit agency (Agency) of the jurisdiction where the building is located. The aggregate housing credit dollar amount that an Agency may allocate for any calendar year is limited to the State housing credit ceiling apportioned to the Agency for that year. Under section 42(h)(3)(C), the State housing credit ceiling of any State for any calendar year is an amount equal to the sum of: (a) $1.25 multiplied by the State population (the population component); (b) the unused State housing credit ceiling, if any, of the State for the preceding calendar year (the unused carryforward component); (c) the amount of State housing credit ceiling returned in the calendar year (the returned credit comp onent); plus (d) the amount, if any, allocated to the State by the Secretary under section 42(h)(3)(D) from a national pool of unused credit (the national pool component). The final regulations set forth the rules governing the order in which credit is allocated from the various components of the State housing credit ceiling under section 42(h)(3)(C) (the stacking rules). In general, under the stacking rules, credit is allocated first from the sum of the population and returned credit components, then from the unused carryforward component, and finally from the national pool component. The final regulations also reflect the statutory rule that unallocated credit attributable to the national pool component cannot be carried forward, and, therefore, is not included in the carryforward component for the following year. In addition, the final regulations provide that no credit allocated prior to calendar year 1990, and no credit allowable under section 42(h)(4) (relating to the portion of credit attributable to eligible basis financed by certain tax-exempt obligations under section 103), may be returned for reallocation. Thus, this credit is not included in the returned credit component for any year.

One commentator requested clarification of the rule in the proposed regulations that if the terms of the allocation violate any requirement of section 42, the allocation is not valid. Specifically, the commentator expressed concern that a misrepresentation by a taxpayer to an Agency would result in the allocation being treated as not valid and as if it had never been made and ineligible for treatment as a returned credit. The final regulations do not include this statement. First, the determination of whether an allocation is valid is not within the scope of these regulations. Second, given the general requirement that an allocation must be valid to qualify as a returned credit, it is unnecessary to include the additional statement that, if the terms of the allocation violate any requirement of section 42, the allocation is not valid and is treated as if it had not been made. However, for all purposes of section 42, including qualification as a returned credit, an allocation must be validly made. See, for example, §1.42-1T and 1.42-6. The final regulations adopt the provision of the proposed regulations requiring that if a credit is returned within 180 days following the close of the first taxable year of a building's credit period and a Form 8609, Low-Income Housing Credit Allocation Certification, has been issued for the building, an Agency must notify the IRS that the credit has been returned. One commentator requested that the procedure for notifying the IRS be clarified. Accordingly, the final regulations clarify that if all of the credit is returned, the Agency must follow the procedures in §1.42-5(e)(3) for filing the Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance. In situations where the credit is only partially returned, the Agency must follow the procedures prescribed for filing an amended Form 8610, Annual Low-Income Housing Credit Agencies Report. The proposed regulations permit an Agency to treat credit returned from a project to the Agency after October 31 of any calendar year and not reallocated by the Agency by the close of the year as returned at the beginning of the succeeding calendar year (the two-month rule). One commentator suggested that the two-month rule of the proposed regulations be changed to allow more time to reallocate credits before the close of the calendar year. Accordingly, the final regulations provide that credit returned to the Agency after September 30 of any calendar year and not reallocated by the close of the year may be treated as returned at the beginning of the succeeding calendar year. In response to another comment, the final regulations clarify that an Agency, in its discretion, may treat a portion of a credit that is so returned and that is not reallocated before the close of the calendar year as returned in the next calendar year. However, to the extent any portion of a credit returned after September 30 of any calendar year is allocated by the close of the calendar year in which it is returned, that portion of the credit is included as part of the returned credit component of the State housing credit ceiling for the year in which the credit is returned. The proposed regulations provide that, if an allocation is cancelled by mutual consent, a signed and dated written agreement between the Agency and the allocation recipient (or its successor in interest) must indicate the amount of the allocation returned and the date on which the credit is returned. Commentators suggested that, if the terms of an allocation state that any unused amounts are automatically returned to the Agency by mutual agreement, the regulations should not require a signed and dated written agreement. If this suggestion were adopted, neither the IRS nor the Agency would know with enough precision the amount of credit returned and the date on which the credit is returned. This information is

necessary to determine with certainty the returned credit component of the State housing credit ceiling and to avoid discrepancies in the amount of credit allocated to a particular project. Thus, the final regulations do not adopt this suggestion. Under section 42(h)(3)(D), States that have unused housing credit carryovers must assign them to the Secretary for inclusion in a national pool of unused housing credit carryovers (National Pool), and the Secretary must allocate National Pool credit among qualified States. In determining whether there is any unallocated credit within the State at the close of a calendar year, the housing credit dollar amounts apportioned to all Agencies within the State (including Agencies of constitutional home rule cities in the State) and the allocations of all Agencies within the State are considered. One commentator suggested that a constitutional home rule city be considered alone rather than in combination with other constitutional home rule cities or Agencies within a State in determining access to the National Pool. Section 42(h)(3)(E) does provide special rules for apportioning credits to constitutional home rule cities. Under these rules, however, credits are apportioned to these cities from the State housing credit ceiling. There is no provision in the Code that permits a constitutional home rule city to receive credit that is not apportioned from the State housing credit ceiling. Accordingly, the final regulations do not adopt this suggestion. In addition to a de minimis exception for States that have 1 percent or less of unallocated credit remaining in their State housing credit ceiling at the close of a calendar year (de minimis rule), the proposed regulations provide that, in other circumstances where relief is deemed appropriate, the IRS may determine that a State is a qualified State eligible to participate in the National Pool. One commentator requested that States that cannot allocate their entire ceiling as a result of a natural disaster be allowed to participate in the National Pool. This type of relief exceeds the scope and intent behind the limited exception provided in the proposed regulations. Further, this type of relief would be inequitable to other States that qualify for the National Pool. Thus, the final regulations do not adopt this suggestion. Another commentator suggested that the de minimis rule provide an alternative fixed dollar amount measurement of de minimis amount to reflect unallocated amounts that are, as a practical matter, insufficient to provide an allocation to a project. Due to variations in construction and housing costs across the United States, this suggestion was not adopted. Similarly, a suggestion that the final regulations provide a separate de minimis rule for the set-aside for nonprofit organizations was not adopted. Under the regulations, however, these situations can be addressed by the IRS on a case-by-case basis. Moreover, if appropriate, additional safe harbors could be provided in the future (e.g., to respond to other common situations not addressed by the 1 percent rule). The final regulations also amend §1.42-5 to provide a cross reference to section 42(g)(8)(B), as added by section 13142(b)(3) of the Revenue Reconciliation Act of 1993. Section 42(g)(8)(B) provides that on application by the taxpayer, the Secretary may waive any annual recertification of tenant income (the Waiver) for purposes of section 42(g), if the entire building is occupied by low-income tenants. Instructions on how to obtain the Waiver will be contained in a forthcoming revenue procedure.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Christopher J. Wilson, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and the Treasury Department participated in their development. Adoption of amendments to the regulations. [TD 8563 adds Reg §1.42-14; and amends §1.42-5 and 602.101(c).]

Treasury Decision 8713 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Temporary regulations.

Summary: This document contains temporary regulations with respect to the lowincome housing tax credit relating to the application of section 42(d)(5) to certain rental assistance programs under section 42(g)(2)(B)(i). The regulations clarify that certain types of federal rental assistance payments do not result in a reduction in the eligible basis of a low-income housing building. The text of these regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register. Effective Date: These regulations are effective January 27, 1997.

For Further Information Contact: Christopher J. Wilson (202) 622-3040 (not a toll-free call). Supplementary Information

Background

Under section 42(d)(1), the eligible basis used to compute the low-income housing tax credit of a new low-income building is the adjusted basis of the building as of the close of the first taxable year of the credit period. Section 42(d)(5) provides that if, during a taxable year in the compliance period (as defined in section 42(i)(1)), a federal grant is made with respect to a low-income building or the operation thereof, the eligible basis of the building for the taxable year and all succeeding taxable years is reduced to the extent of the federal grant. Questions have arisen whether rental assistance payments under section 8 of the United States Housing Act of 1937 (Act) (42 U.S.C. section 1437f) and certain rental assistance payments under section 9 of the Act (42 U.S.C. 1437g) are federal grants requiring a reduction in eligible basis. The legislative history of section 42 indicates that section 42(d)(5) was enacted to prevent a taxpayer from "double- dipping" in federal benefits. S. Rep. No. 313, 99th Cong., 2d Sess. II-767 (1986), 1986-3 (Vol 3) C.B. 767. This would occur, for example, if the owner of a building received both the low-income housing credit and a federal-interest subsidy or federal grant with respect to the building. The legislative history further indicates, however, that Congress did not intend to treat federal rental assistance payments as grants for this purpose. Thus, the legislative history indicates that no basis reduction is required for rental assistance payments provided by the Department of Housing and Urban Development (HUD) under section 8 of the Act. (In contrast to this treatment of section 8 rental assistance payments, section 42(c)(2) generally denies the low-income housing tax credit to buildings that receive "moderate rehabilitation assistance" under section 8(e)(2) of the Act). HUD recently was granted the authority to assist mixed- finance projects under section 9 of the Act. Under this new initiative, public housing authorities receiving HUD assistance are permitted to disburse that assistance to private owners as

reimbursement for the operating expenses of units the owner has agreed to maintain for public -housing tenants. This section 9 assistance for operating expenses functions in a manner similar to rental assistance payments under section 8 of the Act. The section 8 rental assistance payments are designed to compensate the unit owner for all or part of the difference between the rent a low-income tenant is able to pay and a fair market rent standard as set by HUD. Similarly, the section 9 payments are designed to cover an allocable share of operating costs of the units rented to lowincome tenants, thus, in effect, supplementing the rents that these tenants are required to pay.

Explanation of Provisions

These temporary regulations provide that certain federal rental assistance payments made to the owner of a building on behalf of low-income tenants are not federal grants with respect to a building or its operation that require a reduction in the building's eligible basis under section 42(d)(5). These payments include rental assistance payments made under section 8 of the Act, certain payments made under section 9 of the Act, and payments made under such other programs or methods of rental assistance as may be designated in the Federal Register or the Internal Revenue Bulletin.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this temporary regulation will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Christopher J. Wilson, Office of Assistant Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

Treasury Decision 8731 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final and temporary regulations.

Summary: This document contains final regulations with respect to the low-income housing tax credit relating to the application of section 42(d)(5) to certain rental assistance programs under section 42(g)(2)(B)(i). The regulations clarify that certain types of federal rental assistance payments do not result in a reduction in the eligible basis of a low-income housing building. DATES: These regulations are effective September 26, 1997.

For Further Information Contact: Christopher J. Wilson, (202) 622-3040 (not a toll-free call). Supplementary Information

Background

Temporary regulations (TD 8713) and a notice of proposed rulemaking crossreferencing the temporary regulations were published in the Federal Register for January 27, 1997 (62 FR 3792, 3848). Those regulations provide that certain federal rental assistance payments made to the owner of a building on behalf of low-income tenants are not federal grants with respect to a building or its operation that require a reduction in the building's eligible basis under section 42(d)(5) of the Internal Revenue Code (Code). These payments include rental assistance payments made under section 8 of the United States Housing Act of 1937 (Act) (42 U.S.C. 1437f), certain payments made under section 9 of the Act (42 U.S.C. 1437g), and payments made under such other programs or methods of rental assistance as may be designated in the Federal Register or the Internal Revenue Bulletin. The notice of proposed rulemaking indicated that comments would be considered on those areas addressed in the temporary regulations. Written comments responding to the notice of proposed rulemaking were received. There was no request for a public hearing, and no public hearing was held. After consideration of all the written comments, the proposed regulations have been adopted, without change, by this Treasury decision.

Summary of Comments

One commenter suggested that the final regulations provide additional guidance for state agencies to use in determining whether similar programs beyond those described in the regulations should be considered grants that cause a reduction in a building's eligible basis under section 42(d)(5) of the Code. The final regulations do not adopt this suggestion. The scope of this regulation is limited to specified rental assistance payments that are not grants requiring a reduction in a building's eligible basis and any additional payments the Secretary may designate in the future. Another commenter suggested that section 1.42-16(c)(3) should be deleted if it is intended to impose conditions beyond the restrictions under section 9 of the Act, because the IRS is improperly infringing upon the Department of Housing and Urban Development's (HUD) authority to provide subsidies under section 9. The final

regulations do not adopt this suggestion. Section 1.42-16 does not interpret HUD's authority for paying subsidies under section 9; it describes the extent to which section 9 payments may be made without a reduction in a building's eligible basis under section 42(d)(5) of the Code. The conditions imposed on section 9 payments in section 1.42-16(c)(3) serve to differentiate section 9 assistance for operating expenses that function in a manner similar to rental assistance payments under section 8 of the Act from section 9 assistance that is applied to uses more closely associated with operational expenses requiring a reduction in a building's eligible basis under section 42(d)(5). This commenter also suggested that if section 1.42- 16(c)(3) were to be retained, it should be clarified to provide that actual operating costs be determined by HUD and/or the appropriate public housing agency. The commenter reasons that HUD is already making this determination in the context of deciding the proper amount of assistance to make under section 9 of the Act, and that precedent already exists for allowing HUD to make certain interpretations relating to the section 42 program. The final regulations do not adopt this suggestion. The IRS and Treasury believe they should retain the ability to determine what costs are appropriately characterized as operating costs that require a reduction in a building's eligible basis under section 42(d)(5) of the Code.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Christopher J. Wilson, Office of Assistant Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

Treasury Decision 8732 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations concerning the treatment of low-income housing units in a building that are occupied by individuals whose incomes increase above 140 percent of the income limitation applicable under section 42(g)(1). These regulations affect owners of those buildings who claim the low- income housing tax credit.

Dates: These regulations are effective September 26, 1997. For dates of applicability of these regulations, see section 1.42-15(i).

For Further Information Contact: David Selig, (202) 622- 3040 (not a toll-free number). Supplementary Information

Background

On May 30, 1996, the IRS published a notice of proposed rulemaking in the Federal Register (PS-29-95 at 61 FR 27036) proposing amendments to the Income Tax Regulations (26 CFR part 1) under section 42(g)(2)(D) of the Internal Revenue Code. A public hearing was scheduled for September 17, 1996, pursuant to a notice of public hearing published simultaneously with the notice of proposed rulemaking. However, the IRS received no requests to speak at the public hearing, and no public hearing was held. Written comments responding to the notice were received. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury decision. Explanation of Revisions and Summary of Comments The general rule in section 42(g)(2)(D)(i) provides that if the income of an occupant of a low-income unit increases above the income limitation applicable under section 42(g)(1), the unit continues to be treated as a low-income unit. This general rule only applies if the occupant's income initially met the income limitation and the unit continues to be rent-restricted. Section 42(g)(2)(D)(ii), however, provides an exception to the general rule in section 42(g)(2)(D)(i). Under this exception, the unit ceases being treated as a low-income unit when two conditions occur. The first condition is that the occupant's income increases above 140 percent of the income limitation applicable under section 42(g)(1), or above 170 percent for a deep rent skewed project described in section 142(d)(4)(B) (applicable income limitation). When this occurs, the unit becomes an over-income unit. The second condition is that a new occupant, whose income exceeds the applicable income limitation (nonqualified resident), occupies any residential unit in the building of a comparable or smaller size (comparable unit). Rules and Definitions

One commentator suggested that the available unit rule under the proposed regulations did not clearly indicate whether the aggregate income of all occupants of a unit is taken into account. Accordingly, the final regulations clarify that an overincome unit means a low-income unit in which the aggregate income of the occupants of the unit increases above 140 percent of the applicable income limitation under section 42(g)(1), or above 170 percent of the applicable income limitation for deep rent skewed projects described in section 142(d)(4)(B). Commentators requested that the final regulations specify whether a comparable unit is measured by floor space or number of bedrooms. The final regulations provide that a comparable unit must be measured by the same method the taxpayer used to determine qualified basis for the credit year in which the comparable unit became available. Some commentators stated that the provision in the proposed regulations that all available comparable units (not just the "next available" unit) must be rented to qualified residents to continue treating an over-income unit as a low-income unit is inconsistent with the title of section 42(g)(2)(D)(ii). Although the title of that provision uses the term next available unit, the text of the rule provides that if any available comparable unit is occupied by a nonqualified resident, the over-income unit ceases to be treated as a low-income unit. This means that if a building has more than one over-income unit, renting any available comparable unit (a comparably sized or smaller unit) to a qualified resident preserves the status of all over-income units as low-income units. Similarly, if any available comparable unit is rented to a nonqualified resident, all over-income units for which the available unit was a comparable unit lose their status as low-income units; thus, comparably sized or larger over-income units would lose their status as low-income units. In operation, this means that the owner must continue to rent any available comparable unit to a qualified resident until the percentage of low-income units in a building (excluding the over-income units) is equal to the percentage of low- income units on which the credit is based. At that point, failure to maintain the over-income units as lowincome units has no immediate significance. (However, the failure to maintain an over-income unit as a low-income unit may affect the owner's decision of whether or not to rent a particular available unit at market rate at a later time.) Consequently, the final regulations provide that all available comparable units in the building, not only the next available comparable unit, must be rented to qualified residents to retain the low-income status of the over-income units. Application of Rules on a Building by Building Basis The proposed regulations provide that in a project containing more than one lowincome building, the available unit rule applies separately to each building. Some commentators suggested that the regulations should permit residents of over-income units to move to available units in different buildings within the same low-income housing project without violating the available unit rule. However, because the requirements under section 42 must be satisfied on a building by building basis, the final regulations provide that the available unit rule only permits a current resident to move to another unit within the same building of a low-income housing project. In addition, in response to requests from several commentators, the final regulations make clear that when a current resident moves to a different unit within the same low-income building, the units exchange status. (See example 2 of section 1.42-

15(g) of the proposed regulations and section 1.42-15(h) of the final regulations.) Thus, the newly occupied unit adopts the status of the vacated unit, and the vacated unit assumes the status the newly occupied unit had immediately prior to its occupancy by the qualifying residents. Timing Issues The methods of committing rental units to tenants varies in different jurisdictions. However, it is a common rental practice to have some form of preliminary reservation for a unit prior to the date on which a lease is signed or the unit is occupied. Thus, several commentators have requested clarification that once a unit is reserved for a prospective tenant, it is no longer treated as available for purposes of the available unit rule. Accordingly, the final regulations provide that a unit is not available for purposes of the available unit rule when the unit is no longer available for rent due to a reservation that is binding under local law. Finally, financing arrangements using obligations that purport to be exempt facility bonds under section 142 must meet the requirements of sections 103 and 141 through 150 for interest on the obligations to be excluded from gross income under section 103(a). The requirements under section 142(d) may differ from those under section 42. Accordingly, the final regulations provide that the rules under the final regulations are not intended as an interpretation of the applicable rules under section 142.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is David Selig, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

Treasury Decision 8801 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations on the arbitrage restrictions applicable to tax-exempt bonds issued by State and local governments. Changes to applicable law were made by the Tax Reform Act of 1986. These regulations affect issuers of tax-exempt bonds and provide guidance for complying with the arbitrage regulations.

Dates: Effective Date: These regulations are effective on March 1, 1999. Applicability Date: These regulations are applicable to bonds sold on or after March 1, 1999. Issuers may apply these regulations to bonds sold on or after December 30, 1998. and before March 1, 1999.

For Further Information Contact: David White, 202-622-3980 (not a toll-free number).

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 15451490. Responses to these collections of information are required to obtain the benefits of a safe harbor. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the col-

lection of information displays a valid control number. The estimated annual burden per record keeper varies from .75 hour to 2 hours, depending on individual circumstances, with an estimated average of 1 hour. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503. Books or records relating to this collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

These final regulations contain amendments to the income tax regulations (26 CFR Part 1) under section 148 of the Internal Revenue Code of 1986 (Code). Section 148 provides rules addressing the use of proceeds of tax-exempt State and local bonds to acquire higher-yielding investments. On June 18, 1993, final regulations (T.D. 8476, 1993–2 C.B. 13) relating to the arbitrage restrictions and related rules under sections 103, 148, 149, and 150 were published in the Federal Register (58 F.R. 33510). Corrections to these regulations were published in the Federal Register on August 23, 1993 (58 F.R. 44451), and May 11, 1994 (59 F.R. 24350). On June 27, 1996, a notice of proposed rulemaking (FI–28–96, 1996–2 C.B. 458) relating to the arbitrage restrictions was published in the Federal Register (61 F.R. 33405). The proposed regulations provide a rebuttable presumption for establishing fair market value for United States Treasury obligations that are purchased other than directly from the United States Treasury. In addition, the proposed regulations provide a rebuttable presumption that a solicitation that meets certain requirements is a bona fide solicitation for

the guaranteed investment contract safe harbor of §1.148–5(d)(6)(iii). A public hearing was held on Thursday, October 24, 1996, and written comments were received. After consideration of all the comments, the regulations proposed by FI–28–96 are, with modifications, adopted by revision to §1.148–5(d)(6)(iii). The changes are discussed below.

Explanation of Provisions

A. In General

Due to concerns regarding the fair market purchase price of United States Treasury obligations purchased other than directly from the United States Treasury, the proposed regulations provide a rebuttable presumption for establishing fair market value. The proposed regulations generally apply the principles underlying the existing safe harbor in the arbitrage regulations for establishing fair market value for guaranteed investment contracts. The proposed regulations also provide a rebuttable presumption that a solicitation meeting the requirements of the proposed regulations will be a bona fide solicitation for the guaranteed investment contract safe harbor of existing §1.148– 5(d)(6)(iii). Modifications to the proposed regulations have been made to clarify various technical aspects in response to comments received.

B. Safe Harbor

Commentators noted that a rebuttable presumption in the proposed regulations for purchases of United States Treasury obligations provides a lower level of protection to issuers than the safe harbor applicable to guaranteed investment contracts. Commentators generally requested that the final regulations provide a safe harbor for the purchase of United States Treasury obligations. The final regulations create a safe harbor for all investments covered by the regulations, provided that the issuer receives at least three bids as required by the regulations. The premise of the final regulations is that a bidding procedure satisfying the requirements of the final regulations will produce a price that

equals fair market value. If the requirements of the final regulations are not in fact met, no assumption can be made about the relationship of the price paid to fair market value. However, all reasonable and prudent actions taken by the issuer under the circumstances may be considered in determining whether the issuer paid fair market value.

C. Scope of Final Regulations

Generally, the proposed regulations apply to United States Treasury obligations purchased other than directly from the United States Treasury. Commentators requested clarification regarding the scope of the proposed regulations and requested that the regulations only apply to investments purchased for yield restricted refunding and yield restricted sinking fund escrows. In addition, commentators asked that the proposed regulations be expanded to apply to other types of investments that may be purchased for an escrow (e.g., REFCORP strips). The final regulations apply only to guaranteed investment contracts and yield restricted defeasance escrows. With respect to yield restricted defeasance escrows, the final regulations expand the scope of investments covered by the proposed regulations to apply to all investments purchased for the escrow (e.g., United States Agency obligations, REFCORP strips and corporate obligations).

D. Guaranteed Investment Contracts

Commentators requested clarification regarding which investments are covered by the safe harbor for guaranteed investment contracts and which would be covered by the proposed regulations. The term guaranteed investment contract generally does not include investments purchased for a yield restricted defeasance escrow. However, the term guaranteed investment contract does include escrow float contracts and similar agreements purchased for a yield restricted defeasance escrow. In addition, the term guaranteed investment contract includes debt service fund forward agreements and debt service reserve fund agreements (e.g., agreements to deliver United States Treasury obligations over a period of time).

E. No Last Look

The proposed regulations state that all providers must have equal opportunity to bid and that no provider is permitted to review other bids before bidding (e.g., a last look). A small number of commentators noted that the existence of a last look may result in higher yields from competing providers. The final regulations retain the no last look requirement because permitting a last look may adversely affect the bona fides of the bidding process.

F. Reasonably Competitive Providers

The proposed regulations provide that all bidders are required to be reasonably competitive providers of investments of the type being purchased. Numerous comments were received regarding the meaning of the phrase “reasonably competitive provider,” and commentators expressed concern that a bid from a noncompetitive provider may prevent the requirements of the regulations from being satisfied. The final regulations modify this provision. The final regulations provide that the issuer must solicit at least three bids from reasonably competitive providers and that the issuer must receive at least one bid from a reasonably competitive provider. For purposes of the final regulations, a reasonably competitive provider is a provider that has an established industry reputation as a competitive provider of the type of investments being purchased. For example, in connection with the solicitation of bids for a guaranteed investment contract, an entity that has an established industry reputation as a competitive provider of guaranteed investment contracts is a reasonably competitive provider.

G. No Material Financial Interest

The proposed regulations, like the existing safe harbor for guaranteed investment contracts, provide that the issuer must receive at least three bona fide bids from providers that have no material financial interest in the issue. For this purpose, the proposed regulations provide that underwriters and financial advisors for an issue are considered to have a material financial interest. Numerous comments were received regarding the scope of entities that are considered to have a material financial interest under the proposed regulations.

The final regulations clarify that, for purchases of any investment covered by the safe harbor, the lead underwriter in a negotiated underwriting transaction is deemed to have a material financial interest in the issue until 15 days after the issue date of the issue. Any entity acting as a financial advisor with respect to the purchase of the investment at the time that the bid specification form is submitted to potential providers is also deemed to have a material financial interest in the issue. In addition, the final regulations require the provider to represent that its bid is not based on any other formal or informal agreement that the provider has with the issuer or any other person. A provider that is a related party to a provider that has a material financial interest in the issue is also deemed to have a material financial interest in the issue.

H. Commercially Reasonable Terms

The proposed regulations provide that the terms of the purchase agreement must be reasonable. The existing safe harbor for guaranteed investment contracts provides that the terms of the guaranteed investment contract, including the collateral security requirements, must be reasonable. A number of commentators requested clarification regarding what reasonable means in connection with a solicitation of United States Treasury obligations. The final regulations provide that the terms of the bid specification for any investment covered by the safe harbor must be commercially reasonable. A term is commercially reasonable if there is a legitimate business purpose for including the term in the bid specifications other than to lower the yield or increase the cost of the bid. For example, in connection with the solicitation of investments for a yield restricted defeasance escrow, a commercially unreasonable term would be a hold firm period that is longer than the issuer reasonably requires.

I. Comparison to State and Local

Government Series Securities The proposed regulations provide that the yield on any United States Treasury obligation purchased by the issuer may not be less than the yield then available on State and Local Government Series Securities from the United States Department

of the Treasury, Bureau of Public Debt (SLGs) with the same maturity. Commentators requested that the SLGs comparison be removed or that issuers be allowed to make the comparison on a portfolio-by-portfolio basis. Commentators also requested guidance about the time period in which the SLGs comparison is to be made. In general, the final regulations provide that the safe harbor does not apply to investments purchased for a yield restricted defeasance escrow if the lowest cost bid is greater than the cost of the most efficient SLG portfolio. The final regulations provide that the lowest cost bid is the lowest bid for the portfolio or, if the issuer compares bids on an investment-by-investment basis, the aggregate cost of a portfolio comprised of the lowest cost bid for each investment. Any payment received by the issuer from a provider at the time a guaranteed investment contract is purchased (e.g., an escrow float contract) for a yield restricted defeasance escrow under a bidding procedure meeting the requirements of the final regulations is taken into account in determining the lowest cost bid. The final regulations provide the following rules for comparing the lowest cost bid to SLGs. First, the most efficient SLG portfolio consists of one or more SLG securities that will allow the issuer to defease the refunded obligations at the lowest overall cost. Second, the comparison of the most efficient SLG portfolio and the lowest cost bid must be made at the time that bids are required to be submitted pursuant to the terms of the bid specifications. Intra-day pricing movements and closing spot prices of investments before and after the time in which the comparison to SLGs is required to be made are not relevant. Third, if SLGs are not available for purchase on the day that bids are required to be submitted pursuant to terms of the bid specifications because Treasury has suspended sales of those securities, the comparison of the most efficient SLG portfolio to the lowest cost bid is not required. No comparison to SLGs is required for purchases of guaranteed investment contracts.

J. Forward Pricing Data

The proposed regulations provide that the yield on United States Treasury oblig-

ations purchased by the issuer may not be significantly less than the yield then available from the provider on reasonably comparable United States Treasury obligations offered to other persons for purchase on terms comparable to those offered to the issuer from a source of funds other than tax-exempt bonds. If closely comparable forward prices are not available, a reasonable basis for this comparison may be by reference to implied forward prices for Treasury obligations based on standard financial formulas. A certificate provided by the agent conducting the bidding process will establish that the comparison is met. The existing safe harbor for guaranteed investment contracts provides that the yield on the guaranteed investment contract may not be less than the yield then available from the provider on reasonably comparable guaranteed investment contracts, if any, offered to other persons from a source of funds other than gross proceeds of tax-exempt bonds. Commentators noted that, in general, the comparison required by the proposed regulations is either too complex or not possible to construct. In lieu of a comparability requirement, commentators recommended that the regulations adopt certain additional safeguards to protect the integrity of the bidding process. The final regulations remove the comparability requirement for all investments covered by the safe harbor. However, the final regulations include additional requirements to ensure a competitive bidding process. For example, the final regulations require that the bid form forwarded to potential providers include a statement notifying providers that by submitting a bid the potential provider is representing that it did not consult with any other providers about their bid, and that its bid is not being submitted solely as a courtesy to the issuer or any other person for purposes of satisfying the requirement that the issuer receive three bids. It is anticipated that these additional requirements will ensure that the bids reflect fair market value, as determined without regard to the source of funds.

K. Record Keeping Requirements

The proposed regulations provide that issuers are required to retain certain records and information with the bond

documents, including a copy of the bids received (date and time stamped). Numerous comments were received regarding the difficulty of obtaining written bids for Treasury obligations. The final regulations modify the record keeping requirements and apply those requirements to guaranteed investment contracts. One modification to the record keeping requirements is the elimination of the requirement that the bids be received in writing. The final regulations provide that the requirement for recording the bid is satisfied if the issuer or its agent makes a contemporaneous record of the bid, including the time and date each bid was received, and the identification of the person and entity submitting the bid, and keeps this record with the bond documents. The final regulations also provide that, if the terms of the purchase agreement deviate from the terms of the bid solicitation form or if a submitted bid is modified, the issuer must keep a record explaining the purpose of the deviation or modification and, if the purchase agreement price differed from the bid, how that price was determined. If the issuer replaces investments in the winning bid portfolio with other investments, the prices of the new investments are not protected by the safe harbor unless those investments are bid under a bidding procedure meeting the requirements of the final regulations.

L. Broker Fees for Yield Restricted

Defeasance Escrows The proposed regulations provide that a fee paid to a bidding agent is a qualified administrative cost only if the fee is comparable to a fee that would be charged for a reasonably comparable investment of obligations acquired with a source of funds other than gross proceeds of tax-exempt bonds and the fee is reasonable. Under the proposed regulations, the fee is presumed to be reasonable if it does not exceed .02 percent of the amount invested in United States Treasury obligations. Commentators noted that the comparability requirement was unclear and that outside the context of municipal bonds, bidding for closely comparable investments is virtually non-existent. Commentators also noted that the .02 percent fee may result in too much compensation in the case of large escrows and too little compensation in the case of small escrows.

The final regulations retain the comparability and reasonableness requirements. However, the final regulations provide that a broker’s fee will meet the reasonableness and comparability requirements if the fee does not exceed the lesser of $10,000 or .1 percent of the initial principal amount of investments purchased for the yield restricted defeasance escrow.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations do not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the amount of time required to meet the record keeping requirement of these final regulations, an estimated annual average of 1 hour per taxpayer, is small. Also, the regulations affect a small number of taxpayers, approximately 1400 annually. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are David White and Rebecca Harrigal of the IRS Office of Chief Counsel and Edwin G. Oswald of the Department of the Treasury. However, other personnel from the IRS and the Treasury Department participated in their development. *

Adoption of Amendments to the

Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * Par. 2. Section 1.148–5 is amended as follows:

1. Paragraph (d)(6)(iii) is revised. 2. Paragraph (e)(2)(iv) is added. The revision and addition read as follows: §1.148–5 Yield and valuation of investments. (d) (6) * (iii) Safe harbor for establishing fair market value for guaranteed investment contracts and investments purchased for a yield restricted defeasance escrow. The purchase price of a guaranteed investment contract and the purchase price of an investment purchased for a yield restricted defeasance escrow will be treated as the fair market value of the investment on the purchase date if all of the following requirements are satisfied: (A) The issuer makes a bona fide solicitation for the purchase of the investment. A bona fide solicitation is a solicitation that satisfies all of the following requirements: (1) The bid specifications are in writing and are timely forwarded to potential providers. (2) The bid specifications include all material terms of the bid. A term is material if it may directly or indirectly affect the yield or the cost of the investment. (3) The bid specifications include a statement notifying potential providers that submission of a bid is a representation that the potential provider did not consult with any other potential provider about its bid, that the bid was determined without regard to any other formal or informal agreement that the potential provider has with the issuer or any other person (whether or not in connection with the bond issue), and that the bid is not being submitted solely as a courtesy to the issuer or any other person for purposes of satisfying the requirements of paragraph (d)(6)(iii)(B)(1) or (2) of this section. (4) The terms of the bid specifications are commercially reasonable. A term is commercially reasonable if there is a legitimate business purpose for the term other than to increase the purchase price or reduce the yield of the investment. For example, for solicitations of investments for a yield restricted defeasance escrow, the hold firm period must be no longer than the issuer reasonably requires.

(5) For purchases of guaranteed investment contracts only, the terms of the solicitation take into account the issuer’s reasonably expected deposit and drawdown schedule for the amounts to be invested. (6) All potential providers have an equal opportunity to bid. For example, no potential provider is given the opportunity to review other bids (i.e., a last look) before providing a bid. (7) At least three reasonably competitive providers are solicited for bids. A reasonably competitive provider is a provider that has an established industry reputation as a competitive provider of the type of investments being purchased. (B) The bids received by the issuer meet all of the following requirements: (1) The issuer receives at least three bids from providers that the issuer solicited under a bona fide solicitation meeting the requirements of paragraph (d)(6)(iii)(A) of this section and that do not have a material financial interest in the issue. A lead underwriter in a negotiated underwriting transaction is deemed to have a material financial interest in the issue until 15 days after the issue date of the issue. In addition, any entity acting as a financial advisor with respect to the purchase of the investment at the time the bid specifications are forwarded to potential providers has a material financial interest in the issue. A provider that is a related party to a provider that has a material financial interest in the issue is deemed to have a material financial interest in the issue. (2) At least one of the three bids described in paragraph (d)(6)(iii)(B)(1) of this section is from a reasonably competitive provider, within the meaning of paragraph (d)(6)(iii)(A)(7) of this section. (3) If the issuer uses an agent to conduct the bidding process, the agent did not bid to provide the investment. (C) The winning bid meets the following requirements: (1) Guaranteed investment contracts. If the investment is a guaranteed investment contract, the winning bid is the highest yielding bona fide bid (determined net of any broker’s fees). (2) Other investments. If the investment is not a guaranteed investment contract, the following requirements are met: (i) The winning bid is the lowest cost

bona fide bid (including any broker’s fees). The lowest cost bid is either the lowest cost bid for the portfolio or, if the issuer compares the bids on an investment-by-investment basis, the aggregate cost of a portfolio comprised of the lowest cost bid for each investment. Any payment received by the issuer from a provider at the time a guaranteed investment contract is purchased (e.g., an escrow float contract) for a yield restricted defeasance escrow under a bidding procedure meeting the requirements of this paragraph (d)(6)(iii) is taken into account in determining the lowest cost bid. (ii) The lowest cost bona fide bid (including any broker’s fees) is not greater than the cost of the most efficient portfolio comprised exclusively of State and Local Government Series Securities from the United States Department of the Treasury, Bureau of Public Debt. The cost of the most efficient portfolio of State and Local Government Series Securities is to be determined at the time that bids are required to be submitted pursuant to the terms of the bid specifications. (iii) If State and Local Government Series Securities from the United States Department of the Treasury, Bureau of Public Debt are not available for purchase on the day that bids are required to be submitted pursuant to terms of the bid specifications because sales of those securities have been suspended, the cost comparison of paragraph (d)(6)(iii) (C)(2)(ii) of this section is not required. (D) The provider of the investments or the obligor on the guaranteed investment contract certifies the administrative costs that it pays (or expects to pay, if any) to third parties in connection with supplying the investment. (E) The issuer retains the following records with the bond documents until three years after the last outstanding bond is redeemed: (1) For purchases of guaranteed investment contracts, a copy of the contract, and for purchases of investments other than guaranteed investment contracts, the purchase agreement or confirmation. (2) The receipt or other record of the amount actually paid by the issuer for the investments, including a record of any administrative costs paid by the issuer, and

the certification under paragraph (d)(6)(iii)(D) of this section. (3) For each bid that is submitted, the name of the person and entity submitting the bid, the time and date of the bid, and the bid results. (4) The bid solicitation form and, if the terms of the purchase agreement or the guaranteed investment contract deviated from the bid solicitation form or a submitted bid is modified, a brief statement explaining the deviation and stating the purpose for the deviation. For example, if the issuer purchases a portfolio of investments for a yield restricted defeasance escrow and, in order to satisfy the yield restriction requirements of section 148, an investment in the winning bid is replaced with an investment with a lower yield, the issuer must retain a record of the substitution and how the price of the substitute investment was determined. If the issuer replaces an investment in the winning bid portfolio with another investment, the purchase price of the new investment is not covered by the safe harbor unless the investment is bid under a bidding procedure meeting the requirements of this paragraph (d)(6)(iii). (5) For purchases of investments other than guaranteed investment contracts, the cost of the most efficient portfolio of State and Local Government Series Securities, determined at the time that the bids were required to be submitted pursuant to the terms of the bid specifications. (e) (2) (iv) Special rule for investments purchased for a yield restricted defeasance escrow. For investments purchased for a yield restricted defeasance escrow, a fee paid to a bidding agent is a qualified administrative cost only if the following requirements are satisfied: (A) The fee is comparable to a fee that would be charged for a reasonably comparable investment if acquired with a source of funds other than gross proceeds of tax-exempt bonds, and it is reasonable. The fee is deemed to be comparable to a fee that would be charged for a comparable investment acquired with a source of funds other than gross proceeds of tax-exempt bonds, and to be reasonable if the fee does not exceed the lesser of $10,000

or .1% of the initial principal amount of investments deposited in the yield restricted defeasance escrow. (B) For transactions in which a guaranteed investment contract and other investments are purchased for a yield restricted defeasance escrow in a single investment (e.g., an issuer bids United States Treasury obligations and an escrow float contract collectively), a broker’s fee described in paragraph (e)(2)(iv)(A) of this section will apply to the initial principal amount of the investment deposited in the yield restricted defeasance escrow, and a broker ’s fee described in paragraph (e)(2)(iii) of this section will apply only to the guaranteed investment contract portion of the investment. PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT Par. 3. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 4. In §602.101, paragraph (c) is amended by revising the entry for 1.148–5 in the table to read as follows: §602.101 OMB Control numbers. (c) * CFR part or section where identified and described

Current OMB control No.

• • • • • 1.148–5 . . . . . . . . . . . . . . . . . 1545–1098 1545–1490 * Robert E. Wenzel, Deputy Commissioner of Internal Revenue. Approved December 17, 1998. Donald C. Lubick, Assistant Secretary of the Treasury. (Filed by the Office of the Federal Register on December 29, 1998, 8:45 a.m., and published in the issue of the Federal Register for December 30, 1998, 63 F.R. 71748)

Treasury Decision 8859 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations regarding the procedures for compliance monitoring by state and local housing agencies (Agencies) with the requirements of the low-income housing credit; the requirements for making carryover allocations; the rules for Agencies' correction of administrative errors or omissions; and the independent verification of information on sources and uses of funds submitted by taxpayers to Agencies. These final regulations affect owners of low-income housing projects who claim the credit and the Agencies who administer the credit.

Dates: Effective Dates: These regulations are effective January 1, 2001, except that the amendments made to sections 1.42- 5(c)(5) and (e)(3)(i), and 1.42-13 are effective January 14, 2000, and the amendment made to section 1.42-6(d)(4)(ii) is effective January 1, 2000. Applicability Dates: For dates of applicability of the amendments to section 1.42-5, see section 1.42-5(h). For date of applicability of the amendment made to section 1.42-6, see section 1.42-12(c). For date of applicability of the amendments made to section 1.42-13, see section 1.42-13(d). For date of applicability of section 1.42-17, see section 1.42-17(b).

For Further Information Contact: Paul Handleman, (202) 622-3040 (not a tollfree number). Supplementary Information

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507) under control number 15451357. Responses to these collections of information are mandatory. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number. For section 1.42-5, the estimated annual burden per respondent varies from .5 hour to 3 hours for taxpayers and 250 to 5,000 hours for Agencies, with an estimated average of 1 hour for taxpayers and 1,500 hours for Agencies. For section 1.42-13, the estimated annual burden per respondent varies from .5 hour to 10 hours for taxpayers and Agencies, with an estimated average of 3.5 hours for taxpayers and 3 hours for Agencies. For section 1.42-17, the estimated annual burden per respondent varies from .5 hour to 2 hours for taxpayers and .5 hour to 5 hours for Agencies, with an estimated average of 1 hour for taxpayers and 2 hours for Agencies.

Comments concerning the accuracy of these burden estimates and suggestions for reducing these burdens should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503. Books or records relating to this collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On January 8, 1999, the IRS published proposed regulations (REG-114664-97) in the Federal Register (64 FR 1143) inviting comments under section 42. A public hearing was held May 27, 1999. Numerous comments have been received. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury Decision. Public Comments

A. Compliance Monitoring

1. Inspection Requirement for New Buildings. The proposed regulations require that, by the end of the calendar year following the year the last building in a project is placed in service, the Agency conduct on-site inspections of the projects and review the low-income certification, the documentation supporting such certification, and the rent record for each tenant in the project. Most commentators view the requirement for reviewing all tenant records for all buildings in a project as unnecessary and burdensome. Most commentators suggest limiting inspections for new buildings to 20 percent of the project's low-income units. Commentators also suggest extending the time limit for inspecting new buildings to the end of the calendar year following the first year of the credit period or at least until a reasonable time after the Agency issues Form 8609, "Low-Income Housing Credit Allocation Certification." This added flexibility would allow the Agency to combine a physical inspection with a file review of the first year of the credit period. In response to the comments, the final regulations reduce the inspection burden for new buildings by requiring the Agency to conduct on-site inspections of all new buildings in the project and, for at least 20 percent of the project's low-income units, to inspect the units and review the low-income certifications, the documentation supporting the certifications, and the rent records for the tenants in those units. To allow the Agency sufficient time to review the tenant files for the first year of the credit period, the final regulations extend the time limit for inspecting new buildings to the end of the second calendar year following the year the last building in the project is placed in service. 2. Three-year Inspection Requirement.

The proposed regulations require that, at least once every 3 years, each Agency conduct on-site inspections of all buildings in each low-income housing project and, for each tenant in at least 20 percent of the project's low-income units selected by the Agency, review the low-income certification, the documentation supporting such certification, and the rent record. Most commentators agree with requiring physical inspections of the buildings at least once every 3 years. However, commentators recommend reviewing tenant income and rent records once every 5 years, which is one of the options under the current compliance monitoring regulations (see section 1.42-5(c)(2)(ii)(B) requiring an Agency to review tenant files for 20 percent of the low- income housing projects each year). Commentators also recommend reviewing tenant files either on-site or at other locations, including desk audits. Although the physical inspection and file review requirements for new buildings are relaxed in the final regulations, the final regulations retain the 3-year inspection cycle for existing buildings. The final regulations do not separate the physical inspection and file review cycles (every 3 years for physical inspections and every 5 years for file reviews) as suggested by commentators because it is administratively complete to do both during the same year. The tenant income and rent restrictions in section 42(g) are equally important as the habitability standards for a low-income unit in section 42(i)(3)(B)(ii). The final regulations adopt the suggestion that the file review may be done wherever the tenant files are maintained. 3. Health, Safety, and Building Code Inspections. The proposed regulations require the Agency to determine whether the project is suitable for occupancy, taking into account local health, safety, and building codes. Many commentators object to this requirement as too costly and unadministerable because building codes vary considerably within states. Commentators also asked for guidelines as to what constitutes an "inspection." Some commentators propose defining an inspection as looking at selected units in the building and common areas for visible problems or defects without applying the local health, safety, and building codes standards. One commentator suggests inspections based on a complaint from the local jurisdiction or from a tenant. Some commentators suggest using a uniform physical standard such as the uniform physical condition standards for public housing established by the Department of Housing and Urban Development (HUD) in 24 CFR 5.703. Section 42(i)(3)(B)(i) excludes from the definition of a "low-income unit" a unit that is not suitable for occupancy. Under section 42(i)(3)(B)(ii), suitability of a unit for occupancy shall be determined under regulations prescribed by the Secretary taking into account local health, safety, and building codes. Recognizing that these codes vary considerably within states, the final regulations require an Agency to determine whether a low-income housing project satisfies these codes, or satisfies the HUD uniform physical condition standards. The HUD standards are intended to ensure that housing is decent, safe, sanitary, and in good repair. Though it would be appropriate that an Agency use HUD's inspection protocol under 24 CFR 5.705, the final regulations do not mandate use of HUD's inspection protocol because to do so could increase costs to the Agencies as well as limit their latitude in applying standards consistent with their own operating procedures and practices. The final regulations except a building from the inspection requirement if the building is financed by the

Rural Housing Service (RHS) under the section 515 program, the RHS inspects the building (under 7 CFR part 1930(c)), and the RHS and Agency enter into a memorandum of understanding, or other similar arrangement, under which the RHS agrees to notify the Agency of the inspection results. Irrespective of the physical inspection standard selected by the Agency, a low- income housing project under section 42 must continue to satisfy local health, safety, and building codes. The proposed regulations limit an Agency's delegation of the physical inspection of a project to only a state or local government unit responsible for making building code inspections. Commentators suggest expanding the delegation of inspections to professional firms. The final regulations remove the delegation limitation and Agencies may delegate the physical inspection requirement to state or local governmental agencies, HUD, or private contractors. 4. Local Reports of Building Code Violations. The proposed regulations require the owner of a low-income housing project to certify that for the preceding 12- month period the state or local government unit responsible for making building code inspections did not issue a report of a violation for the project. If the governmental unit issued a report of a violation, the owner is required to attach a copy of the report of the violation to the annual certification submitted to the Agency. A commentator noted that the number of violations attached to the annual owner certification would be considerable because even the highest quality rental housing operations do not have an inspection without a report or notice of some violation. Two commentators suggest attaching reports only for violations that have not been corrected prior to filing the annual owner certification or requiring that owners only attach reports for "major" violations. The commentators suggest defining major violations as violations not corrected within 90 days of the notice of violation or violations where the cost to comply exceeds $2,500. A commentator suggests that Agencies be allowed to distinguish between minor technical violations and serious violations (i.e., lack of heat or hot water, hazardous conditions, and security) in reporting noncompliance. Though a minor violation will not lead to the disallowance or recapture of section 42 credits, a series of minor violations may be the equivalent of a major violation resulting in disallowance or recapture of credits. Determining the difference between a major and minor violation is subjective. The final regulations do not exclude minor violations from the reporting and recordkeeping requirement. However, to reduce the inspection vio lation paperwork, the final regulations require that the owner must either attach a statement summarizing the violations or a copy of each violation report to the annual owner certification submitted to the Agency. The owner must state on the certification whether the violation has been corrected. In addition, the final regulations require that the owner retain the original violation report for the Agency's physical inspection. Retention of the original violation report is not required once the Agency reviews the violation and completes its inspection, unless the violation remains uncorrected. 5. Correction of Noncompliance or Failure to Certify.

The final regulations adopt commentators' suggestion to limit to a 3-year period after the end of the correction period in section 1.42-5(e)(4) the requirement that Agencies file Form 8823, "Low-Income Housing Credit Agencies Report of Noncompliance," with the IRS reporting the correction of the noncompliance or failure to certify. 6. Compliance Monitoring Effective Dates. Commentators suggest an effective date of at least one year after the final regulations are published in the Federal Register. Commentators also recommend on-site inspections apply only to new buildings allocated section 42 credits after the effective date of the final regulations. Because the amendments to the compliance monitoring regulations will require amendments to qualified allocation plans, the final regulations relating to compliance generally contain a January 1, 2001, effective date. Thus, the requirements to attach local health, safety, or building code violations to the annual owner certification and to inspect buildings and review tenant files for existing projects are effective January 1, 2001. The inspection requirement and tenant file review for new buildings is effective for buildings placed in service on or after January 1, 2001. 7. Section 8 and Federal Civil Rights Laws. Two commentators state that insufficient controls are in place to ensure that lowincome housing projects adhere to the requirement in section 42(h)(6)(B)(iv) of nondiscrimination against Section 8 voucher or certificate holders. The commentators suggest that the IRS could help compensate for lack of controls by working with HUD to ensure that Section 8 voucher or certificate holders are aware of, and have access to, low-income housing projects. The commentators also suggest that Agencies provide regional HUD offices a list of low-income housing projects in that state, with information that would be helpful for prospective tenants. One commentator suggests that the prohibition on discrimination based on Section 8 status be clarified to exclude policies that bar Section 8 tenants but have no substantial business justification. For example, low- income housing projects should not be permitted to exclude Section 8 voucher or certificate holders through a rule that requires every applicant to have income equal to at least three times the total rent. The commentators also suggest that the Agencies should be required to develop a plan for educating applicants and owners of projects of the prohibition against discrimination on the basis of Section 8 voucher or certificate status. They recommend that the Agencies should be required to have a procedure for accepting and processing complaints about discrimination against Section 8 voucher or certificate holders. They also recommend that IRS and HUD should work together to study the circumstances under which Section 8 voucher or certificate holders are, or are not, accessing projects. Section 42(h)(6)(A) provides that no credit shall be allowed by reason of section 42 with respect to any building for the taxable year unless an extended low-income housing commitment is in effect as of the end of such taxable year. Section 42(h)(6)(B)(iv) defines the term "extended low-income housing commitment" to include any agreement between the taxpayer and the housing credit agency that prohibits the refusal to lease to a holder of a voucher or certificate of eligibility under

section 8 of the United States Housing Act of 1937 because of the status of the prospective tenant as such a holder. To help monitor compliance with section 42(h)(6)(B)(iv), the final regulations amend the annual owner certification relating to the extended low-income housing commitment under section 1.42-5(c)(1)(xi) to require owners to certify that the owner has not refused to lease a unit in the project to a Section 8 applicant because the applicant holds a Section 8 voucher or certificate. The IRS has informed HUD of the comments received about preventing discrimination based on Section 8 status. Agencies should provide HUD with publicly available information on section 42 low- income housing projects if HUD requests it. A commentator also suggests that the compliance monitoring regulations be amended to acknowledge the authority of Title VIII of the 1968 Civil Rights Act, as well as HUD's Title VIII regulations; specify the civil rights obligations of the Agencies; and specify what developers and owners of projects must do to satisfy their civil rights obligations. To monitor for compliance with the Fair Housing Act, the final regulations amend the annual owner certification relating to the general public use requirement in section 1.42-5(c)(1)(v) to require owners to certify that no finding of discrimination under the Fair Housing Act has occurred for the project (a finding of discrimination includes an adverse final decision by HUD, an adverse final decision by a substantially equivalent state or local fair housing agency, or an adverse judgment from a Federal court).

B. Sources and Uses of Funds

Section 42(m)(2)(A) requires Agencies to limit the housing credit dollar amount allocated to a project to only the amount necessary for the financial feasibility of a project and its viability as a qualified low-income project through the credit period. The proposed regulations require an Agency to evaluate the housing credit dollar amount at four times: (1) at application for the housing credit dollar amount, (2) the allocation of the housing credit dollar amount, (3) the date the building is placed in service, and (4) after the building is placed in service, but before the Agency issues the Form 8609. Commentators recommend elimination of the evaluation at the placed-in-service date. In practice, Agencies currently evaluate the credit amount at the three other times. The final regulations adopt the recommendation by deleting the fourth time requirement and clarifying that the placed-in-service evaluation may occur not later than the date the Agency issues the Form 8609. Commentators are concerned that the opinion by a certified public accountant, based upon the accountant's audit or examination, on the financial determinations and

certifications required in the proposed regulations, could have significant cost implications, particularly for smaller developers. Commentators suggest limiting the requirement to projects with 25 or more units, or projects with total development costs of $5 million or more. The third-party validation on financial information was recommended in the report by the General Accounting Office (GAO), "Tax Credits: Opportunities to Improve Oversight of the Low-Income Housing Program," (GAO/GGD/RCED-97-55), dated March 28, 1997. The GAO report states on page 93 that an accounting firm with a tax credit speciality would charge in the $5,000 to $7,500 range per engagement for tax credit certifications (opinion on total costs, eligible basis, and tax credit amount) prepared on the basis of an audit done in accordance with AICPA audit standards even for projects costing upwards of $5 million to $10 million. As a percentage of development costs, the CPA tax credit certifications represent a minimal cost for validating financial information. However, in recognition that the cost may be burdensome for smaller developers, the final regulations limit the requirement for an audited schedule of costs for projects with more than 10 units. Two commentators were concerned that the meaning of the term "financial determinations and certifications" is unclear. A CPA would not be able to evaluate what needs to be audited and whether there are relevant and reliable criteria against which the information can be evaluated. To conduct an audit or attestation engagement, CPAs require that the subject matter be defined and that such subject matter be capable of evaluation against reasonable criteria. Reasonable criteria are essential so that CPAs using the same criteria will be able to arrive at similar conclusions. Another concern expressed by commentators involved uncertainty as to whether the CPA is being asked to report on financial information that is only historical or whether the CPA is also being asked to examine prospective financial information. CPAs can compile or examine and report on certain types of prospective financial information. However, such engagements generally are more costly than audits of historical information because of minimum presentation guidelines required by professional standards as well as increased risk associated with future-oriented information. The commentators believe that if an Agency were to require CPAs to be associated with prospective financial information, the related costs to the taxpayer may far exceed any perceived benefits to the Agency. Accordingly, the final regulations have been revised to specify that the CPA's opinion only relates to historical project costs.

C. Correction of Administrative Errors and Omissions

Commentators recommend filing the corrected allocation document with the current year's Form 8610, "Annual Low-Income Housing Credit Agencies Report," instead of amending the Form 8610 for the year the allocation was made. Because the administrative errors covered by the automatic approval provision will not have an effect on the total amount of credit the Agency allocated to the building(s) or project, commentators view an amended Form 8610 as unnecessary. Agency recordkeeping would be simplified if all corrected allocation documents could be submitted with the current year's Form 8610. The final regulations adopt this recommendation.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collections of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the burden on taxpayers is minimal and the burden on small entity Agencies is not signif icant. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Paul F. Handleman, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

Treasury Decision 8971 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Temporary regulations.

Summary: This document contains temporary regulations that provide guidance for taxpayers claiming the new markets tax credit under section 45D. A taxpayer making a qualified equity investment in a qualified community development entity that has received a new markets tax credit allocation may claim a 5–percent tax credit with respect to the qualified equity investment on each of the first 3 credit allowance dates and a 6–percent tax credit with respect to the qualified equity investment on each of the remaining 4 credit allowance dates. The text of these temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in REG– 119436–01 on page 377 of this Bulletin.

Dates: Effective Date: These regulations are effective December 26, 2001. Date of Applicability: For date of applicability of § 1.45D–1T, see § 1.45D– 1T(h).

For Further Information Contact: Paul Handleman (202) 622–3040.

Paperwork Reduction Act

These regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the

collections of information contained in these regulations have been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget under control number 1545–1765. Responses to these collections of information are mandatory. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number. For further information concerning these collections of information, and where to submit comments on the collections of information and the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble to the cross-referencing notice of proposed rulemaking published elsewhere in this issue of the Bulletin. Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document contains temporary regulations relating to the new markets tax credit under section 45D of the Internal Revenue Code (Code). This provision was added to the Code by section 121(a) of the Community Renewal Tax Relief Act of 2000 (Public Law 106–554). The Secretary has delegated certain administrative, application, allocation, monitoring, and other programmatic functions relating to the new markets tax credit program to the Under Secretary (Domestic Finance), who in turn has delegated those functions to the Community Development Financial Institutions Fund (CDFI Fund). On May 1, 2001, the IRS published an advance notice of proposed rulemaking (Announcement 2001–49, 2001–20 I.R.B. 1183) in the Federal Register (66 FR 21844) inviting comments relating to tax issues arising under section 45D. Numerous comments have been received. The IRS and Treasury Department have reviewed and considered all the comments in the process of preparing this

308

Treasury decision. This preamble to the temporary regulations describes many, but not all, of the comments received by the IRS.

Explanation of Provisions

General Overview

Taxpayers may claim a new markets tax credit on a credit allowance date in an amount equal to the applicable percentage of the taxpayer’s qualified equity investment in a qualified community development entity (CDE). The credit allowance date for any qualified equity investment is the date on which the investment is initially made and each of the 6 anniversary dates thereafter. The applicable percentage is 5 percent for the first 3 credit allowance dates and 6 percent for the remaining credit allowance dates. A CDE is any domestic corporation or partnership if: (1) the primary mission of the entity is serving or providing investment capital for low-income communities or low-income persons; (2) the entity maintains accountability to residents of low-income communities through their representation on any governing board of the entity or on any advisory board to the entity; and (3) the entity is certified by the Secretary for purposes of section 45D as being a CDE. The new markets tax credit may be claimed only for a qualified equity investment in a CDE. A qualified equity investment is any equity investment in a CDE for which the CDE has received an allocation from the Secretary if, among other things, the CDE uses substantially all of the cash from the investment to make qualified low-income community investments. Under a safe harbor, the substantially-all requirement is treated as met if at least 85 percent of the aggregate gross assets of the CDE are invested in qualified low-income community investments. Qualified low-income community investments consist of: (1) any capital or equity investment in, or loan to, any qualified active low-income community business; (2) the purchase from another CDE of any loan made by such entity that

January 22, 2002

is a qualified low-income community investment; (3) financial counseling and other services to businesses located in, and residents of, low-income communities; and (4) certain equity investments in, or loans to, a CDE. In general, a qualified active lowincome community business is a corporation or a partnership if for the taxable year: (1) at least 50 percent of the total gross income of the entity is derived from the active conduct of a qualified business within any low-income community; (2) a substantial portion of the use of the tangible property of the entity is within any low-income community; (3) a substantial portion of the services performed for the entity by its employees is performed in any low-income community; (4) less than 5 percent of the average of the aggregate unadjusted bases of the property of the entity is attributable to certain collectibles; and (5) less than 5 percent of the average of the aggregate unadjusted bases of the property of the entity is attributable to certain nonqualified financial property. Substantially All As indicated above, a CDE must use substantially all of the cash from a qualified equity investment to make qualified low-income community investments. Most commentators suggest that the substantially-all test should require that at least 85 percent of the taxpayer’s cash be committed to, or invested in, qualified low-income community investments. Some commentators propose that in order to provide CDEs with financial flexibility in managing their investments, the percentage should be reduced for the later years of the 7–year credit period. The temporary regulations adopt the suggestion to define substantially all as 85 percent or more and reduce the substantiallyall percentage to 75 percent for the seventh year of the 7–year credit period. Some commentators suggest that a CDE’s costs of obtaining equity investments in the CDE (such as underwriters’ fees and broker fees) and the CDE’s overhead expenses (such as staff salaries) should count toward satisfying the substantially-all requirement. Some commentators suggest that reserves maintained by the CDE of up to 10 percent of the taxpayer’s cash investment in the

January 22, 2002

CDE should count toward satisfying the substantially-all requirement. The temporary regulations do not include issuance costs or CDE overhead expenses as counting toward the substantially-all requirement. However, the temporary regulations provide that reserves (but not in excess of 5 percent of the taxpayer’s cash investment) for loan losses and for additional investments in existing qualified low-income community investments are treated as invested in a qualified lowincome community investment. Several commentators suggest that, for purposes of the “85 percent of the aggregate gross assets” safe harbor, aggregate gross assets should be determined according to cost basis and not, for example, fair market value. The temporary regulations adopt this suggestion. Cost basis is defined under the temporary regulations as cost basis under section 1012. Commentators propose that a CDE should have from 12 months to 5 years to invest the cash from a qualified equity investment in a qualified low-income community investment, depending upon the type of investment. The temporary regulations adopt a 12–month period for investing the taxpayer’s cash investment. Commentators propose that repayments to a CDE of equity or principal from qualified low-income community investments should have to be reinvested by the CDE within 12 months, but that no reinvestment should be required in the sixth and seventh years of the 7–year credit period. One commentator proposes that reinvestment should be encouraged, but not required. Another commentator would limit the time period to 45 days for identifying the investment and 180 days for making the investment. The temporary regulations adopt the suggestion that repayment amounts reinvested within 12 months are treated as continuously invested in qualified low-income community investments. In addition, repayments received in the seventh year of the 7–year credit period are not required to be reinvested. Qualified Active Low-Income Community Businesses As indicated above, qualified lowincome community investments include any capital or equity investment in, or loan to, any qualified active low-income

309

community business. A business is a qualified active low-income community business only if, among other things: (1) at least 50 percent of the total gross income of the business is derived from the active conduct of a qualified business within any low-income community; (2) a substantial portion of the use of the tangible property of the business is within any low-income community; and (3) a substantial portion of the services performed for the business by its employees is performed in any low-income community. Commentators propose that, to satisfy the “50 percent of the total gross income derived from the active conduct” requirement (50–percent requirement) in the case of a manufacturing business, 50 percent of production, but not sales, should have to occur within a low-income community. For a services business, commentators recommend a requirement that at least 50 percent of the services be provided by employees of offices in lowincome communities even if the services are provided elsewhere. One commentator suggests that the 50–percent requirement should be deemed met if the business is located in the low-income community and most of the employees are residents of the low-income community. Another commentator suggests that the requirement should be satisfied if 50 percent of the total gross income is derived from: (1) the operation of, or production at, a facility located in a lowincome community; (2) most of the employees are based at such a facility; and (3) the management is located within the low-income community. For purposes of the tangible property and services performed requirements, recommendations for the percentage that should constitute a substantial portion range from 20 percent to 50 percent. Alternatively, some commentators propose that the tangible property and services performed requirements should be satisfied if the business satisfies one of the following: (1) the business is located in a qualified area; (2) the business operates a major facility in a qualified area; (3) the business’ primary business activity takes place in a qualified area; or (4) the business’ primary mission is working with people in qualified areas.

For purposes of the tangible property and services performed requirements, the temporary regulations define a substantial portion as 40 percent. In addition, the temporary regulations provide that the 50–percent requirement is deemed to be satisfied if the entity meets the requirements of either the tangible property test or the services performed test, if 50 percent is substituted for 40 percent. Further, the entity may satisfy the 50-percent requirement based on all the facts and circumstances. Commentators propose that for purposes of determining when a trade or business constitutes a qualified active low-income community business, an entity should qualify as a qualified active low-income community business if the CDE reasonably expects, at the time the CDE makes the capital or equity investment in, or loan to, the entity, that the entity will satisfy the requirements to be a qualified active low-income community business throughout the entire period of the investment or loan. This proposal has been adopted in the temporary regulations, except in the case where the CDE controls the entity. If the CDE controls the entity at any time during the 7-year credit period, the reasonable expectation test does not apply and the entity must be a qualified active low-income community business during the entire period the CDE controls the entity. Commentators suggest that control for this purpose should be defined as at least 50 percent of voting power. Some commentators suggest that control should be determined based on whether the CDE is related to the entity within the meaning of sections 267(b) or 707(b)(1). The temporary regulations define control with respect to an entity as direct or indirect ownership (based on value) or control (based on voting or management rights) of 33 percent or more of the entity. However, a CDE does not control an entity if an unrelated person possesses greater control over the entity than the CDE. Financial Counseling and Other Services Commentators suggest that the definition of financial counseling and other services should include services for identifying CDE investment opportunities; preparing business owners to use finan-

cial products; underwriting loans and investments; helping business owners create viable business plans; and, after loans and investments are made, enhancing business planning, marketing, management, and financial skills of business owners and serving on their boards of directors. The temporary regulations define financial counseling and other services as advice provided by the CDE relating to the organization or operation of a trade or business that is provided to a qualified active low-income community business or to residents of a low-income community. Investments in Other CDEs Commentators propose that, for purposes of the substantially-all requirement, tracing should not be required when a CDE invests in another CDE, but other mechanisms should be required (for example, decertifying the recipient CDE if it does not use funds properly). Alternatively, commentators propose tracing at the recipient CDE level, but minimizing the reporting and recapture burdens for the recipient CDEs. Some commentators suggest that the recipient CDE should have the same restrictions placed on it as the investing CDE. The temporary regulations provide that an equity investment in, or loan to, another CDE is a qualified low-income community investment only to the extent that the recipient CDE uses the proceeds: (1) for either an investment in, or a loan to, a qualified active lowincome community business, or financial counseling and other services; and (2) in a manner that would constitute a qualified low-income community investment if it were made directly by the CDE making the equity investment or loan. Recapture A recapture event requiring an investor to recapture credits previously taken may occur for an equity investment in a CDE if the CDE: (1) ceases to be a CDE; (2) ceases to use substantially all of the proceeds of the equity investment for qualified low-income community investments; or (3) redeems the investor’s equity investment. Commentators suggest that a CDE should be permitted to take remedial actions to avoid recapture. The temporary

310

regulations adopt this suggestion by providing a CDE the opportunity to request a waiver of a requirement or an extension of time to meet a deadline contained in the temporary regulations if such waiver or extension does not materially frustrate the purposes of section 45D and the regulations thereunder. A CDE that believes it has good cause for a waiver or an extension may request relief from the Commissioner in a ruling request. In considering such a ruling request, the Commissioner may consult with the CDFI Fund in a manner consistent with section 6103. The granting of a waiver or an extension may require adjustments of the CDE’s requirements under section 45D and the regulations thereunder as may be appropriate. Other Federal Tax Benefits The Treasury Department is authorized to prescribe regulations that limit the new markets tax credit for investments that are directly or indirectly subsidized by other Federal tax benefits (including the lowincome housing tax credit under section 42 and the exclusion from gross income under section 103). Commentators suggest that a CDE should not be permitted to use the proceeds of a qualified equity investment to purchase tax-exempt bonds. However, the same commentators state that there should be no restriction on the receipt of tax-exempt bond proceeds by a qualified active low-income community business. The temporary regulations do not prohibit a CDE from purchasing taxexempt bonds because tax-exempt financing provides a subsidy to borrowers and not bondholders. Moreover, a loan by a CDE directly to a qualified active lowincome community business cannot be a tax-exempt bond because the loan is not an obligation of a state or local government. Because the rental to others of residential rental property cannot be a qualified active low-income community business, a taxpayer cannot receive the low-income housing tax credit and new markets tax credit on the same investment. Although the temporary regulations do not provide specific rules on double tax benefit issues, the IRS and the Treasury Department request additional comments on what Federal tax benefits should limit the new markets tax credit.

January 22, 2002

Reporting Requirements

The Treasury Department is authorized to prescribe regulations that impose appropriate reporting requirements for the new markets tax credit. Commentators suggest that the information reporting to the Treasury Department should be undertaken on an annual basis and that CDEs should be required to provide the following information: financial statements, a list of investors and closing and commitment dates, a list of eligible investments, terms of investments and location of investments, information on loan loss or investments reserves, and information on financial counseling and other services. The reporting requirements in the temporary regulations require a CDE to provide notice: (1) to any taxpayer who acquires a qualified equity investment in the CDE at its original issue that the equity investment is a qualified equity investment entitling the taxpayer to claim the new markets tax credit; and (2) in the case of a recapture event, to each holder of an equity investment, including all prior holders of that investment, that a recapture event has occurred. CDEs must comply with such reporting requirements to the Secretary as the Secretary may prescribe. Taxpayers may claim the new markets tax credit by completing Form 8874, “New Markets Credit,” and by filing the form with the taxpayer’s Federal income tax return.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that any burden on taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

January 22, 2002

Drafting Information

The principal author of these regulations is Paul F. Handleman, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development. *

Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows: Authority: 26 U.S.C. 7805 Section 1.45D–1T also issued under 26 U.S.C. 45D(i); Par. 2. Section 1.45D–1T is added to read as follows: § 1.45D–1T New markets tax credit. (a) Table of contents. This paragraph lists the headings that appear in § 1.45D– 1T. (a) Table of contents. (b) Allowance of credit (1) In general. (2) Credit allowance date. (3) Applicable percentage. (4) Amount paid at original issue. (c) Qualified equity investment. (1) In general. (2) Equity investment. (3) Equity investments made prior to allocation. (i) In general. (ii) Exception. (iii) Initial investment date. (4) Limitations. (i) In general. (ii) Allocation limitation. (5) Substantially all. (i) In general. (ii) Direct-tracing calculation. (iii) Safe harbor calculation. (iv) Time limit for making investments. (v) Reduced substantially-all percentage. (6) Aggregation of equity investments. (7) Subsequent purchasers.

311

(d) Qualified low-income community investments. (1) In general. (i) Investment in a qualified active low-income community business. (ii) Purchase of certain loans from CDEs. (iii) Financial counseling and other services. (iv) Investments in other CDEs. (2) Payments of, or for, capital, equity or principal. (i) In general. (ii) Subsequent reinvestments. (iii) Special rule for loans. (iv) Example. (3) Special rule for reserves. (4) Qualified active low-income community business. (i) In general. (A) Gross-income requirement. (B) Use of tangible property. (C) Services performed. (D) Collectibles. (E) Nonqualified financial property. (ii) Proprietorships. (iii) Portions of business. (5) Qualified business. (i) In general. (ii) Rental of real property. (iii) Exclusions. (A) Trades or businesses involving intangibles. (B) Certain other trades or businesses. (C) Farming. (6) Qualifications. (i) In general. (ii) Control. (A) In general. (B) Definition of control. (7) Financial counseling and other services. (e) Recapture. (1) In general. (2) Recapture event. (3) Bankruptcy. (4) Waiver of requirement or extension of time. (i) In general. (ii) Manner for requesting a waiver or extension. (iii) Terms and conditions. (5) Example. (f) Basis reduction. (1) In general. (2) Adjustment in basis of interest in partnership or S corporation. (g) Other rules.

(1) Anti-abuse. (2) Reporting requirements. (i) Notification by CDE to taxpayer. (A) Allowance of new markets tax credit. (B) Recapture event. (ii) CDE reporting requirements to Secretary. (iii) Manner of claiming new markets tax credit. (iv) Reporting recapture tax. (h) Effective date. (b) Allowance of credit—(1) In general. For purposes of the general business credit under section 38, a taxpayer holding a qualified equity investment on a credit allowance date which occurs during the taxable year may claim the new markets tax credit determined under section 45D and this section for such taxable year in an amount equal to the applicable percentage of the amount paid to a qualified community development entity (CDE) for such investment at its original issue. Qualified equity investment is defined in paragraph (c) of this section. Credit allowance date is defined in paragraph (b)(2) of this section. Applicable percentage is defined in paragraph (b)(3) of this section. A CDE is a qualified community development entity as defined in section 45D(c). The amount paid at original issue is determined under paragraph (b)(4) of this section. (2) Credit allowance date. The term credit allowance date means, with respect to any qualified equity investment— (i) The date on which the investment is initially made; and (ii) Each of the 6 anniversary dates of such date thereafter. (3) Applicable percentage. The applicable percentage is 5 percent for the first 3 credit allowance dates and 6 percent for the other 4 credit allowance dates. (4) Amount paid at original issue. The amount paid to the CDE for a qualified equity investment at its original issue consists of all amounts paid by the taxpayer to, or on behalf of, the CDE (including any underwriter’s fees) to purchase the investment at its original issue. (c) Qualified equity investment—(1) In general. The term qualified equity investment means any equity investment (as defined in paragraph (c)(2) of this section) in a CDE if—

(i) The investment is acquired by the taxpayer at its original issue (directly or through an underwriter) solely in exchange for cash; (ii) Substantially all (as defined in paragraph (c)(5) of this section) of such cash is used by the CDE to make qualified low-income community investments (as defined in paragraph (d)(1) of this section); and (iii) The investment is designated for purposes of section 45D and this section by the CDE on its books and records using any reasonable method. (2) Equity investment. The term equity investment means any stock (other than nonqualified preferred stock as defined in section 351(g)(2)) in an entity that is a corporation for Federal tax purposes and any capital interest in an entity that is a partnership for Federal tax purposes. See §§ 301.7701–1 through 301.7701–3 of this chapter for rules governing when a business entity, such as a business trust or limited liability company, is classified as a corporation or a partnership for Federal tax purposes. (3) Equity investments made prior to allocation—(i) In general. Except as provided in paragraph (c)(3)(ii) of this section, an equity investment in an entity is not eligible to be designated as a qualified equity investment if it is made before the entity enters into an allocation agreement with the Secretary. An allocation agreement is an agreement between the Secretary and a CDE relating to a new markets tax credit allocation under section 45D(f)(2). (ii) Exception. Notwithstanding paragraph (c)(3)(i) of this section, an equity investment in an entity is eligible to be designated as a qualified equity investment under paragraph (c)(1)(iii) of this section if— (A) The equity investment is made on or after April 20, 2001; (B) The entity in which the equity investment is made is certified by the Secretary as a CDE under section 45D(c) before January 1, 2003; (C) The entity in which the equity investment is made receives notification of the credit allocation (with the actual receipt of such credit allocation contingent upon subsequently entering into an allocation agreement) from the Secretary before January 1, 2003; and

312

(D) The equity investment otherwise satisfies the requirements of section 45D and this section. (iii) Initial investment date. If an equity investment is designated as a qualified equity investment in accordance with paragraph (c)(3)(ii) of this section, the investment is treated as initially made on the effective date of the allocation agreement between the CDE and the Secretary. (4) Limitations—(i) In general. The term qualified equity investment does not include— (A) Any equity investment issued by a CDE more than 5 years after the date the CDE enters into an allocation agreement (as defined in paragraph (c)(3)(i) of this section) with the Secretary; and (B) Any equity investment by a CDE in another CDE, if the CDE making the investment has received an allocation under section 45D(f)(2). (ii) Allocation limitation. The maximum amount of equity investments issued by a CDE that may be designated under paragraph (c)(1)(iii) of this section by the CDE may not exceed the portion of the limitation amount allocated to the CDE by the Secretary under section 45D(f)(2). (5) Substantially all—(i) In general. Except as provided in paragraph (c)(5)(v) of this section, the term substantially all means at least 85 percent. The substantially-all requirement must be satisfied for each annual period in the 7-year credit period using either the directtracing calculation under paragraph (c)(5)(ii) of this section, or the safe harbor calculation under paragraph (c)(5)(iii) of this section. The substantially-all requirement is treated as satisfied for an annual period if either the direct-tracing calculation under paragraph (c)(5)(ii) of this section, or the safe harbor calculation under paragraph (c)(5)(iii) of this section, is performed every six months and the average of the two calculations for the annual period is at least 85 percent. For purposes of this paragraph (c)(5)(i), the 7-year credit period means the period of 7 years beginning on the date the qualified equity investment is initially made. See paragraph (c)(6) of this section for circumstances in which a CDE may treat more than one equity investment as a single qualified equity investment.

January 22, 2002

(ii) Direct-tracing calculation. The substantially-all requirement is satisfied if at least 85 percent of the taxpayer’s investment is directly traceable to qualified low-income community investments as defined in paragraph (d)(1) of this section. The direct-tracing calculation is a fraction the numerator of which is the CDE’s aggregate cost basis determined under section 1012 in all of the qualified low-income community investments that are directly traceable to the taxpayer’s cash investment, and the denominator of which is the amount of the taxpayer’s cash investment under paragraph (b)(4) of this section. For purposes of this paragraph (c)(5)(ii), cost basis includes the cost basis of any qualified low-income community investment that becomes worthless. See paragraph (d)(2) of this section for the treatment of amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment. (iii) Safe harbor calculation. The substantially-all requirement is satisfied if at least 85 percent of the aggregate gross assets of the CDE are invested in qualified low-income community investments as defined in paragraph (d)(1) of this section. The safe harbor calculation is a fraction the numerator of which is the CDE’s aggregate cost basis determined under section 1012 in all of its qualified lowincome community investments, and the denominator of which is the CDE’s aggregate cost basis determined under section 1012 in all of its assets. For purposes of this paragraph (c)(5)(iii), cost basis includes the cost basis of any qualified low-income community investment that becomes worthless. See paragraph (d)(2) of this section for the treatment of amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment. (iv) Time limit for making investments. The taxpayer’s cash investment received by a CDE is treated as invested in a qualified low-income community investment as defined in paragraph (d)(1) of this section only to the extent that the cash is so invested no later than 12 months after the date the cash is paid by the taxpayer (directly or through an underwriter) to the CDE.

January 22, 2002

(v) Reduced substantially-all percentage. For purposes of the substantially-all requirement (including the direct-tracing calculation under paragraph (c)(5)(ii) of this section and the safe harbor calculation under paragraph (c)(5)(iii) of this section), 85 percent is reduced to 75 percent for the seventh year of the 7-year credit period (as defined in paragraph (c)(5)(i) of this section). (6) Aggregation of equity investments. A CDE may treat any qualified equity investments issued on the same day as one qualified equity investment. If a CDE aggregates equity investments under this paragraph (c)(6), the rules in this section shall be construed in a manner consistent with that treatment. (7) Subsequent purchasers. A qualified equity investment includes any equity investment that would (but for paragraph (c)(1)(i) of this section) be a qualified equity investment in the hands of the taxpayer if the investment was a qualified equity investment in the hands of a prior holder. (d) Qualified low-income community investments—(1) In general. The term qualified low-income community investment means any of the following— (i) Investment in a qualified active low-income community business. Any capital or equity investment in, or loan to, any qualified active low-income community business (as defined in paragraph (d)(4) of this section). (ii) Purchase of certain loans from CDEs. The purchase from another CDE (whether or not that CDE has received an allocation from the Secretary under section 45D(f)(2)) of any loan made by such entity that is a qualified low-income community investment. A loan purchased from another CDE is a qualified lowincome community investment if it qualifies as such either— (A) At the time the selling CDE made the loan; or (B) At the time the loan is purchased from the selling CDE. (iii) Financial counseling and other services. Financial counseling and other services (as defined in paragraph (d)(7) of this section) provided to any qualified active low-income community business, or to any residents of a low-income community (as defined in section 45D(e)).

313

(iv) Investments in other CDEs. Any equity investment in, or loan to, any CDE, but only to the extent that the CDE in which the equity investment or loan is made uses the proceeds of the investment or loan in a manner— (A) That is described in paragraphs (d)(1)(i) or (iii) of this section; and (B) That would constitute a qualified low-income community investment if it were made directly by the CDE making such equity investment or loan. (2) Payments of, or for, capital, equity or principal—(i) In general. Except as otherwise provided in this paragraph (d)(2), amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified lowincome community investment must be reinvested by the CDE in a qualified lowincome community investment no later than 12 months from the date of receipt to be treated as continuously invested in a qualified low-income community investment. If the amounts received by the CDE are equal to or greater than the cost basis of the original qualified low-income community investment (or applicable portion thereof), and the CDE reinvests, in accordance with this paragraph (d)(2)(i), an amount at least equal to such original cost basis, then an amount equal to such original cost basis will be treated as continuously invested in a qualified lowincome community investment. In addition, if the amounts received by the CDE are equal to or greater than the cost basis of the original qualified low-income community investment (or applicable portion thereof), and the CDE reinvests, in accordance with this paragraph (d)(2)(i), an amount less than such original cost basis, then only the amount so reinvested will be treated as continuously invested in a qualified low-income community investment. If the amounts received by the CDE are less than the cost basis of the original qualified low-income community investment (or applicable portion thereof), and the CDE reinvests an amount in accordance with this paragraph (d)(2)(i), then the amount treated as continuously invested in a qualified lowincome community investment will equal the excess (if any) of such original cost basis over the amounts received by the CDE that are not so reinvested. Amounts received by a CDE in payment of, or for,

capital, equity or principal with respect to a qualified low-income community investment during the seventh year of the 7-year credit period (as defined in paragraph (c)(5)(i) of this section) do not have to be reinvested by the CDE in a qualified low-income community investment in order to be treated as continuously invested in a qualified low-income community investment. (ii) Subsequent reinvestments. In applying paragraph (d)(2)(i) of this section to subsequent reinvestments, the original cost basis is reduced by the amount (if any) by which the original cost basis exceeds the amount determined to be continuously invested in a qualified low-income community investment. (iii) Special rule for loans. Periodic amounts received during a calendar year as repayment of principal on a loan that is a qualified low-income community investment are treated as continuously invested in a qualified low-income community investment if the amounts are reinvested in another qualified lowincome community investment by the end of the following calendar year. (iv) Example. The application of paragraphs (d)(2)(i) and (ii) of this section is illustrated by the following example: Example. On April 1, 2003, A, B, and C each pay $100,000 to acquire a capital interest in X, a partnership. X is a CDE that has received a new markets tax credit allocation from the Secretary. X treats the 3 partnership interests as one qualified equity investment under paragraph (c)(6) of this section. In August 2003, X uses the $300,000 to make a qualified low-income community investment under paragraph (d)(1) of this section. In August 2005, the qualified low-income community investment is redeemed for $250,000. In February 2006, X reinvests $230,000 of the $250,000 in a second qualified low-income community investment and uses the remaining $20,000 for operating expenses. Under paragraph (d)(2)(i) of this section, $280,000 of the proceeds of the qualified equity investment is treated as continuously invested in a qualified lowincome community investment. In December 2008, X sells the second qualified low-income community investment and receives $400,000. In March 2009, X reinvests $320,000 of the $400,000 in a third qualified low-income community investment. Under paragraphs (d)(2)(i) and (ii) of this section, $280,000 of the proceeds of the qualified equity investment is treated as continuously invested in a qualified low-income community investment ($40,000 is treated as invested in another qualified low-income community investment in March 2009).

(3) Special rule for reserves. Reserves (not in excess of 5 percent of the taxpayer’s cash investment under paragraph (b)(4) of this section) maintained by the

CDE for loan losses or for additional investments in existing qualified lowincome community investments are treated as invested in a qualified lowincome community investment under paragraph (d)(1) of this section. (4) Qualified active low-income community business—(i) In general. The term qualified active low-income community business means, with respect to any taxable year, a corporation (including a nonprofit corporation) or a partnership, if the requirements in paragraphs (d)(4)(i)(A), (B), (C), (D), and (E) are met. (A) Gross-income requirement. At least 50 percent of the total gross income of such entity is derived from the active conduct of a qualified business (as defined in paragraph (d)(5) of this section) within any low-income community (as defined in section 45D(e)). An entity is deemed to satisfy this paragraph (d)(4)(i)(A) if the entity meets the requirements of either paragraph (d)(4)(i)(B) or (C) of this section, if “50 percent” is applied instead of 40 percent. In addition, an entity may satisfy this paragraph (d)(4)(i)(A) based on all the facts and circumstances. (B) Use of tangible property. At least 40 percent of the use of the tangible property of such entity (whether owned or leased) is within any low-income community. This percentage is determined based on a fraction the numerator of which is the average value of the tangible property owned or leased by the entity and used by the entity during the taxable year in a low-income community and the denominator of which is the average value of the tangible property owned or leased by the entity and used by the entity during the taxable year. Property owned by the entity is valued at its cost basis as determined under section 1012. Property leased by the entity is valued at a reasonable amount established by the entity. (C) Services performed. At least 40 percent of the services performed for such entity by its employees are performed in a low-income community. This percentage is determined based on a fraction the numerator of which is the total amount paid by the entity for employee services performed in a low-income community during the taxable year and the denominator of which is the total amount paid by

314

the entity for employee services during the taxable year. (D) Collectibles. Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to collectibles (as defined in section 408(m)(2)) other than collectibles that are held primarily for sale to customers in the ordinary course of business. (E) Nonqualified financial property. Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property (as defined in section 1397C(e)). Because the definition of nonqualified financial property in section 1397C(e) includes debt instruments with a term in excess of 18 months, banks, credit unions, and other financial institutions are generally excluded from the definition of a qualified active lowincome community business. (ii) Proprietorships. Any business carried on by an individual as a proprietor is a qualified active low-income community business if the business would meet the requirements of paragraph (d)(4)(i) of this section if the business were incorporated. (iii) Portions of business. A CDE may treat any trade or business as a qualified active low-income community business if the trade or business would meet the requirements of paragraph (d)(4)(i) of this section if the trade or business were separately incorporated. (5) Qualified business—(i) In general. Except as otherwise provided in this paragraph (d)(5), the term qualified business means any trade or business. There is no requirement that employees of a qualified business be residents of a low-income community. (ii) Rental of real property. The rental to others of real property located in any low-income community (as defined in section 45D(e)) is a qualified business if and only if the property is not residential rental property (as defined in section 168(e)(2)(A)) and there are substantial improvements located on the real property. (iii) Exclusions—(A) Trades or businesses involving intangibles. The term qualified business does not include any trade or business consisting predominantly of the development or holding of intangibles for sale or license.

January 22, 2002

(B) Certain other trades or businesses. The term qualified business does not include any trade or business consisting of the operation of any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. (C) Farming. The term qualified business does not include any trade or business the principal activity of which is farming (within the meaning of section 2032A(e)(5)(A) or (B)) if, as of the close of the taxable year of the taxpayer conducting such trade or business, the sum of the aggregate unadjusted bases (or, if greater, the fair market value) of the assets owned by the taxpayer that are used in such a trade or business, and the aggregate value of the assets leased by the taxpayer that are used in such a trade or business, exceeds $500,000. For purposes of this paragraph (d)(5)(iii)(C), two or more trades or businesses will be treated as a single trade or business under rules similar to the rules of section 52(a) and (b). (6) Qualifications—(i) In general. Except as provided in paragraph (d)(6)(ii) of this section, an entity is treated as a qualified active low-income community business for the duration of the CDE’s investment in the entity if the CDE reasonably expects, at the time the CDE makes the capital or equity investment in, or loan to, the entity, that the entity will satisfy the requirements to be a qualified active low-income community business under paragraph (d)(4)(i) of this section throughout the entire period of the investment or loan. (ii) Control—(A) In general. If a CDE controls or obtains control of an entity at any time during the 7-year credit period (as defined in paragraph (c)(5)(i) of this section), the entity will be treated as a qualified active low-income community business only if the entity satisfies the requirements of paragraph (d)(4)(i) of this section throughout the entire period the CDE controls the entity. (B) Definition of control. Generally, control means, with respect to an entity, direct or indirect ownership (based on value) or control (based on voting or management rights) of 33 percent or

January 22, 2002

more of the entity. However, a CDE does not control an entity if an unrelated person possesses greater control over the entity than the CDE. (7) Financial counseling and other services. The term financial counseling and other services means advice provided by the CDE relating to the organization or operation of a trade or business. (e) Recapture—(1) In general. If, at any time during the 7-year period beginning on the date of the original issue of a qualified equity investment in a CDE, there is a recapture event under paragraph (e)(2) of this section with respect to such investment, then the tax imposed by Chapter 1 of the Internal Revenue Code for the taxable year in which the recapture event occurs is increased by the credit recapture amount under section 45D(g)(2). A recapture event under paragraph (e)(2) of this section requires recapture of credits allowed to the taxpayer who purchased the equity investment from the CDE at its original issue and to all subsequent holders of that investment. (2) Recapture event. There is a recapture event with respect to an equity investment in a CDE if— (i) The entity ceases to be a CDE; (ii) The proceeds of the investment cease to be used in a manner that satisfies the substantially-all requirement of paragraph (c)(1)(ii) of this section; or (iii) The investment is redeemed by the CDE. (3) Bankruptcy. Bankruptcy of a CDE is not a recapture event. (4) Waiver of requirement or extension of time—(i) In general. The Commissioner may waive a requirement or extend a deadline if such waiver or extension does not materially frustrate the purposes of section 45D and this section. (ii) Manner for requesting a waiver or extension. A CDE that believes it has good cause for a waiver or an extension may request relief from the Commissioner in a ruling request. The request should set forth all the relevant facts and include a detailed explanation describing the event or events relating to the request for a waiver or an extension. For further information on the application procedure for a ruling, see Rev. Proc. 2001–1 (2001–1 I.R.B. 1) (see §601.601(d)(2) of this chapter).

315

(iii) Terms and conditions. The granting of a waiver or an extension to a CDE under this section may require adjustments of the CDE’s requirements under section 45D and this section as may be appropriate. (5) Example. The application of this paragraph (e) is illustrated by the following example: Example. In 2003, A and B acquire separate qualified equity investments in X, a partnership. X is a CDE that has received a new markets tax credit allocation from the Secretary. X uses the proceeds of A’s qualified equity investment to make a qualified low-income community investment in Y, and X uses the proceeds of B’s qualified equity investment to make a qualified low-income community investment in Z. Y and Z are not CDEs. X controls both Y and Z within the meaning of paragraph (d)(6)(ii)(B) of this section. In 2003, Y and Z are qualified active low-income community businesses. In 2007, Y, but not Z, is a qualified active lowincome community business and X does not satisfy the substantially-all requirement using the safe harbor calculation under paragraph (c)(5)(iii) of this section. A’s equity investment satisfies the substantially-all requirement of paragraph (c)(1)(ii) of this section using the direct-tracing calculation of paragraph (c)(5)(ii) of this section because A’s equity investment is traceable to Y. However, B’s equity investment fails the substantially-all requirement using the direct-tracing calculation because B’s equity investment is traceable to Z. Therefore, under paragraph (e)(2)(ii) of this section, there is a recapture event for B’s equity investment (but not A’s equity investment).

(f) Basis reduction—(1) In general. A taxpayer’s basis in a qualified equity investment is reduced by the amount of any new markets tax credit determined under paragraph (b)(1) of this section with respect to the investment. A basis reduction occurs on each credit allowance date under paragraph (b)(2) of this section. This paragraph (f) does not apply for purposes of sections 1202, 1400B, and 1400F. (2) Adjustment in basis of interest in partnership or S corporation. The adjusted basis of either a partner’s interest in a partnership, or stock in an S corporation, must be appropriately adjusted to take into account adjustments made under paragraph (f)(1) of this section in the basis of a qualified equity investment held by the partnership or S corporation (as the case may be). (g) Other rules—(1) Anti-abuse. If a principal purpose of a transaction or a series of transactions is to achieve a result that is inconsistent with the purposes of section 45D and this section, the Commissioner may treat the transaction or

series of transactions as causing a recapture event under paragraph (e)(2) of this section. (2) Reporting requirements—(i) Notification by CDE to taxpayer—(A) Allowance of new markets tax credit. A CDE must provide notice to any taxpayer who acquires a qualified equity investment in the CDE at its original issue that the equity investment is a qualified equity investment entitling the taxpayer to claim the new markets tax credit. The notice must be provided by the CDE to the taxpayer no later than 60 days after the date the taxpayer makes the investment in the CDE. The notice must contain the amount paid to the CDE for the qualified equity investment at its original issue and the taxpayer identification number of the CDE. (B) Recapture event. If, at any time during the 7–year period beginning on the date of the original issue of a qualified equity investment in a CDE, there is a

recapture event under paragraph (e)(2) of this section with respect to such investment, the CDE must provide notice to each holder, including all prior holders, of the investment that a recapture event has occurred. The notice must be provided by the CDE no later than 60 days after the date the CDE becomes aware of the recapture event. (ii) CDE reporting requirements to Secretary. Each CDE must comply with such reporting requirements to the Secretary as the Secretary may prescribe. (iii) Manner of claiming new markets tax credit. A taxpayer may claim the new markets tax credit for each applicable taxable year by completing Form 8874, “New Markets Credit,” and by filing Form 8874 with the taxpayer’s Federal income tax return. (iv) Reporting recapture tax. If there is a recapture event with respect to a taxpayer’s equity investment in a CDE, the taxpayer must include the credit recapture

amount under section 45D(g)(2) on the line for recapture taxes on the taxpayer’s Federal income tax return for the taxable year in which the recapture event under paragraph (e)(2) of this section occurs (or on the line for total tax, if there is no such line for recapture taxes) and write NMCR (new markets credit recapture) next to the entry space. (h) Effective date. This section applies on or after December 26, 2001. PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT Par. 3. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 4. In § 602.101, paragraph (b) is amended by adding an entry to the table in numerical order to read as follows: § 602.101 OMB Control numbers. **** (b)

CFR part or section where identified and described

Current OMB control No.

***** 1.45D–1T..................................................................................................................................................................

1545–1765

***** Robert E. Wenzel, Deputy Commissioner of Internal Revenue. Approved December 17, 2001. Mark Weinberger, Assistant Secretary of the Treasury. (Filed by the Office of the Federal Register on December 21, 2001, 8:45 a.m., and published in the issue of the Federal Register for December 26, 2001, 66 F.R. 66307)

Section 106.—Contributions by Employer to Accident and Health Plans

Rev. Rul. 2002–3

FACTS

ISSUE

(Also Section 125 — Cafeteria Plans and Section 105 — Amounts Received Under Accident and Health Plans).

Whether, under the facts described, the exclusions from gross income under §§106(a) or 105(b) of the Internal Revenue Code apply to reimbursements by an employer to employees for salary reduction amounts used to pay for health insurance premiums.

Employer M provides health coverage for its employees through a group health insurance policy. The coverage constitutes accident or health coverage for purposes of the exclusion for employerprovided accident or health coverage under §106(a).

Application of sections 106(a) and 105(b) to reimbursements of employees for salary reduction amounts previously excluded from gross income under section 106(a).

316

January 22, 2002

Treasury Decision 9110 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations that amend several existing regulations concerning the low-income housing tax credit. The regulations primarily reflect changes to the law made by the Community Renewal Tax Relief Act of 2000 and affect owners of low-income housing projects who claim the credit and the State or local housing credit agencies who administer the credit.

Dates: Effective Date: These regulations are effective January 6, 2004. Applicability Dates: For dates of applicability of these regulations, see §§ 1.42–12(a)(2) and (3), and 1.42– 14(l)(2).

For Further Information Contact: Lauren R. Taylor (202) 622–3040 or Christopher J. Wilson (808) 539–2874 (not toll-free numbers).

Background

On July 7, 2003, the IRS published a notice of proposed rulemaking in the Federal Register (68 FR 40218) proposing amendments to the Income Tax Regulations (26 CFR part 1) under section 42 of the Internal Revenue Code. These amendments provide guidance regarding changes to section 42 made by the Community Renewal Tax Relief Act of 2000 (Public Law 106–554) (2000 Act) and make certain changes to the regulations to help facilitate the electronic filing (E-filing) of income tax returns. One commentator submitted written comments in response to the notice of proposed rulemaking. A public hearing was scheduled for September 23, 2003, pursuant to a notice of public hearing published simultaneously with the

notice of proposed rulemaking. The IRS received one request to speak at the public hearing. This request was withdrawn before the hearing date. On September 15, 2003, the IRS published a notice (68 FR 53926) canceling the public hearing on the proposed regulations. After consideration of the comments received, the proposed regulations are adopted as revised by this Treasury decision. The revisions are discussed below.

Explanation of Provisions

Section 42 provides for a low-income housing tax credit that may be claimed as part of the general business credit under section 38. In general, the credit is allowable only if the owner of a qualified low-income building receives a housing credit allocation from a State or local housing credit agency (Agency) of the jurisdiction where the building is located. In general, an allocation must be made not later than the close of the calendar year in which the building is placed in service. Under section 42(h)(1)(E), an allocation (carryover allocation) may be made to a ‘‘qualified building’’ that has not yet been placed in service, provided the building is placed in service not later than the close of the second calendar year following the calendar year of the allocation. Section 42(h)(1)(F) provides rules for multi-building projects receiving project-based carryover allocations. Following the changes made by the 2000 Act, section 42(h)(1)(E)(ii) defines a qualified building as any building that is part of a project if the taxpayer’s basis in the project (as of the later of the date which is 6 months after the date that the allocation was made or the close of the calendar year in which the allocation is made) is more than 10 percent of the taxpayer’s reasonably expected basis in the project (as of the close of the second calendar year following the calendar year of the allocation). The commentator recommended revising § 1.42–6(a)(2) of the proposed regulations to clarify that each building in a multi-building project receiving a project-based carryover allocation under section 42(h)(1)(F) need not separately meet the 10 percent basis requirement. The commentator states that the proposed regulations appear to require that each building in a multi-building project that receives a project-based carryover allocation must meet the 10 percent basis requirement separately. The proposed regulations do not require that each building in a multi-building project satisfy the 10 percent basis requirement separately for project-based carryover allocations made under

section 42(h)(1)(F). For allocations made under section 42(h)(1)(F), the 10 percent basis requirement is only required to be met on a project basis. The final regulations clarify this issue.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a new collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking that preceded this Treasury decision was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Christopher J. Wilson and Lauren R. Taylor, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations ■ Accordingly, 26 CFR part 1 is amended

as follows: PART 1—INCOME TAXES ■ Paragraph 1. The authority citation for

part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * ■ Par. 2. Section 1.42–6 is amended by: ■ 1. Revising paragraphs (a), (b)(4)

Example 2, (c)(1), (c)(3), (d)(2)(viii), and (d)(4)(i). ■ 2. Removing the word ‘‘September’’ from paragraph (b)(4) Example 1. and adding the word ‘‘May’’ in its place; removing the year ‘‘1993’’ each place it appears and by adding the year ‘‘2003’’ in its place; and removing the year ‘‘1995’’ and adding the year ‘‘2005’’ in its place. ■ 3. Removing the language ‘‘by the close of the calendar year of the allocation’’ from the first and last sentences of

06JAR1

paragraph (c)(2) and adding the language ‘‘by the close of the calendar year of the allocation (for allocations made before July 1) or by the close of the date that is 6 months after the date the allocation is made (for allocations made after June 30)’’ in its place. ■ 4. Removing the language ‘‘, ‘‘Carryover Allocation of the LowIncome Housing Credit,’’ from paragraph (d)(4)(ii). ■ 5. Removing the language ‘‘before the close of the calendar year of the allocation’’ from the first sentence of paragraph (e)(2) and adding the language ‘‘by the close of the calendar year of the allocation (for allocations made before July 1) or by the close of the date that is 6 months after the date the allocation is made (for allocations made after June 30)’’ in its place. The revisions read as follows: § 1.42–6 Buildings qualifying for carryover allocations.

(a) Carryover allocations—(1) In general. A carryover allocation is an allocation that meets the requirements of section 42(h)(1)(E) or (F). If the requirements of section § 42(h)(1)(E) or (F) that are required to be satisfied by the close of a calendar year are not satisfied, the allocation is not valid and is treated as if it had not been made for that calendar year. For example, if a carryover allocation fails to satisfy a requirement in § 1.42–6(d) for making an allocation, such as failing to be signed or dated by an authorized official of an allocating agency by the close of a calendar year, the allocation is not valid and is treated as if it had not been made for that calendar year. (2) 10 percent basis requirement. A carryover allocation may only be made with respect to a qualified building. A qualified building is any building which is part of a project if, by the date specified under paragraph (a)(2)(i) or (ii) of this section, a taxpayer’s basis in the project is more than 10 percent of the taxpayer’s reasonably expected basis in the project as of the close of the second calendar year following the calendar year the allocation is made. For purposes of meeting the 10 percent basis requirement, the determination of whether a building is part of a singlebuilding project or multi-building project is based on whether the carryover allocation is made under section 42(h)(1)(E) (building-based allocation) or section 42(h)(1)(F) (project-based allocation). In the case of a multi-building project that receives an allocation under section 42(h)(1)(F), the 10 percent basis requirement is satisfied by reference to the entire project.

(i) Allocation made before July 1. If a carryover allocation is made before July 1 of a calendar year, a taxpayer must meet the 10 percent basis requirement by the close of that calendar year. If a taxpayer does not meet the 10 percent basis requirement by the close of the calendar year, the carryover allocation is not valid and is treated as if it had not been made. (ii) Allocation made after June 30. If a carryover allocation is made after June 30 of a calendar year, a taxpayer must meet the 10 percent basis requirement by the close of the date that is 6 months after the date the allocation was made. If a taxpayer does not meet the 10 percent basis requirement by the close of the required date, the carryover allocation must be returned to the Agency. Unlike a carryover allocation made before July 1, if a taxpayer does not meet the 10 percent basis requirement by the close of the required date, the carryover allocation is treated as a valid allocation for the calendar year of allocation, but is included in the ‘‘returned credit component’’ for purposes of determining the State housing credit ceiling under section 42(h)(3)(C) for the calendar year following the calendar year of the allocation. See § 1.42–14(d)(1). (b) (4) Example 2. (i) Facts. D, an accrual-method taxpayer, received a carryover allocation from Agency, the state housing credit agency of State X, on September 12, 2003. As of that date, D has not begun construction of the low-income housing building D plans to build and D does not have basis in the land on which D plans to build the building. From September 12, 2003, to the close of March 12, 2004, D incurs some costs related to the planned building, including architects’ fees. As of the close of March 12, 2004, these costs do not exceed 10 percent of D’s reasonably expected basis in the single-building project as of the close of 2005. (ii) Determination of whether building is qualified. Because D’s carryover-allocation basis as of the close of March 12, 2004, is not more than 10 percent of D’s reasonably expected basis in the single-building project, the building is not a qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph (a) of this section. Accordingly, the carryover allocation to D must be returned to the Agency. The allocation is valid for purposes of determining the amount of credit allocated by Agency from State X’s 2003 State housing credit ceiling, but is included in the returned credit component of State X’s 2004 housing credit ceiling.

(c) Verification of basis by Agency— (1) Verification requirement. An Agency that makes a carryover allocation to a taxpayer must verify that the taxpayer has met the 10 percent basis

503

requirement of paragraph (a)(2) of this section. (2) (3) Time of verification—(i) Allocations made before July 1. For a carryover allocation made before July 1, an Agency may require that the basis certification be submitted to or received by the Agency prior to the close of the calendar year of allocation or within a reasonable time following the close of the calendar year of allocation. The Agency will need to verify basis as provided in paragraph (c)(2) of this section to accurately complete the Form 8610, ‘‘Annual Low-Income Housing Credit Agencies Report,’’ and the Schedule A (Form 8610), ‘‘Carryover Allocation of Low-Income Housing Credit,’’ for the calendar year of the allocation. If the basis certification is not timely made, or supporting documentation is lacking, inadequate, or does not actually support the certification, the Agency should notify the taxpayer and try to get adequate documentation. If the Agency cannot verify before the Form 8610 is filed that the taxpayer has satisfied the 10 percent basis requirement for a carryover allocation made before July 1, the allocation is not valid and is treated as if it had not been made and the carryover allocation should not be reported on the Schedule A (Form 8610). (ii) Allocations made after June 30. An Agency may require that the basis certification be submitted to or received by the Agency prior to the close of the date that is 6 months after the date the allocation was made or within a reasonable period of time following the close of the date that is 6 months after the date the allocation was made. The Agency will need to verify basis as provided in paragraph (c)(2) of this section. If the basis certification is not timely made, or supporting documentation is lacking, inadequate, or does not actually support the certification, the Agency should notify the taxpayer and try to get adequate documentation. If the Agency cannot verify that the taxpayer has satisfied the 10 percent basis requirement for a carryover allocation made after June 30, the allocation must be returned to the Agency. The carryover allocation is a valid allocation for the calendar year of the allocation, but is included in the returned credit component of the State housing credit ceiling for the calendar year following the calendar year of the allocation . (d) (2) * (viii) For carryover allocations made before July 1, the taxpayer’s basis in the

06JAR1

504

project (land and depreciable basis) as of the close of the calendar year of the allocation and the percentage that basis bears to the reasonably expected basis in the project (land and depreciable basis) as of the close of the second calendar year following the calendar year of allocation; (4) Recordkeeping requirements—(i) Taxpayer. When an allocation is made pursuant to section 42(h)(1)(E) or (F), the taxpayer must retain a copy of the allocation document. The Form 8609 that reflects the allocation must be filed for the first taxable year that the credit is claimed and for each taxable year thereafter throughout the compliance period, whether or not a credit is claimed for the taxable year. ■ Par. 3. Section 1.42–8 is amended by: ■ 1. Revising the second sentence of paragraph (a)(6)(i), paragraph (a)(6)(ii), the sixth sentence of paragraph (a)(7) Example 1. (ii), (a)(7) Example 1. (iv), (a)(7) Example 2 (iv), and (b)(4)(ii). ■ 2. Removing the year ‘‘1993’’ each place it appears in paragraph (a)(7), Example 1 and Example 2 and adding the year ‘‘2003’’ in its place; removing the year ‘‘1994’’ each place it appears in paragraph (a)(7) and adding the year ‘‘2004’’ in its place. ■ 3. Removing the second sentence of paragraph (a)(7) Example 1. (iii), the third sentence of paragraph (a)(7) Example 2 (iii), and third sentence of paragraph (b)(4)(i). The revisions read as follows: § 1.42–8 Election of appropriate percentage month.

(a) (6) Procedures—(i) Taxpayer. The taxpayer must retain a copy of the binding agreement and the election statement. (ii) Agency. The Agency must retain the original of the binding agreement and election statement and, to the extent required by Schedule A (Form 8610), ‘‘Carryover Allocation of Low-Income Housing Credit,’’ account for the binding agreement and election statement on that schedule. (7) Example 1. (ii) Because allocations were made for the building in two separate calendar years, Agency must issue two Forms 8609, ‘‘Low-Income Housing Credit Allocation Certification,’’ to X.

(iv) Agency retains the original of the binding agreement, election statement, and 2003 carryover allocation document. Agency accounts for the binding agreement, election statement, and 2003 carryover allocation on

the Schedule A (Form 8610) that it files for the 2003 calendar year. After the building is placed in service in 2004, and assuming other necessary requirements for issuing a Form 8609 are met (for example, taxpayer has certified all sources and uses of funds and development costs for the building under § 1.42–17), Agency issues to X a copy of the Form 8609 reflecting the 2003 carryover allocation of $100,000. Agency files the original of this Form 8609 with the Form 8610, ‘‘Annual Low-Income Housing Credit Agencies Report,’’ that it files for the 2004 calendar year. Agency also issues to X a copy of the Form 8609 reflecting the 2004 allocation of $50,000 and files the original of this Form 8609 with the Form 8610 that it files for the 2004 calendar year. Agency retains copies of the Forms 8609 that are issued to X. Example 2. *

(iv) Agency retains the original of the binding agreements, election statements, and carryover allocation documents. Agency accounts for the binding agreement, election statement, and 2003 carryover allocation on the Schedule A (Form 8610) that it files for the 2003 calendar year. Agency also accounts for the binding agreement, election statement, and 2004 carryover allocation on the Schedule A (Form 8610) that it files for the 2004 calendar year. After each separate new building is placed in service, and assuming other necessary requirements for issuing a Form 8609 are met (for example, taxpayer has certified all sources and uses of funds and development costs for the building under § 1.42–17), the Agency will issue to X a copy of the Form 8609 reflecting the 2003 carryover allocation of $70,000 and a copy of the Form 8609 reflecting the 2004 carryover allocation of $50,000, respectively. Agency files the original of each Form 8609 with the Form 8610 that reflects the calendar year each Form 8609 is issued. Agency retains copies of the Forms 8609 that are issued to X.

(b) (4) (ii) Agency. The Agency must retain the original of the election statement and a copy of the Form 8609 that reflects the election statement. The Agency must file an additional copy of the Form 8609 with the Agency’s Form 8610 that reflects the calendar year the Form 8609 is issued. ■ Par. 4. Section 1.42–12 is amended by revising paragraph (a) to read as follows: § 1.42–12 rules.

Effective dates and transitional

(a) Effective dates—(1) In general. Except as provided in paragraphs (a)(2) and (a)(3) of this section, the rules set forth in §§ 1.42–6 and 1.42–8 through 1.42–12 are applicable on May 2, 1994. However, binding agreements, election statements, and carryover allocation documents entered into before May 2, 1994, that follow the guidance set forth in Notice 89–1, 1989–1 C.B. 620 (see

§ 601.601(d)(2)(ii)(b) of this chapter) need not be changed to conform to the rules set forth in §§ 1.42–6 and 1.42–8 through 1.42–12. (2) Community Renewal Tax Relief Act of 2000–(i) In general. Section 1.42– 6 (a), (b)(4)(iii) Example 1 and Example 2, (c), (d)(2)(viii), and (e)(2) are applicable for housing credit dollar amounts allocated after January 6, 2004. However, the rules in § 1.42–6 (a), (b)(4)(iii) Example 1 and Example 2, (c), (d)(2)(viii), and (e)(2) may be applied by Agencies and taxpayers for housing credit dollar amounts allocated after December 31, 2000, and on or before January 6, 2004. Otherwise, subject to the applicable effective dates of the corresponding statutory provisions, the rules that apply for housing credit dollar amounts allocated on or before January 6, 2004 are contained in § 1.42–6 in effect on and before January 6, 2004 (see 26 CFR part 1 revised as of April 1, 2003). (3) Electronic filing simplification changes. Sections 1.42–6(d)(4) and 1.42–8(a)(6)(i), (a)(6)(ii), (a)(7) Example 1 and Example 2, (b)(4)(i), and (b)(4)(ii) are applicable for forms filed after January 6, 2004. The rules that apply for forms filed on or before January 6, 2004 are contained in § 1.42–6 and § 1.42–8 in effect on and before January 6, 2004 (see 26 CFR part 1 revised as of April 1, 2003). * ■ Par. 5. Section 1.42–14 is amended by: ■ 1. Revising the section heading and paragraphs (a), (g), (i)(2), (k) and (l). ■ 2. Removing paragraph (c) and the second to last sentence of paragraph (e). ■ 3. Redesignating paragraph (b) as paragraph (c). ■ 4. Adding a new paragraph (b). ■ 5. Adding a new sentence at the end of paragraph (d)(2)(iv)(A). The revisions and additions read as follows: § 1.42–14 Allocation rules for post-2000 State housing credit ceiling amount.

(a) State housing credit ceiling—(1) In general. The State housing credit ceiling for a State for any calendar year after 2000 is comprised of four components. The four components are— (i) The unused State housing credit ceiling, if any, of the State for the preceding calendar year (the unused carryforward component); (ii) The greater of— (A) $1.75 ($1.50 for calendar year 2001) multiplied by the State population; or (B) $2,000,000 (the population component); (iii) The amount of State housing credit ceiling returned in the calendar

06JAR1

year (the returned credit component); plus (iv) The amount, if any, allocated to the State by the Secretary under section 42(h)(3)(D) from a national pool of unused credit (the national pool component). (2) Cost of Living Adjustment—(i) General rule. For any calendar year after 2002, the $2,000,000 and $1.75 amounts in paragraph (a)(1)(ii) of this section are each increased by an amount equal to— (A) The dollar amount; multiplied by (B) The cost-of-living adjustment determined under section 1(f)(3) for the calendar year by substituting ‘‘calendar year 2001’’ for ‘‘calendar year 1992’’ in section 1(f)(3)(B). (ii) Rounding. Any increase resulting from the application of paragraph (a)(2)(i) of this section which, in the case of the $2,000,000 amount, is not a multiple of $5,000, is rounded to the next lowest multiple of $5,000, and which, in the case of the $1.75 amount, is not a multiple of 5 cents, is rounded to the next lowest multiple of 5 cents. (b) The unused carryforward component. The unused carryforward component of the State housing credit ceiling for any calendar year is the unused State housing credit ceiling, if any, of the State for the preceding calendar year. The unused State housing credit ceiling for any calendar year is the excess, if any, of— (1) The sum of the population, returned credit, and national pool components for the calendar year; over (2) The aggregate housing credit dollar amount allocated for the calendar year reduced by the housing credit dollar amounts allocated from the unused carryforward component for the calendar year. (d) (2) (iv) (A) Building not qualified within required time period. Also, a building that has received a post-June 30 carryover allocation is not qualified within the required time period if the taxpayer does not meet the 10 percent basis requirement by the date that is 6 months after the date the allocation was made (as described in § 1.42–6(a)(2)(ii)). * (g) Stacking Order. Credit is treated as allocated from the various components of the State housing credit ceiling in the following order. The first credit allocated for any calendar year is treated as credit from the unused carryforward component of the State housing credit ceiling for the calendar year. After all of the credit in the unused carryforward component has been allocated, any

credit allocated is treated as allocated from the sum of the population, returned credit, and national pool components of the State housing credit ceiling. (i) (2) Unused housing credit carryover. The unused housing credit carryover of a State for any calendar year is the excess, if any, of— (i) The unused carryforward component of the State housing credit ceiling for the calendar year; over (ii) The total housing credit dollar amount allocated for the calendar year. * (k) Example. (1) The operation of the rules of this section is illustrated by the following examples. Unless otherwise stated in an example, Agency A is the sole Agency authorized to make allocations of housing credit dollar amounts in State M, all of Agency A’s allocations are valid, and for calendar year 2003, Agency A has available for allocation a State housing credit ceiling consisting of the following housing credit dollar amounts:

A.

unused carryforward component .............................................

B. population component .............

C. returned credit component ......

D. national pool component .........

$50 110 10 0

Total .........................................

170

(2) In addition, the $10 of returned credit component was returned before October 1, 2003. Example 1—(i) Additional facts. By the close of 2003, Agency A had allocated $80 of the State M housing credit ceiling. Of the $80 allocated, $17 was allocated to projects involving qualified nonprofit organizations. (ii) Application of stacking rules. The $80 of allocated credit is first treated as allocated from the unused carryforward component of the State housing credit ceiling. The $80 of allocated credit exceeds the $50 attributable to the unused carryforward component by $30. Because the unused carryforward component is fully utilized no credit will be forfeited by State M to the 2004 National Pool. The remaining $30 of allocated credit will next be treated as allocated from the $120 in credit determined by aggregating the population, returned credit, and national pool components ($110 + 10 + 0 = $120). The $90 of unallocated credit remaining in State M’s 2003 State housing credit ceiling ($120 ¥ 30 = $90) represents the unused carryforward component of State M’s 2004 State housing credit ceiling. Under paragraph (i)(3) of this section, State M does not qualify for credit from the 2004 National Pool. (iii) Nonprofit set-aside. Agency A allocated exactly the amount of credit to projects involving qualified nonprofit organizations as necessary to meet the nonprofit set-aside requirement ($17, 10% of the $170 ceiling).

505

Example 2—(i) Additional facts. By the close of 2003, Agency A had allocated $40 of the State M housing credit ceiling. Of the $40 allocated, $20 was allocated to projects involving qualified nonprofit organizations. (ii) Application of stacking rules. The $40 of allocated credit is first treated as allocated from the unused carryforward component of the State housing credit ceiling. Because the $40 of allocated credit does not exceed the $50 attributable to the unused carryforward component, the remaining components of the State housing credit ceiling are unaffected. The $10 remaining in the unused carryforward component is assigned to the Secretary for inclusion in the 2004 National Pool. The $120 in credit determined by aggregating the population, returned credit, and national pool components becomes the unused carryforward component of State M’s 2004 State housing credit ceiling. Under paragraph (i)(3) of this section, State M does not qualify for credit from the 2004 National Pool. (iii) Nonprofit set-aside. Agency A allocated $3 more credit to projects involving qualified nonprofit organizations than necessary to meet the nonprofit set-aside requirement. This does not reduce the application of the 10% nonprofit set-aside requirement to the State M housing credit ceiling for calendar year 2004. Example 3—(i) Additional fact. None of the applications for credit that Agency A received for 2003 are for projects involving qualified nonprofit organizations. (ii) Nonprofit set-aside. Because at least 10% of the State housing credit ceiling must be set aside for projects involving a qualified nonprofit organization, Agency A can allocate only $153 of the $170 State housing credit ceiling for calendar year 2003 ($170 ¥17 = $153). If Agency A allocates $153 of credit, the credit is treated as allocated $50 from the unused carryforward component and $103 from the sum of the population, returned credit, and national pool components. The $17 of unallocated credit that is set aside for projects involving qualified nonprofit organizations becomes the unused carryforward component of State M’s 2004 State housing credit ceiling. Under paragraph (i)(3) of this section, State M does not qualify for credit from the 2004 National Pool. Example 4—(i) Additional facts. The $10 of returned credit component was returned prior to October 1, 2003. However, a $40 credit that had been allocated in calendar year 2002 to a project involving a qualified nonprofit organization was returned to the Agency by a mutual consent agreement dated November 15, 2003. By the close of 2003, Agency A had allocated $170 of the State M’s housing credit ceiling, including $17 of credit to projects involving qualified nonprofit organizations. (ii) Effect of three-month rule. Under the three-month rule of paragraph (d)(2)(iii) of this section, Agency A may treat all or part of the $40 of previously allocated credit as returned on January 1, 2004. If Agency A treats all of the $40 amount as having been returned in calendar year 2004, the State M housing credit ceiling for 2003 is $170. This entire amount, including the $17 nonprofit

06JAR1

506

set-aside, has been allocated in 2003. Under paragraph (i)(3) of this section, State M qualifies for the 2004 National Pool. (iii) If three-month rule not used. If Agency A treats all of the $40 of previously allocated credit as returned in calendar year 2003, the State housing credit ceiling for the 2003 calendar year will be $210 of which $50 will be attributable to the returned credit component ($10 + $40 = $50). Because credit amounts allocated to a qualified nonprofit organization in a prior calendar year that are returned in a subsequent calendar year do not retain their nonprofit character, the nonprofit set-aside for calendar year 2003 is $21 (10% of the $210 State housing credit ceiling). The $170 that Agency A allocated during 2003 is first treated as allocated from the unused carryforward component of the State housing credit ceiling. The $170 of allocated credit exceeds the $50 attributable to the unused carryforward component by $120. Because the unused carryforward component is fully utilized no credit will be forfeited by State M to the 2004 National Pool. The remaining $120 of allocated credit will next be treated as allocated from the $160 in credit determined by aggregating the population, returned credit, and national pool components ($110 + 50 + 0 = $160). The $40 of unallocated credit (which includes $4 of unallocated credit from the $21 nonprofit set-aside) remaining in State M’s 2003 housing credit ceiling ($160¥120 = $40) represents the unused carryforward component of State M’s 2004 housing credit ceiling. Under paragraph (i)(3) of this section, State M does not qualify for credit from the 2004 National Pool.

(l) Effective dates—(1) In general. Except as provided in paragraph (l)(2) of this section, the rules set forth in § 1.42– 14 are applicable on January 1, 1994. (2) Community Renewal Tax Relief Act of 2000 changes. Paragraphs (a), (b), (c), (e), (i)(2) and (k) of this section are applicable for housing credit dollar amounts allocated after January 6, 2004. However, paragraphs (a), (b), (c), (e), (i)(2) and (k) of this section may be applied by Agencies and taxpayers for housing credit dollar amounts allocated after December 31, 2000, and on or before January 6, 2004. Otherwise, subject to the applicable applicability dates of the corresponding statutory provisions, the rules that apply for housing credit dollar amounts allocated on or before January 6, 2004 are contained in this section in effect on and before January 6, 2004 (see 26 CFR part 1 revised as of April 1, 2003). Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved: December 19, 2003. Pamela F. Olson, Assistant Secretary of the Treasury. am]

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 301 [TD 9111] RIN 1545–AY94

Definition of Agent for Certain Purposes

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations relating to the definition of agent for certain purposes. The final regulations clarify that the term agent in certain provisions of section 6103 of the Internal Revenue Code (Code) includes contractors.

Dates: Effective Date: These regulations are effective January 6, 2004. Applicability Date: For dates of applicability, see §§ 301.6103(l)–1(b) and 301.6103(m)–1(b).

For Further Information Contact: Helene R. Newsome, (202) 622–4570 (not a toll-free number).

Background

This document contains amendments to 26 CFR part 301 under section 6103(l) and (m) of the Code. On February 1, 2002, the Federal Register published a notice of proposed rulemaking (REG– 120135–01) regarding the definition of agent for certain purposes (67 FR 4938). No public comments or requests for hearing were received. The Treasury decision adopts the regulations as proposed. Generally, returns and return information are confidential under section 6103 of the Code unless a specific statutory exception applies. In cases of non-tax-related disclosures, returns and return information generally may be disclosed only to officers and employees of Federal, state, and local government agencies, and not to contractors or agents of such agencies. In certain limited circumstances, however, Congress has permitted disclosures to ‘‘agents’’ of these agencies. See section 6103(l)(6)(B), (l)(12), (m)(2), (m)(4), (m)(5), (m)(7). This document contains final regulations that clarify that the term agent in section 6103(l) and (m) includes contractors. Clarification that the term agent includes contractors is necessary for the purpose of bringing certain statutory grants of disclosure authority into alignment with the reality of many agencies’ operations. Agencies

generally procure the services of third parties under public contracting laws, which do not necessarily incorporate common law concepts of agent. This clarification is also consistent with Congressional intent. For example, the Senate Finance Committee, in amending section 6103(m)(2), stated, ‘‘[a]gents are those who are engaged directly in performing or assisting in collection functions for the federal government, presumably, private collection agencies who have contracted with the government to collect claims * .’’ S. Rep. No. 97–378, at 15 (1982). This clarification does not provide any new disclosure authority, nor does it authorize the disclosure of return information to contractors that Congress has not previously specifically authorized in the Code. With regard to protection of taxpayer data, agents/ contractors are subject to safeguard requirements, redisclosure prohibitions, and civil and criminal penalties for unauthorized disclosures. Accordingly, the regulations do not have an impact on taxpayer privacy.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) and (d) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel of the Small Business Administration for comment on its impact on small businesses.

Drafting Information

The principal author of these regulations is Helene R. Newsome, Office of the Associate Chief Counsel (Procedure & Administration), Disclosure & Privacy Law Division.

List of Subjects in 26 CFR part 301

Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations ■ Accordingly, 26 CFR part 301 is

amended as follows:

06JAR1

Treasury Decision 9112 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Background

In 1998, Congress enacted the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA 1998), Public Law 105–206 (112 Stat. 685) (1998). Section 2001(a) of RRA 1998 states that the policy of Congress is that paperless filing should be the preferred and most convenient means of filing Federal tax returns. Section 2001(a) of RRA 1998 also sets a long-range goal for the IRS to have at least 80 percent of all Federal tax returns filed electronically by 2007. Section 2001(b) of RRA 1998 requires the IRS to establish a 10-year strategic plan to eliminate barriers to electronic filing. The IRS has identified § 1.42–1T(e)(1) and (h)(2) as regulatory provisions that impede electronic filing of Form 8609, ‘‘Low-Income Housing Credit Allocation Certification,’’ by requiring a taxpayer to include a third-party signature from an authorized State or local housing credit agency (Agency) official when filing the form. This Treasury decision eliminates that requirement.

Explanation of Provisions

Section 42 provides for a low-income housing credit that may be claimed as part of the general business credit under section 38. In general, the credit is allowable only if the owner of a qualified low-income building receives a housing credit allocation from an Agency of the jurisdiction where the building is located. Section 1.42–1T(d)(8)(ii) provides that housing credit allocations are deemed made when Part I of Form 8609 is completed and signed by an authorized Agency official and mailed to the owner of the qualified low-income building. Under § 1.42–1T(e)(1), an owner is required to complete the Form 8609 on which the Agency made the applicable housing credit allocation and submit a copy of it with the owner’s Federal income tax return for each year in the compliance period. Under § 1.42– 1T(h)(2), the owner is required to file a

completed Form 8609 (or copy thereof) with the owner’s Federal income tax return for each of the 15 taxable years in the compliance period. Section 1.42– 1T(h)(2) also provides other rules for completing Form 8609. This Treasury decision facilitates the electronic filing of Federal tax returns by eliminating the requirements in § 1.42–1T(e)(1) and (h)(2) that an owner file a copy of the completed Form 8609 that is signed by the authorized Agency official with the owner’s Federal income tax return for each of the 15 taxable years in the compliance period. Notwithstanding that the owner need not file a copy of the Form 8609 signed by the Agency official, the building owner must continue to retain that form for 3 years after the due date, including extensions, of the building owner’s tax return for the tax year that includes the end of the 15-year compliance period. The other rules in § 1.42–1T(h)(2) for completing Form 8609 are also deleted. The requirements for completing and filing Form 8609 are addressed in the instructions to the form.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) and (d) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Because no notice of proposed rulemaking is required, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Paul F. Handleman, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations ■ Accordingly, 26 CFR part 1 is amended

as follows:

PART 1—INCOME TAXES

DEPARTMENT OF THE TREASURY

■ Paragraph 1. The authority citation for

Alcohol and Tobacco Tax and Trade Bureau

part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 *

Section 1.42–1 also issued under 26 U.S.C. 42(n); * ■ Par. 2. Section 1.42–1 is added to read as follows:

27 CFR Parts 4, 5, 13, 19, 24, 25, 28, 70, 194, and 252

DERIVATION TABLE FOR PART 28

RIN 1513–AA76

The requirements of section:

Exportation of Liquors; Recodification of Regulations; Administrative Changes Due to the Homeland Security Act of 2002

(a) through (g) [Reserved]. For further guidance, see § 1.42–1T(a) through (g). (h) Filing of forms. A completed Form 8586, ‘‘Low-Income Housing Credit,’’ must be filed with the owner’s Federal income tax return for each taxable year the owner of a qualified low-income building is claiming the low-income housing credit under section 42(a). A completed Form 8609, ‘‘Low-Income Housing Credit Allocation Certification,’’ must be filed with the owner’s Federal income tax return for each of the 15 taxable years of the compliance period. Failure to comply with the requirement of the preceding sentence for any taxable year after the first taxable year in the credit period will be treated as a mathematical or clerical error for purposes of section 6213(b)(1) and (g)(2). (i) [Reserved]. For further guidance, see § 1.42–1T(i). (j) Effective date. Section 1.42–1(h) applies to forms filed on or after January 27, 2004. The rule that applies for forms filed before January 27, 2004 is contained in § 1.42–1T(h) in effect before January 27, 2004 (see 26 CFR part 1 revised as of April 1, 2003). ■ Par. 3. Section 1.42–1T is amended by: ■ 1. Removing the last two sentences in paragraph (e)(1). ■ 2. Revising paragraph (h). ■ The revision reads as follows:

Agency: Alcohol and Tobacco Tax and Trade Bureau (TTB), Treasury.

Action: Final rule; Treasury decision.

• • • • (h) Filing of forms. For further guidance, see § 1.42–1(h). * Approved: January 19, 2004. Mark E. Mathews, Deputy Commissioner for Services and Enforcement. Pamela F. Olson, Assistant Secretary of the Treasury.

Treasury, we are making administrative changes to part 28. This reorganization requires us to amend each of the CFR parts under our jurisdiction to reflect our Bureau’s new name and organizational structure.

[T.D. TTB–8]

§ 1.42–1 Limitation on low-income housing credit allowed with respect to qualified lowincome buildings receiving housing credit allocations from a State or local housing credit agency.

§ 1.42–1T Limitation on low-income housing credit allowed with respect to qualified low-income buildings receiving housing credit allocations from a State or local housing credit agency (temporary).

Summary: The Alcohol and Tobacco Tax and Trade Bureau is recodifying its regulations pertaining to exportation of liquors. Due to the Homeland Security Act, we are also making administrative changes to these regulations to reflect the Bureau’s new name and organizational structure. This document does not include any substantive regulatory changes.

Dates: This rule is effective on January 27, 2004.

For Further Information Contact: Lisa

M. Gesser, Regulations and Procedures

Division, Alcohol and Tobacco Tax and Trade Bureau, P.O. Box 128, Morganza, Maryland 20660; (301–290–1460) or email Lisa.Gesser@ttb.gov.

Background

As a part of our continuing efforts to reorganize title 27, chapter I, Code of Federal Regulations (27 CFR), we are removing all of part 252, Exportation of Liquors, from subchapter M—Alcohol, Tobacco and Other Excise Taxes, and recodifying it as part 28 in subchapter A—Liquor, of that chapter. We are also changing the title of subchapter A to ‘‘Subchapter A—Alcohol’’ and are revising the title of the new part 28 to read ‘‘Part 28—Exportation of Alcohol.’’ These changes better describe the contents of that subchapter and part. The table below shows from which section of part 252 the requirements of part 28 are derived. In addition, because section 1111 of the Homeland Security Act of 2002 (Public Law 107–296, 116 Stat. 2135) divided the Bureau of Alcohol, Tobacco and Firearms, Department of the Treasury, into two separate agencies, the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) in the Department of Justice, and the Alcohol and Tobacco Tax and Trade Bureau (TTB), which remains in the Department of the

3827

Are derived from section:

Subpart A 28.1 ..................................... 28.2 ..................................... 28.3 ..................................... 28.4 .....................................

252.1 252.2 252.3 252.4

Subpart B 28.11 ...................................

252.11

Subpart C 28.20 ................................... 28.21 ................................... 28.22 ................................... 28.23 ................................... 28.25 ................................... 28.26 ................................... 28.27 ................................... 28.28 ................................... 28.30 ................................... 28.35 ................................... 28.36 ................................... 28.37 ................................... 28.38 ................................... 28.40 ................................... 28.41 ................................... 28.42 ................................... 28.43 ................................... 28.45 ................................... 28.48 ...................................

252.20 252.21 252.22 252.23 252.25 252.26 252.27 252.28 252.30 252.35 252.36 252.37 252.38 252.40 252.41 252.42 252.43 252.45 252.48

Subpart D 28.51 ................................... 28.52 ................................... 28.52a ................................. 28.52b ................................. 28.53 ................................... 28.54 ................................... 28.55 ................................... 28.56 ................................... 28.57 ................................... 28.58 ................................... 28.59 ................................... 28.60 ................................... 28.61 ................................... 28.62 ................................... 28.63 ................................... 28.64 ................................... 28.65 ................................... 28.66 ................................... 28.67 ................................... 28.70 ................................... 28.71 ................................... 28.72 ................................... 28.73 ................................... 28.74 ................................... 28.80 ...................................

252.51 252.52 252.52a 252.52b 252.53 252.54 252.55 252.56 252.57 252.58 252.59 252.60 252.61 252.62 252.63 252.64 252.65 252.66 252.67 252.70 252.71 252.72 252.73 252.74 252.80

Subpart E 28.91 ...................................

252.91

Treasury Decision 9204 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations that provide guidance regarding the limitation on the effective rate of mortgage interest for purposes of mortgage revenue bonds issued by State and local governments. These regulations provide guidance to State and local governments that issue tax-exempt mortgage revenue bonds.

Dates: Effective Date: These regulations are effective May 23, 2005. Applicability Date: For dates of applicability, see §1.143(g)-1(d) of these regulations.

For Further Information Contact: 3980 (not a toll-free number).

Background

Michael P. Brewer, (202) 622-

2 This document amends the Income Tax Regulations (26 CFR part 1) under section 143(g) of the Internal Revenue Code by providing rules regarding the limitation on the effective rate of mortgage interest for purposes of mortgage revenue bonds issued by State and local governments.

On November 5, 2003, the

IRS published in the Federal Register a notice of proposed rulemaking (REG-146692-03)(68 FR 62549)(the proposed regulations).

The proposed regulations would add §1.143(g)-1 to

provide rules for calculating the effective rate of mortgage interest.

A public hearing on the proposed regulations was

scheduled for January 28, 2004.

The public hearing was

cancelled because no requests to speak were received.

Written

comments were received regarding the proposed regulations. After consideration of the written comments, the proposed regulations are adopted by this Treasury decision without change (other than certain clarifying changes to the effective date provisions). A.

Mortgage Revenue Bonds Section 103(a) of the Internal Revenue Code of 1986 (Code)

provides that, generally, interest on any State or local bond is not included in gross income.

However, this exclusion does not

apply to any private activity bond that is not a qualified bond.

3 Section 141(e)(1) provides that a qualified mortgage bond or a qualified veterans’ mortgage bond (together, mortgage revenue bonds) issued under section 143 may be a qualified bond. Sections 143(a)(2)(A)(ii) and 143(b) provide, in part, that for an issue to be an issue of qualified mortgage bonds or qualified veterans’ mortgage bonds, respectively, the issue must satisfy the requirements of section 143(g).

Section 143(g)(1)

provides that an issue will meet the requirements of section 143(g) if the issue satisfies the requirements of section 143(g)(2) and, in the case of an issue 95 percent or more of the net proceeds of which are to be used to provide residences for veterans, if the issue satisfies the requirements of section 143(g)(3). Section 143(g)(2)(A) provides that an issue will meet the requirements of section 143(g)(2) only if the excess of (1) the effective interest rate on the mortgages provided under the issue, over (2) the yield on the issue, is not greater than 1.125 percentage points. Section 143(g)(2)(B)(i) provides that in determining the effective rate of interest on any mortgage for purposes of section 143(g)(2), all fees, charges, and other amounts borne by the mortgagor that are attributable to the mortgage or the bond issue are taken into account as additional interest paid.

4 Section 143(g)(2)(B)(ii) provides that, for purposes of determining the effective rate of mortgage interest, the following items (among others) shall be treated as borne by the mortgagor:

(1) All points or similar charges paid by the seller

of the property; and (2) the excess of the amounts received from any person other than the mortgagor by any person in connection with the acquisition of the mortgagor's interest in the property over the usual and reasonable acquisition costs of a person acquiring like property when owner-financing is not provided through the use of mortgage revenue bonds. Section 143(g)(2)(B)(iii) provides that, for purposes of determining the effective rate of mortgage interest, the following items shall not be taken into account:

(1) Any

expected rebate of arbitrage profits; and (2) any application fee, survey fee, credit report fee, insurance charge, or similar amount to the extent such amount does not exceed amounts charged in such area in cases when owner-financing is not provided through the use of mortgage revenue bonds.

The exclusion for

application fees, survey fees, credit report fees, insurance charges, or similar amounts does not apply to origination fees, points, or similar amounts. In the case of an issue 95 percent or more of the net proceeds of which are to be used to provide residences for veterans, section 143(g)(3) provides that certain earnings on

5 nonpurpose investments must either be paid or credited to mortgagors, or paid to the United States, in certain circumstances. In the Tax Reform Act of 1986, Public Law 99-514 (the 1986 Act), Congress reorganized sections 103 and 103A of the Internal Revenue Code of 1954 (1954 Code) regarding tax-exempt bonds into sections 103 and 141 through 150 of the Code.

Congress intended

that to the extent not amended by the 1986 Act, all principles of pre-1986 Act law would continue to apply to the reorganized provisions.

2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-

686 (1986), 1986-3 (Vol. 4) C.B. 686. Interpreting section 103A(i)(2)(B)(iii) of the 1954 Code, which is substantially identical to section 143(g)(2)(B)(iii) of the Code, §6a.103A-2(i)(2)(ii)(C) of the Temporary Income Tax Regulations provides the following:

“For example, amounts paid

for FHA, VA, or similar private mortgage insurance on an individual's mortgage need not be taken into account so long as such amounts do not exceed the amounts charged in the area with respect to a similar mortgage that is not financed with qualified mortgage bonds.

Premiums charged for pool mortgage

insurance will be considered amounts in excess of the usual and reasonable amounts charged for insurance in cases where owner financing is not provided through the use of qualified mortgage

6 bonds.”

Pool mortgage insurance is not defined in the

regulations. B.

Qualified Guarantees Under §1.148-4(f), for purposes of computing yield on an

issue, fees paid for a qualified guarantee for the issue are treated as additional interest on the issue. guarantee is a qualified guarantee if:

In general, a

(1) As of the date the

guarantee is obtained, the issuer reasonably expects that the present value of the fees for the guarantee will be less than the present value of the expected interest savings on the issue as a result of the guarantee; (2) the arrangement creates a guarantee in substance; and (3) the fees for the guarantee do not exceed a reasonable, arm's-length charge for the transfer of credit risk.

The regulations provide that the guarantee of a

loan of proceeds of an issue, as opposed to a guarantee of the issue, may constitute a qualified guarantee, but this rule does not apply to guarantees of mortgages financed with mortgage revenue bonds.

Explanation of Provisions

A.

Pool Mortgage Insurance Prior to the issuance of the proposed regulations,

questions arose regarding whether an issuer should be required to treat the portion of the interest payments on a pool of mortgages used to pay fees for a guarantee of a pass-through

7 security backed by the pool of mortgages as an amount borne by the mortgagors that must be taken into account in determining the effective rate of interest on the mortgages for purposes of section 143(g).

Taking the guarantee fees into account results

in a higher effective rate of interest on the mortgages than if the fees were not taken into account. The IRS and Treasury Department have determined that the guarantee fees should not be treated as amounts borne by the mortgagors that must be taken into account in determining the effective rate of interest on the mortgages for purposes of section 143(g).

An issuer may achieve substantially the same

result as not taking the guarantee fees into account in computing the effective rate of interest on the mortgages by substituting a qualified guarantee on the bonds for the guarantee of the pool of mortgages.

If an issuer does not take

the mortgage guarantee fees into account in computing the effective rate of interest on the mortgages, the difference between the bond yield and the effective rate on the mortgages is reduced because the effective rate on the mortgages is reduced.

A qualified guarantee of the bonds accomplishes the

same result by increasing bond yield, rather than reducing the effective rate of interest on the mortgages.

Issuers should not

be required to change the form of their transactions in these circumstances.

8 Accordingly, to the extent the amounts charged for a guarantee of a pool of mortgages do not exceed amounts charged in the area in cases when owner-financing is not provided through the use of mortgage revenue bonds, the proposed regulations would provide that such amounts are not treated as borne by the mortgagors and are not taken into account in determining the effective rate of interest on the mortgages for purposes of section 143(g).

B. Proposed Regulations

The proposed regulations propose a new §1.143(g)-1.

The

proposed regulations provide that an issue satisfies the requirements of section 143(g) only if the issue meets the requirements of §1.143(g)-1(b) and, in the case of an issue 95 percent or more of the net proceeds of which are to be used to provide residences for veterans, the issue also meets the requirements of §1.143(g)-1(c).

The requirements of section

143(g) and the proposed regulations are applicable in addition to the requirements of section 148 and §§1.148-0 through 1.14811. The proposed regulations provide that an issue shall be treated as meeting the requirements of §1.143(g)-1(b) only if the excess of (1) the effective rate of interest on the mortgages financed by the issue, over (2) the yield on the

9 issue, is not greater over the term of the issue than 1.125 percentage points. In determining the effective rate of interest on any mortgage, the proposed regulations provide that all fees, charges, and other amounts borne by the mortgagor that are attributable to the mortgage or to the bond issue are taken into account.

Such amounts include points, commitment fees,

origination fees, servicing fees, and prepayment penalties paid by the mortgagor. The proposed regulations provide that items that are treated as borne by the mortgagor and are taken into account in calculating the effective rate of interest also include: (1) All points, commitment fees, origination fees, or similar charges borne by the seller of the property; and (2) the excess of any amounts received from any person other than the mortgagor by any person in connection with the acquisition of the mortgagor's interest in the property over the usual and reasonable acquisition costs of a person acquiring like property where owner-financing is not provided through the use of mortgage revenue bonds. The proposed regulations further provide that the following items are not treated as borne by the mortgagor and are not taken into account in calculating the effective rate of

10 interest:

(1) Any expected rebate of arbitrage profit; and

(2) any application fee, survey fee, credit report fee, insurance charge or similar settlement or financing cost to the extent such amount does not exceed amounts charged in the area in cases where owner-financing is not provided through the use of mortgage revenue bonds. With respect to insurance charges, the proposed regulations provide that amounts paid for Federal Housing Administration, Veterans’ Administration, or similar private mortgage insurance on an individual's mortgage, or amounts paid for pool mortgage insurance on a pool of mortgages, are not taken into account so long as such amounts do not exceed the amounts charged in the area with respect to a similar mortgage, or pool of mortgages, that is not financed with mortgage revenue bonds.

Moreover, for

this purpose, amounts paid for pool mortgage insurance include amounts paid to an entity (for example, the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, or other mortgage insurer) to directly guarantee the pool of mortgages financed with the bonds, or to guarantee a pass-through security backed by the pool of mortgages financed with the bonds. The proposed regulations do not provide guidance regarding all aspects of the application of section 143(g)(2).

The

11 proposed regulations provide that to the extent not inconsistent with the 1986 Act or subsequent law, the provisions of §6a.103A2(i)(2) (other than paragraphs (i)(2)(i) and (i)(2)(ii)(A) through (C)) apply to provide

additional rules relating to

compliance with the requirement that the effective rate of mortgage interest not exceed the bond yield by more than 1.125 percentage points. The proposed regulations also do not provide guidance regarding the application of section 143(g)(3).

The proposed

regulations provide that to the extent not inconsistent with the 1986 Act or subsequent law, the provisions of §6a.103A-2(i)(4) apply to provide guidance regarding the application of section 143(g)(3).

C. Final Regulations

All of the public comments expressed support for the proposed regulations as proposed, and the proposed regulations are adopted by this Treasury decision without change other than certain changes to the effective date provisions to reflect that the regulations are being issued in final form. Effective Dates

12 The final regulations apply to bonds sold on or after May 23, 2005, that are subject to section 143.

Issuers may apply

the final regulations in whole, but not in part, to bonds sold before May 23, 2005, that are subject to section 143.

Subject

to the applicable effective dates for the corresponding statutory provisions, issuers may apply the final regulations, in whole, but not in part, to bonds that are subject to section 103A(i) of the Internal Revenue Code of 1954.

To the extent

that an issuer applies the final regulations to bonds that were issued before July 1, 1993, §6a.103A-2(i)(3) also applies.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866.

Therefore, a regulatory assessment is not required.

It

has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Pursuant

to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

13 The principal authors of these regulations are Timothy L. Jones and Michael P. Brewer, Office of Associate Chief Counsel (Tax-exempt and Government Entities), IRS.

However, other

personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows: PART 1--INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * Par. 2.

Section 1.143(g)-1 is added to read as follows:

§1.143(g)-1 Requirements related to arbitrage. (a) In general.

Under section 143, for an issue to be an

issue of qualified mortgage bonds or qualified veterans’ mortgage bonds (together, mortgage revenue bonds), the requirements of section 143(g) must be satisfied.

An issue

satisfies the requirements of section 143(g) only if such issue meets the requirements of paragraph (b) of this section and, in the case of an issue 95 percent or more of the net proceeds of which are to be used to provide residences for veterans, such issue also meets the requirements of paragraph (c) of this

14 section.

The requirements of section 143(g) and this section

are applicable in addition to the requirements of section 148 and §§1.148-0 through 1.148-11. (b) Effective rate of mortgage interest not to exceed bond yield by more than 1.125 percentage points--(1) Maximum yield. An issue shall be treated as meeting the requirements of this paragraph (b) only if the excess of the effective rate of interest on the mortgages financed by the issue, over the yield on the issue, is not greater over the term of the issue than 1.125 percentage points. (2) Effective rate of interest. (i) In determining the effective rate of interest on any mortgage for purposes of this paragraph (b), there shall be taken into account all fees, charges, and other amounts borne by the mortgagor that are attributable to the mortgage or to the bond issue.

Such amounts

include points, commitment fees, origination fees, servicing fees, and prepayment penalties paid by the mortgagor. (ii) Items that shall be treated as borne by the mortgagor and shall be taken into account in calculating the effective rate of interest also include-(A) All points, commitment fees, origination fees, or similar charges borne by the seller of the property; and

15 (B) The excess of any amounts received from any person other than the mortgagor by any person in connection with the acquisition of the mortgagor's interest in the property over the usual and reasonable acquisition costs of a person acquiring like property when owner-financing is not provided through the use of mortgage revenue bonds. (iii) The following items shall not be treated as borne by the mortgagor and shall not be taken into account in calculating the effective rate of interest-(A) Any expected rebate of arbitrage profit under paragraph (c) of this section; and (B) Any application fee, survey fee, credit report fee, insurance charge or similar settlement or financing cost to the extent such amount does not exceed amounts charged in the area in cases when owner-financing is not provided through the use of mortgage revenue bonds.

For example, amounts paid for Federal

Housing Administration, Veterans’ Administration, or similar private mortgage insurance on an individual's mortgage, or amounts paid for pool mortgage insurance on a pool of mortgages, are not taken into account so long as such amounts do not exceed the amounts charged in the area with respect to a similar mortgage, or pool of mortgages, that is not financed with mortgage revenue bonds.

For this purpose, amounts paid for pool

16 mortgage insurance include amounts paid to an entity (for example, the Government National Mortgage Association, the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation, or other mortgage insurer) to directly guarantee the pool of mortgages financed with the bonds, or to guarantee a pass-through security backed by the pool of mortgages financed with the bonds. (C) The following example illustrates the provisions of this paragraph (b)(2)(iii): Example. Housing Authority X issues bonds intended to be qualified mortgage bonds under section 143(a). At the time the bonds are issued, X enters into an agreement with a group of mortgage lending institutions (lenders) under which the lenders agree to originate and service mortgages that meet certain specified requirements. After originating a specified amount of mortgages, each lender issues a "pass-though security" (each, a PTS) backed by the mortgages and sells the PTS to X. Under the terms of the PTS, the lender pays X an amount equal to the regular monthly payments on the mortgages (less certain fees), whether or not received by the lender (plus any prepayments and liquidation proceeds in the event of a foreclosure or other disposition of any mortgages). FNMA guarantees the timely payment of principal and interest on each PTS. From the payments received from each mortgagor, the lender pays a fee to FNMA for its guarantee of the PTS. The amounts paid to FNMA do not exceed the amounts charged in the area with respect to a similar pool of mortgages that is not financed with mortgage revenue bonds. Under this paragraph (b)(2)(iii), the fees for the guarantee provided by FNMA are an insurance charge because the guarantee is pool mortgage insurance. Because the amounts charged for the guarantee do not exceed the amounts charged in the area with respect to a similar pool of mortgages that is not financed with mortgage revenue bonds, the amounts charged for the guarantee are not taken into account in computing the effective rate of interest on the mortgages financed with X’s bonds.

17 (3) Additional rules.

To the extent not inconsistent with

the Tax Reform Act of 1986, Public Law 99-514 (the 1986 Act), or subsequent law, §6a.103A-2(i)(2) (other than paragraphs (i)(2)(i) and (i)(2)(ii)(A) through (C)) of this chapter applies to provide additional rules relating to compliance with the requirement that the effective rate of mortgage interest not exceed the bond yield by more than 1.125 percentage points. (c) Arbitrage and investment gains to be used to reduce costs of owner-financing.

As provided in section 143(g)(3),

certain earnings on nonpurpose investments must either be paid or credited to mortgagors, or paid to the United States, in certain circumstances.

To the extent not inconsistent with the

1986 Act or subsequent law, §6a.103A-2(i)(4) of this chapter applies to provide guidance relating to compliance with this requirement. (d) Effective dates--(1) In general.

Except as otherwise

provided in this section, §1.143(g)-1 applies to bonds sold on or after May 23, 2005, that are subject to section 143. (2) Permissive retroactive application in whole.

Except as

provided in paragraph (d)(4) of this section, issuers may apply §1.143(g)-1, in whole, but not in part, to bonds sold before May 23, 2005, that are subject to section 143.

18 (3) Bonds subject to the Internal Revenue Code of 1954. Except as provided in paragraph (d)(4) of this section and subject to the applicable effective dates for the corresponding statutory provisions, an issuer may apply §1.143(g)-1, in whole, but not in part, to bonds that are subject to section 103A(i) of the Internal Revenue Code of 1954.

19 (4) Special rule for pre-July 1, 1993 bonds.

To the extent

that an issuer applies this section to bonds issued before July 1, 1993, §6a.103A-2(i)(3) of this chapter also applies to the bonds.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement.

Approved:

Eric Solomon, Acting Deputy Assistant Secretary of the Treasury.

Treasury Decision 9295 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final and temporary regulations.

Summary: This document contains temporary and final regulations under sections 6011, 6111, and 6112 of the Internal Revenue Code that modify the rules relating to the disclosure of reportable transactions and the list maintenance requirements. These regulations affect taxpayers participating in reportable transactions under section 6011, material advisors responsible for disclosing reportable transactions under section 6111, and material advisors responsible for keeping lists under section 6112. These temporary and final regulations are being issued concurrently with proposed regulations under sections 6011, 6111, and 6112 published elsewhere in the Federal Register.

Dates: Effective Date: These regulations are effective November 1, 2006.

For Further Information Contact: Tara P. Volungis or Charles Wien, 202622-3070 (not a toll-free number).

Background

This document amends 26 CFR parts 1 and 301 by modifying the rules relating

to the disclosure of reportable transactions under sections 6011 and 6111 and the list maintenance rules under section 6112. On February 28, 2003, the IRS issued final regulations under sections 6011, 6111, and 6112 (TD 9046) (the February 2003 regulations). The February 2003 regulations were published in the Federal Register (68 FR 10161) on March 4, 2003. On December 29, 2003, the IRS issued final regulations under section 6011 and 6112 (TD 9108) (the December 2003 regulations). The December 2003 regulations were published in the Federal Register (68 FR 75128) on December 30, 2003.

Explanation of Provisions

These regulations relate to the provisions for obtaining a private letter ruling and the tolling of the time for providing disclosure under §1.6011-4 and section 6111 and for maintaining a list under section 6112 during the time the request for a ruling is pending. Because the IRS and Treasury Department believe that the removal of the tolling provision will promote effective tax administration, these regulations eliminate the tolling of the time for providing disclosure and for maintaining the list when a taxpayer or a potential material advisor requests a private letter ruling. Proposed regulations removing the tolling provision are being issued concurrently with these temporary regulations. Taxpayers and potential material advisors may still request a ruling on a transaction under the regular procedures for requesting a ruling, provided the ruling request is not factual or hypothetical, but the time for providing disclosure or for maintaining a list will not be tolled. The removal of the tolling provision is effective for all ruling requests received on or after November 1, 2006.

2

Special Analyses

It has been determined that these regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For applicability of the Regulatory Flexibility Act, please refer to the cross-reference notice of proposed rulemaking published elsewhere in this issue of the Federal Register. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Tara P. Volungis and Charles Wien, Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 301 Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.

Amendments to the Regulations

3

Accordingly, 26 CFR parts 1 and 301 are amended as follows: PART 1--INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read, in part, as follows: Authority: 26 U.S.C. 7805 Section 1.6011-4T also issued under 26 U.S.C. 6011 Par. 2. Section 1.6011-4 is amended by: 1. Revising paragraphs (f)(1) and (f)(3). 2. Redesignating the text of paragraph (h) as (h)(1) and adding a heading. 3. Adding paragraph (h)(2). The revisions and additions read as follows: '1.6011-4 Requirement of statement disclosing participation in certain transactions by taxpayers. (f) (1) [Reserved]. For further guidance, see §1.6011-4T(f)(1). (2) (3) [Reserved]. For further guidance, see §1.6011-4T(f)(1). (h) Effective date--(1) In general. * (2) [Reserved]. For further guidance, see §1.6011-4T(h)(2). Par. 3. Section 1.6011-4T is added to read as follows: §1.6011-4T Requirement of statement disclosing participation in certain transactions by taxpayers (temporary). 4

(a) through (e) [Reserved]. For further guidance, see §1.6011-4(a) through (e). (f) Rulings and protective disclosures--(1) Rulings. If a taxpayer requests a ruling on the merits of a specific transaction on or before the date that disclosure would otherwise be required under this section, and receives a favorable ruling as to the transaction, the disclosure rules under this section will be deemed to have been satisfied by that taxpayer with regard to that transaction, so long as the request fully discloses all relevant facts relating to the transaction which would otherwise be required to be disclosed under this section. If a taxpayer requests a ruling as to whether a specific transaction is a reportable transaction on or before the date that disclosure would otherwise be required under this section, the Commissioner in his discretion may determine that the submission satisfies the disclosure rules under this section for the taxpayer requesting the ruling for that transaction if the request fully discloses all relevant facts relating to the transaction which would otherwise be required to be disclosed under this section. The potential obligation of the taxpayer to disclose the transaction under this section will not be suspended during the period that the ruling request is pending. (f)(2) through (g) [Reserved]. For further guidance, see §1.6011-4(f)(2) through (g). (h) Effective date--(1) [Reserved]. For further guidance, see §1.6011-4(h)(1). (2) Tolling provision. Paragraph (f)(1) of this section applies to ruling requests received on or after November 1, 2006. The applicability of this section expires on or before November 2, 2009. PART 301--PROCEDURE AND ADMINISTRATION 5

Par. 4. The authority citation for part 301 is amended by adding an entry in numerical order to read, in part, as follows: Authority: 26 U.S.C. 7805 Section 301.6111-3T also issued under 26 U.S.C. 6111 Par. 5. Section 301.6111-3T is added to read as follows: §301.6111-3T Disclosure of reportable transactions (temporary). (a) through (g) [Reserved]. (h) Rulings. If a potential material advisor requests a ruling as to whether a specific transaction is a reportable transaction on or before the date that disclosure would otherwise be required under this section, the Commissioner in his discretion may determine that the submission satisfies the disclosure rules under this section for that transaction if the request fully discloses all relevant facts relating to the transaction which would otherwise be required to be disclosed under this section. The potential obligation of the person to disclose the transaction under this section (or to maintain or furnish the list under §301.6112-1) will not be suspended during the period that the ruling request is pending. (i) Effective date--(1) [Reserved]. (2) Tolling provision. Paragraph (h) of this section applies to ruling requests received on or after November 1, 2006. The applicability of this section expires on or before November 2, 2009. Par. 6. Section 301.6112-1 is amended by revising paragraph (i) to read as follows:

6

§301.6112-1 Requirement to prepare, maintain, and furnish lists with respect to potentially abusive tax shelters. (i) [Reserved]. For further guidance, see §301.6111-3T(h).

Mark E. Matthews Deputy Commissioner for Services and Enforcement.

Approved: October 25, 2006

Eric Solomon Acting Deputy Assistant Secretary of the Treasury (Tax Policy).

7

Treasury Decision 9334 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS),

Treasury.

Action: Final and temporary

regulations.

Summary: This document contains final and temporary regulations providing guidance relating to the requirement of a return to accompany payment of excise taxes under section 4965 of the Internal Revenue Code (Code) and the time for filing that return. These regulations affect a broad array of taxexempt entities, including charities, state and local government entities, Indian tribal governments and employee benefit plans, as well as entity managers of these entities. This action is necessary to implement section 516 of the Tax Increase Prevention and Reconciliation Act of 2005. The text of the temporary regulations also serves as the text of the proposed regulations set forth in the Proposed Rules section in this issue of the Federal Register.

Dates: Effective date. These regulations are effective on July 6, 2007. Applicability date. For dates of applicability, see §§ 53.6071–1T(g) and 54.6011–1T(c) of these regulations.

For Further Information Contact: Galina Kolomietz, (202) 622–6070, Michael Blumenfeld, (202) 622–1124, or Dana Barry, (202) 622–6060 (not tollfree numbers).

Background

The Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109–222 (120 Stat. 345) (TIPRA), enacted on May 17, 2006, added section 4965 to the Code. Section 4965 affects a broad array of tax-exempt entities as defined in section 4965(c). Tax-exempt entities described in section 4965(c)(1), (2), or (3) (referred to herein as ‘‘nonplan entities’’) include entities described in section 501(c), religious or apostolic associations or corporations described in section 501(d), entities described in section 170(c), including states, possessions of the United States, the District of Columbia, political subdivisions of states and political subdivisions of possessions of the United States (but not including the

United States), and Indian tribal governments within the meaning of section 7701(a)(40). Tax-exempt entities described in section 4965(c)(4), (c)(5), (c)(6), or (c)(7) (referred to herein as ‘‘plan entities’’) include tax-favored retirement plans, individual retirement arrangements, and savings arrangements described in section 401(a), 403(a), 403(b), 529, 457(b), 408(a), 220(d), 408(b), 530 or 223(d). Section 4965 imposes two new excise taxes, one on the tax-exempt entity (the entity-level tax) and the other on certain of the tax-exempt entity’s managers (the manager-level tax). The entity-level tax is imposed on non-plan entities that are parties to prohibited tax shelter transactions. The entity-level tax does not apply to plan entities. Prohibited tax shelter transactions are transactions that are identified by the IRS as ‘‘listed transactions’’ (within the meaning of section 6707A(c)(2)) and reportable transactions that are confidential transactions or transactions with contractual protection (as defined in section 6707A(c)(1) and § 1.6011–4(b) of this chapter). The entity-level tax applies to each taxable year during which the non-plan entity is a party to a prohibited tax shelter transaction and has net income or proceeds attributable to the transaction which are properly allocable to that taxable year. The amount of the entity-level tax depends on whether the non-plan entity knew or had reason to know that the transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction. If the non-plan entity did not know (and did not have reason to know) that the transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction, the tax is the highest rate of tax under section 11 (currently 35 percent) multiplied by the greater of: (i) The entity’s net income with respect to the prohibited tax shelter transaction (after taking into account any tax imposed by Subtitle D, other than by this section, with respect to such transaction) for the taxable year or (ii) 75 percent of the proceeds received by the entity for the taxable year that are attributable to such transaction. If the non-plan entity knew or had reason to know that the transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction, the tax is the greater of (i) 100 percent of the entity’s net income with respect to the transaction (after taking into account any tax imposed by Subtitle D, other than by this section, with respect to such transaction) for the taxable year or (ii) 75 percent of the

proceeds received by the entity for the taxable year that are attributable to such transaction. In the case of a transaction that becomes a prohibited tax shelter transaction by reason of becoming a listed transaction after the non-plan entity has become a party to such transaction (subsequently listed transactions), the amount of tax is based on the net income or proceeds attributable to such transaction that are properly allocable to the period beginning on the date the transaction became listed or the first day of the entity’s taxable year, whichever is later. No entity-level tax applies to any income or proceeds that are properly allocable to a period ending on or before August 15, 2006. The manager-level tax is imposed on entity managers (as defined in section 4965(d)) of all tax-exempt entities described in section 4965(c) who approve the entity as a party (or otherwise cause the entity to be a party) to a prohibited tax shelter transaction and know or have reason to know that the transaction is a prohibited tax shelter transaction. In the case of nonplan entities, the term entity manager means the person with authority or responsibility similar to that exercised by an officer, director or trustee, and, with respect to any act, the person having authority or responsibility with respect to such act. In the case of plan entities, the term entity manager means the person who approves or otherwise causes the entity to be a party to the prohibited tax shelter transaction. An individual beneficiary (including a plan participant) or owner of the tax-favored retirement plans, individual retirement arrangements, and savings arrangements described in section 401(a), 403(a), 403(b), 529, 457(b), 408(a), 220(d), 408(b), 530 or 223(d), may be liable as an entity manager if the individual beneficiary or owner has broad investment authority under the arrangement. The amount of the manager-level tax is $20,000 for each approval or other act causing the entity to be a party to a prohibited tax shelter transaction. The manager-level tax applies separately to each entity manager. These final and temporary regulations are being issued concurrently with proposed regulations under sections 4965, 6033(a)(2) and 6011(g) published elsewhere in the Federal Register.

Explanation of Provisions

The regulations provide that non-plan entities (including exempt organizations and governments) that are liable for section 4965 excise taxes and entity managers of non-plan entities who are

liable for section 4965 excise taxes as entity managers are required to file a return on Form 4720, ‘‘Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.’’ The entity return is due on or before the date the non-plan entity’s annual return under section 6033(a)(1) (for example, Form 990, ‘‘Return of Organization Exempt From Income Tax’’) is due, if the non-plan entity is required to file such a return. In all other cases, the entity return is due on or before the 15th day of the fifth month after the end of the non-plan entity’s accounting period for which the liability under section 4965 was incurred. In the case of a nonplan entity manager, the entity manager return is due on or before the 15th day of the fifth month following the close of the manager’s taxable year during which the entity entered into a prohibited tax shelter transaction. The regulations also provide that entity managers of plan entities who are liable for section 4965 taxes as entity managers are required to file a return on Form 5330, ‘‘Return of Excise Taxes Related to Employee Benefit Plans.’’ For section 4965 taxes, the Form 5330 is due on or before the 15th day of the fifth month following the close of the manager’s taxable year during which the entity entered into a prohibited tax shelter transaction. The regulations provide a transition rule that returns of section 4965 taxes that are or were due on or before October 4, 2007 will be deemed timely if the return is filed and the tax is paid before that date.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For the applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), refer to the Special Analyses section of the preamble to the cross-referencing notice of proposed rulemaking published in the Proposed Rules section in this issue of the Federal Register. Pursuant to section 7805(f) of the Code, these regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on business.

Drafting Information

The principal authors of these regulations are Galina Kolomietz and Dana Barry, Office of Division Counsel/

Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects

26 CFR Part 53 Excise taxes, Foundations, Investments, Lobbying, Reporting and recordkeeping requirements. 26 CFR Part 54 Excise Taxes, Pensions, Reporting and recordkeeping requirements.

Amendments to the Regulations

■ Accordingly, 26 CFR parts 53 and 54

are amended as follows: PART 53—FOUNDATION AND SIMILAR EXCISE TAXES ■ Paragraph 1. The authority citation

for part 53 continues to read in part as follows: Authority: 26 U.S.C. 7805 * § 53.6011–1

[Amended]

■ Par. 2. In § 53.6011–1, paragraph (b) is

amended by: ■ 1. Removing from the first sentence, the language ‘‘or 4958(a),’’ and adding ‘‘4958(a), or 4965(a),’’ in its place. ■ 2. Removing from the last sentence, the language ‘‘or 4958(a),’’ and adding ‘‘4958(a), or 4965(a),’’ in its place. ■ Par. 3. Section 53.6071–1 is amended by adding and reserving paragraph (g) and adding paragraph (h) to read as follows: § 53.6071–1

Time for filing returns.

• • • • (g) [Reserved]. For further guidance, see § 53.6071–1T(g). (h) Effective/applicability date. For the applicability date of paragraph (g) of this section, see § 53.6071–1T(h). ■ Par. 4. Section 53.6071–1T is added to read as follows: § 53.6071–1T (temporary).

Time for filing returns

(a) through (f) [Reserved]. For further guidance, see § 53.6071–1(a) through (f). (g) Taxes imposed with respect to prohibited tax shelter transactions to which tax-exempt entities are parties— (1) Returns by certain tax-exempt entities. A Form 4720, ‘‘Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code,’’ required by § 53.6011–1(b) for a taxexempt entity described in section 4965(c)(1), (c)(2) or (c)(3) that is a party to a prohibited tax shelter transaction and is liable for tax imposed by section 4965(a)(1) shall be filed on or before the

due date (not including extensions) for filing the tax-exempt entity’s annual information return under section 6033(a)(1). If the tax-exempt entity is not required to file an annual information return under section 6033(a)(1), the Form 4720 shall be filed on or before the 15th day of the fifth month after the end of the tax-exempt entity’s taxable year or, if the entity has not established a taxable year for Federal income tax purposes, the entity’s annual accounting period. (2) Returns by entity managers of taxexempt entities described in section 4965(c)(1), (c)(2) or (c)(3). A Form 4720, required by § 53.6011–1(b) for an entity manager of a tax-exempt entity described in section 4965(c)(1), (c)(2) or (c)(3) who is liable for tax imposed by section 4965(a)(2) shall be filed on or before the 15th day of the fifth month following the close of the entity manager’s taxable year during which the entity entered into the prohibited tax shelter transaction. (3) Transition rule. A Form 4720, for a section 4965 tax that is or was due on or before October 4, 2007 will be deemed to have been filed on the due date if it is filed by October 4, 2007 and if all section 4965 taxes required to be reported on that Form 4720 are paid by October 4, 2007. (h) Effective/applicability date—(1) In general. Paragraph (g) of this section is applicable on July 6, 2007. (2) Expiration date. Paragraph (g) of this section will cease to apply on July 6, 2010. PART 54—PENSION EXCISE TAXES ■ Par. 5. The authority citation for part

54 continues to read in part as follows: ■ Par. 6. Section 54.6011–1 is amended

by adding and reserving paragraph (c) and adding paragraph (d) to read as follows: § 54.6011–1 General requirement of return, statement, or list.

• • • • (c) [Reserved]. For further guidance, see § 54.6011–1T(c). (d) Effective/applicability date. For the applicability date of paragraph (c) of this section, see § 54.6011–1T(d). ■ Par. 7. Section 54.6011–1T is amended as follows: ■ 1. The undesignated text is designated as paragraph (a) and a paragraph heading is added. ■ 2. Paragraph (b) is added and reserved. ■ 3. Paragraphs (c) and (d) are added.

(a) Tax on reversions of qualified plan assets to employer. * (b) [Reserved]. (c) Entity manager tax on prohibited tax shelter transactions—(1) In general. Any entity manager of a tax-exempt entity described in section 4965(c)(4), (c)(5), (c)(6), or (c)(7) who is liable for tax under section 4965(a)(2) shall file a return on Form 5330, ‘‘Return of Excise Taxes Related to Employee Benefit Plans,’’ on or before the 15th day of the fifth month following the close of such entity manager’s taxable year during which the entity entered into the prohibited tax shelter transaction, and shall include therein the information required by such form and the instructions issued with respect thereto. (2) Transition rule. A Form 5330, ‘‘Return of Excise Taxes Related to Employee Benefit Plans,’’ for an excise tax under section 4965 that is or was due on or before October 4, 2007 will be deemed to have been filed on the due date if it is filed by October 4, 2007 and if the section 4965 tax that was required to be reported on that Form 5330 is paid by October 4, 2007. (d) Effective/applicability date—(1) In general. Paragraph (c) of this section is applicable on July 6, 2007. (2) Expiration date. Paragraph (c) of this section will expire on July 5, 2010. Kevin M. Brown, Deputy Commissioner for Services and Enforcement. Approved: June 21, 2007. Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

Authority: 26 U.S.C. 7805 *

§ 54.6011–1T General requirement of return, statement or list (temporary).

EQUAL EMPLOYMENT OPPORTUNITY COMMISSION 29 CFR Part 1625 RIN 3046–AA78

Coverage Under the Age Discrimination in Employment Act

Agency: Equal Employment

Opportunity Commission.

Action: Final rule.

Summary: The Equal Employment Opportunity Commission (‘‘EEOC’’ or ‘‘Commission’’) is publishing this final rule to amend its Age Discrimination in Employment Act (the ‘‘Act’’ or ‘‘ADEA’’) regulations to conform them to the Supreme Court’s holding in General Dynamics Land System, Inc. v. Cline,

540 U.S. 581 (2004), that the ADEA only prohibits discrimination based on relatively older age, not discrimination based on age generally. Thus, the final rule deletes language in EEOC’s ADEA regulations that prohibited discrimination against relatively younger individuals. The new rule explains that the ADEA only prohibits employment discrimination based on old age and, therefore, does not prohibit employers from favoring relatively older individuals.

Dates: Effective date July 6, 2007.

For Further Information Contact: Raymond Peeler, Senior Attorney Advisor, Office of Legal Counsel, at (202) 663–4537 (voice) or (202) 663– 7026 (TTY) (These are not toll free numbers). This final rule also is available in the following formats: large print, braille, audio tape and electronic file on computer disk. Requests for this final rule in an alternative format should be made to the Publications Information Center at 1–800–669–3362.

Supplementary Information: On August 11, 2006, the EEOC published a Notice of Proposed Rulemaking (‘‘NPRM’’) in the Federal Register to amend regulations that prohibited any agebased discrimination against individuals forty years old or older, regardless of whether the age-bias favored older or younger individuals.1 Relying on the Supreme Court’s decision in General Dynamics Land System, Inc. v. Cline, 540 U.S. 581 (2004),2 the NPRM explained that the ADEA protects only relatively older individuals. Overview of Public Comments The Commission received nine public comments during the public comment period, which ended on October 10, 2006. Six commenters strongly supported the proposed rule: AARP, National Employment Lawyers Association (NELA), Equal Employment Advisory Counsel (EEAC), U.S. Chamber of Commerce, TOC Management Services, and the National Federation of Independent Business (NFIB). Two federal employee unions opposed the rule. The Conference 1 EEOC Notice of Proposed Rulemaking, 71 FR 46177, Aug. 11, 2006. 2 In Cline, a group of employees between the ages of forty and forty-nine sued their employer for age discrimination when it eliminated its future obligation to pay retiree health benefits for any employee then under fifty years old. The Supreme Court rejected their claim, finding that the ADEA’s prohibition against discrimination ‘‘because of age’’ only prevents discrimination that favors younger workers, not actions that place older workers in a more favorable position. The Court’s rationale is described in detail in the NPRM. See 71 FR at 46178.

Treasury Decision 9335 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS),

Treasury.

Action: Temporary regulations.

Summary: This document contains temporary regulations under section 6033(a)(2) of the Internal Revenue Code (Code) that provide rules regarding the form, manner and timing of disclosure obligations with respect to prohibited tax shelter transactions to which taxexempt entities are parties. These temporary regulations affect a broad array of tax-exempt entities, including charities, state and local government

entities, Indian Tribal governments and employee benefit plans, as well as entity managers of these entities. This action is necessary to implement section 516 of the Tax Increase Prevention and Reconciliation Act of 2005. The text of the temporary regulations also serves as the text of the proposed regulations set forth in the Proposed Rules section in this issue of the Federal Register.

Dates: Effective Date: These regulations are effective on July 6, 2007. Applicability Date: For dates of applicability, see § 1.6033–5T(g).

For Further Information Contact: Galina Kolomietz, (202) 622–6070, or Michael Blumenfeld, (202) 622–1124 (not toll-free numbers). For questions specifically relating to qualified pension plans, individual retirement accounts, and similar tax-favored savings arrangements, contact Dana Barry, (202) 622–6060 (not a toll-free number).

Background

The Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109–222 (120 Stat. 345) (TIPRA), enacted on May 17, 2006, defines certain transactions as prohibited tax shelter transactions and imposes excise taxes and disclosure requirements with respect to prohibited tax shelter transactions to which a tax-exempt

entity is a party. TIPRA creates new section 4965 and amends sections 6033(a)(2) and 6011(g) of the Code. The amended section 6033(a)(2) requires every tax-exempt entity to which section 4965 applies that is a party to a prohibited tax shelter transaction to disclose to the IRS (in such form and manner and at such time as determined by the Secretary) the following information: (a) That such entity is a party to the prohibited tax shelter transaction; and (b) the identity of any other party to the transaction which is known to the tax-exempt entity. The amended section 6011(g) requires any taxable party to a prohibited tax shelter transaction to disclose by statement to any tax-exempt entity to which section 4965 applies that is a party to such transaction that such transaction is a prohibited tax shelter transaction. On July 11, 2006, the IRS released Notice 2006–65 (2006–31 IRB 102), which alerted taxpayers to the new provisions. On February 7, 2007, the IRS released Notice 2007–18 (2007–9 IRB 608), which provided interim guidance regarding the circumstances under which a tax-exempt entity will be treated as a party to a prohibited tax shelter transaction for purposes of sections 4965, 6033(a)(2) and 6011(g) and regarding the allocation to various periods of net income and proceeds

attributable to a prohibited tax shelter transaction, including amounts received prior to the effective date of the section 4965 tax. See § 601.601(d)(2)(ii)(b). These temporary regulations are being issued concurrently with proposed regulations under sections 4965, 6033(a)(2) and 6011(g) published elsewhere in the Federal Register.

Penalties, Reporting and recordkeeping requirements.

Explanation of Provisions

These temporary regulations contain rules concerning disclosure requirements imposed by section 6033(a)(2) on tax-exempt entities that are parties to prohibited tax shelter transactions. Proposed regulations providing rules concerning disclosure requirements under section 6033(a)(2) are being issued concurrently with these temporary regulations.

■ Paragraph 1. The authority citation

Effective Date These temporary regulations are applicable with respect to transactions entered into by a tax-exempt entity after May 17, 2006.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For the applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), refer to the Special Analyses section of the preamble to the cross-referencing notice of proposed rulemaking published in the Proposed Rules section in this issue of the Federal Register. Pursuant to section 7805(f) of the Code, these regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal authors of these regulations are Galina Kolomietz and Dana Barry, Office of Division Counsel/ Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 301 Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes,

Adoption of Amendments to the

Regulations ■ Accordingly, 26 CFR parts 1 and 301

are amended as follows: PART 1—INCOME TAXES for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * ■ Par. 2. Section 1.6033–5T is added to

read as follows: § 1.6033–5T Disclosure by tax-exempt entities that are parties to certain reportable transactions (temporary).

(a) In general. Every tax-exempt entity (as defined in section 4965(c)) shall file with the IRS on Form 8886–T, ‘‘Disclosure by Tax-Exempt Entity Regarding Prohibited Tax Shelter Transaction’’ (or a successor form), in accordance with this section and the instructions to the form, a disclosure of— (1) Such entity’s being a party (as defined in paragraph (b) of this section) to a prohibited tax shelter transaction (as defined in section 4965(e)); and (2) The identity of any other party (whether taxable or tax-exempt) to such transaction that is known to the taxexempt entity. (b) Definition of tax-exempt party to a prohibited tax shelter transaction—(1) In general. For purposes of section 6033(a)(2), a tax-exempt entity is a party to a prohibited tax shelter transaction if the entity— (i) Facilitates a prohibited tax shelter transaction by reason of its tax-exempt, tax indifferent or tax-favored status; (ii) Enters into a listed transaction and the tax-exempt entity’s tax return (whether an original or an amended return) reflects a reduction or elimination of its liability for applicable Federal employment, excise or unrelated business income taxes that is derived directly or indirectly from tax consequences or tax strategy described in the published guidance that lists the transaction; or (iii) Is identified in published guidance, by type, class or role, as a party to a prohibited tax shelter transaction. (2) Published guidance may identify which tax-exempt entities, by type, class or role, will not be treated as a party to a prohibited tax shelter transaction for purposes of section 6033(a)(2). (c) Frequency of disclosure. A single disclosure is required for each prohibited tax shelter transaction.

(d) By whom disclosure is made—(1) Tax-exempt entities referred to in section 4965(c)(1), (2) or (3). In the case of tax-exempt entities referred to in section 4965(c)(1), (2) or (3), the disclosure required by this section must be made by the entity. (2) Tax-exempt entities referred to in section 4965(c)(4), (5), (6) or (7). In the case of tax-exempt entities referred to in section 4965(c)(4), (5), (6) or (7), including a fully self-directed qualified plan, IRA, or other savings arrangement, the disclosure required by this section must be made by the entity manager (as defined in section 4965(d)(2)) of the entity. (e) Time and place for filing—(1) Taxexempt entities described in paragraph (b)(1)(i) of this section—(i) In general. The disclosure required by this section shall be filed on or before May 15 of the calendar year following the close of the calendar year during which the taxexempt entered into the prohibited tax shelter transaction. (ii) Subsequently listed transactions. In the case of subsequently listed transactions (as defined in section 4965(e)(2)), the disclosure required by this section shall be filed on or before May 15 of the calendar year following the close of the calendar year during which the transaction was identified by the Secretary as a listed transaction. (2) Tax-exempt entities described in paragraph (b)(1)(ii) of this section. The disclosure required by this section shall be filed on or before the date on which the first tax return (whether an original or an amended return) is filed which reflects a reduction or elimination of the tax-exempt entity’s liability for applicable Federal employment, excise or unrelated business income taxes that is derived directly or indirectly from tax consequences or tax strategy described in the published guidance that lists the transaction. (3) Transition rule. If a tax-exempt entity entered into a prohibited tax shelter transaction after May 17, 2006 and before January 1, 2007, the disclosure required by this section shall be filed— (i) In the case of tax-exempt entities described in paragraph (b)(1)(i) of this section, on or before November 5, 2007; (ii) In the case of tax-exempt entities described in paragraph (b)(1)(ii) of this section, on or before the later of— (A) November 5, 2007; or (B) The date on which the first tax return (whether an original or an amended return) is filed which reflects a reduction or elimination of the taxexempt entity’s liability for applicable Federal employment, excise or unrelated business income taxes that is

derived directly or indirectly from tax consequences or tax strategy described in the published guidance that lists the transaction. (4) Disclosure is not required with respect to any prohibited tax shelter transaction entered into by a tax-exempt entity on or before May 17, 2006. (f) Penalty for failure to provide disclosure statement. See section 6652(c)(3) for penalties applicable to failure to disclose a prohibited tax shelter transaction in accordance with this section. (g) Effective date—(1) Applicability date. This section applies with respect to transactions entered into by a taxexempt entity after May 17, 2006. (2) Expiration date. This section will expire on July 6, 2010. PART 301—PROCEDURE AND ADMINISTRATION ■ Par. 3. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * ■ Par. 4. Section 301.6033–5T is added to read as follows:

§ 301.6033–5T Disclosure by tax-exempt entities that are parties to certain reportable transactions (temporary).

(a) In general. For provisions relating to the requirement of the disclosure by a tax-exempt entity that it is a party to certain reportable transactions, see § 1.6033–5T of this chapter (Income Tax Regulations). (b) Effective date—(1) Applicability date. This section applies with respect to transactions entered into by a taxexempt entity after May 17, 2006. (2) Expiration date. This section will expire on July 5, 2010. Kevin M. Brown, Deputy Commissioner for Services and Enforcement. Approved: June 21, 2007. Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 53 and 54

Treasury Decision 9407 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS),

Treasury.

Action: Final and temporary regulations and removal of temporary regulations.

Summary: This document contains final and temporary regulations relating to the simplification of procedures for obtaining automatic extensions of time to file certain returns. For these returns,

the final and temporary regulations also remove the requirements for a signature and an explanation of the need for an extension of time to file. The final and temporary regulations affect taxpayers who are required to file certain returns and need an extension of time to file. The text of the temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register.

Dates: Effective Date: These regulations are effective on July 1, 2008. Applicability Date: For dates of applicability of these regulations see §§ 1.6081–1(c), 1.6081–2T(i), 1.6081– 3(e), 1.6081–4(f), 1.6081–5(f), 1.6081– 6T(h), 1.6081–7(g), 1.6081–10(f), 1.6081–11(e), 25.6081–1(f), 26.6081– 1(f), 53.6081–1(f), 55.6081–1(f), 156.6081–1(f), 157.6081–1(f), and 301.6081–2(e).

For Further Information Contact: Matthew P. Howard, (202) 622–4910 (not a toll-free number).

Background

This document contains amendments to 26 CFR parts 1, 25, 26, 53, 55, 156, 157, and 301 under section 6081 of the Internal Revenue Code (Code). On November 8, 2005, a temporary regulation (TD 9229) relating to the simplification of procedures for obtaining automatic extensions of time to file certain returns was published in the Federal Register (70 FR 67356). A notice of proposed rulemaking (REG– 144898–04) cross-referencing the temporary regulations was published in the Federal Register for the same day (70 FR 67397). No public hearing was requested or held. Written or electronic comments responding to the notice of proposed rulemaking were received. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury decision containing both final and temporary regulations. The revisions are discussed in this preamble. A notice of proposed rulemaking (REG–115457–08) crossreferencing the temporary regulations appears in the Proposed Rules section of this issue of the Federal Register.

Summary of Comments and

Explanation of Revisions These final and temporary regulations simplify the extension process by allowing certain taxpayers to file a single request for an automatic extension of time to file certain returns. Because the extension is automatic, these taxpayers do not need to sign the

extension request or provide an explanation of the reasons for requesting an extension. Simplifying, consolidating, and standardizing extension forms will reduce taxpayer burden. This simplification will also lower processing costs and facilitate increased efficiency for the IRS. Individual Income Taxpayers The proposed regulations provided an automatic six-month extension to taxpayers who must file an individual income tax return if they submit a timely, completed application for extension on Form 4868 ‘‘Application for Automatic Extension of Time To File a U.S. Individual Income Tax Return.’’ This new procedure, adopted in the final regulations, replaces the process where an individual could obtain an initial automatic four-month extension by filing Form 4868 and apply for an additional two-month discretionary extension by filing Form 2688, ‘‘Application for Additional Extension of Time To File U.S. Individual Income Tax Return.’’ In connection with the new procedure, the IRS eliminated Form 2688. One commentator noted that individuals who are abroad may qualify for an extension beyond six months and previously applied for this extension using Form 2688. The commentator suggests that the elimination of this form places an added administrative burden on these individual taxpayers who are abroad. The commentator notes that without Form 2688, the alternative for requesting an additional extension beyond six months is to write a letter in accordance with Treas. Reg. § 1.6081– 1(b). Thus, the commentator requests that Form 2688 be retained for use by taxpayers who are abroad and require more than a six-month extension of time to file. The primary goal for these regulatory revisions is to reduce taxpayer burden by simplifying the extension process through the elimination of unnecessary forms and required information. The elimination of Form 2688 is among those measures aimed at streamlining the extension process. Although previously used by some taxpayers who are abroad to apply for an additional extension beyond six months, the Treasury Department and the IRS have determined that retention of this form for such a limited purpose and small class of taxpayers would not be efficient. The Treasury Department and the IRS have also determined that due to the discretionary nature of any additional extension for taxpayers who are abroad, requiring a letter explaining the need for the extension is the most

appropriate procedure. There is no additional administrative burden from this decision as in both situations the taxpayer must file a document containing substantially the same information and the IRS must process it. Thus, the comment is not adopted and the final regulations eliminate all references to the obsoleted Form 2688. Individual taxpayers who are abroad seeking guidance on applying for an additional extension of time to file beyond six months should refer to IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, or the IRS Internet site at http://www. irs.gov/formspubs/article/ 0,,id=154856,00.html. Corporate Income Taxpayers The proposed regulations did not change the rules regarding filing extensions for corporations but merely changed the appearance and title of Form 7004, now titled ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns.’’ While not specifically addressed by the proposed regulations, one comment was received regarding extensions for affiliated groups of corporations filing a consolidated return. The commentator suggests that the requirement under § 1.6081–3(a)(4) to include a statement listing the name and address of each member of the affiliated group if the affiliated group will file a consolidated return is inconsistent with § 1.1502– 75(a). Section 1.1502–75(a) allows a group which did not file a consolidated return for the immediately preceding taxable year to file a consolidated return, provided that each member of the group that is eligible to do so files a Form 1122, ‘‘Authorization & Consent of Subsidiary Corporation to be included in a Consolidated Income Tax Return,’’ not later than the last day prescribed by law (including extensions of time) for the filing of the common parent’s return. The commentator contends that § 1.6081–3 suggests that in order to have a valid extension all members of the affiliated group must be listed with the extension request even though the affiliated group may not have decided at the time the extension is filed if a consolidated return will be elected. Although, § 1.6081–3 requires a listing of subsidiaries with the extension request, the commentator suggests that, because § 1.1502–75(a) does not require the members of an affiliated group to elect to file a consolidated return until the common parent’s extended due date, the failure to include the name and address of a member of the affiliated group that will be filed as part of the

consolidated return should not invalidate a request for an automatic extension of time to file. The IRS and Treasury Department find no inconsistency between these regulations. If, at the time the extension request is due, the affiliated entities have not decided whether to file a consolidated return, the various affiliated entities must either file separate returns or individually request an extension of time to file. The failure to do either will result in a late return. Additionally, by including a list of affiliated members with the extension request, each member is deemed to be applying for an extension of time to file. In the event that a subsidiary does not file as part of a consolidated return, that entity will have a valid extension to file its own return. Therefore, the final regulations retain the requirement to list the name and address of each member of the affiliated group with the extension request. To address the commentator’s concern, the final regulations explicitly state that the attached list will grant an extension for each member’s separate return in the event that the member does not file as part of the consolidated group. Partnership, Trust, and Estate Taxpayers The proposed regulations provided for an automatic six-month extension of time to file returns for certain entities not taxed at the entity level (passthrough entities). Recognizing the potential that some taxpayers may not receive timely information returns from pass-through entities (for example, Schedule K–1s from partnerships) needed to complete their own income tax returns, the proposed regulations specifically requested comments on whether a shorter extension of time to file for pass-through entities might reduce overall taxpayer burden. Several comments addressing this issue were received. Four commentators suggested that the filing date for pass-through entities should be moved back to March 15th instead of April 15th. This would allow these entities to receive six-month extensions of time to file (until September 15th ) but still allow individual taxpayers with ownership interests in the pass-through entities to receive information needed to file a timely and complete income tax return by the October 15th extended due date. The filing dates for these pass-through entity returns are governed by statute. See for example, sections 6012(a), and 6072. Accordingly, without legislative action, the Treasury Department and the IRS are unable to change the filing due dates for these pass-through entities.

The remaining comments on this topic suggested that an extension period for pass-through entities of five months or less would benefit individual taxpayers with ownership interests in pass-through entities in preparation of their own individual income tax returns. Three commentators suggested that the proposed regulations would actually increase taxpayer burden by making it easier for pass-through entities to delay the filing of their returns. Two commentators also pointed out that the five-month extension period would not alleviate the burden on corporate taxpayers with ownership interests in pass-through entities. These commentators expressed a concern that even a five-month extension period for pass-through entities would, in most cases, simply align the extended due date for pass-through entities with the extended due date for corporate returns, resulting in the same delay of information to corporate owners of passthrough entities. This delay, the commentators contend, would greatly increase the need for filing amended returns. These commentators suggested shortening the automatic extension for pass-through entities to a period of less than five months, which would ultimately reduce burden on both taxpayers and the IRS. In response to these comments, the Treasury Department and IRS have adopted temporary regulations which will provide for a five-month automatic extension period with no additional extension for certain pass-through entities. These entities are partnerships filing Form 1065, ‘‘U.S. Partnership Return of Income,’’ or Form 8804, ‘‘Annual Return for Partnership Withholding Tax,’’ and estates and trusts filing Form 1041, ‘‘U.S. Income Tax Return for Estates and Trusts.’’ While some commentators suggested adopting an extension period shorter than five months, the Treasury Department and the IRS believe a fivemonth automatic extension period for certain partnerships, trusts, and estates, strikes a reasonable balance and reduces the overall burden on taxpayers. The Treasury Department and IRS believe the five-month extension period allows pass-through entities, including complex and tiered entities, an adequate time for preparation of the required pass-through return and also ensures the timely and accurate dissemination of information to a large number of taxpayers who require that information for completion of their own income tax returns. It is recognized that some corporations with ownership interests in pass-through entities may continue to

experience delayed receipt of information needed to complete their own corporate returns and some passthrough entities may find it difficult to complete their returns. Thus the Treasury Department and the IRS request comments on whether the fivemonth automatic extension of time to file for these pass-through entities increases or reduces overall taxpayer burden. Please follow the instructions in the ‘‘Comments and Public Hearing’’ section in the notice of proposed rulemaking accompanying these temporary regulations in this issue of the Federal Register. Transitional Rule for Pass-Through Entities The temporary regulations allowing certain pass-through entities to obtain an automatic five-month extension apply to applications by these entities for an automatic extension of time to file certain returns due on or after January 1, 2009. These entities will be allowed to obtain an automatic six-month extension of time to file the applicable returns, which are required to be filed before January 1, 2009.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Although these final regulations reference forms that are approved under the Paperwork Reduction Act (44 U.S.C. chapter 35), the regulations themselves do not impose a collection of information on small entities. Therefore the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. For the applicability of the Regulatory Flexibility Act to the temporary regulations, refer to the Special Analyses section of the preamble to the cross-reference notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses. Pursuant to the same provision, the temporary regulations contained in this Treasury Decision will be submitted for comment on their impact on small businesses.

Drafting Information

The principal author of these regulations is Matthew P. Howard of the Office of the Associate Chief Counsel (Procedure and Administration).

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 25 Gift taxes, Reporting and recordkeeping requirements. 26 CFR Part 26 Generation-skipping transfer taxes, Reporting and recordkeeping requirements. 26 CFR Part 53 Excise taxes, Foundations, Investments, Lobbying, Reporting and recordkeeping requirements. 26 CFR Part 55 Excise taxes, Investments, Reporting and recordkeeping requirements. 26 CFR Part 156 Excise taxes, Reporting and recordkeeping requirements. 26 CFR Part 157 Excise taxes, Reporting and recordkeeping requirements. 26 CFR Part 301 Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations ■ Accordingly, 26 CFR parts 1, 25, 26,

53, 55, 156, 157, and 301 are amended as follows: PART 1—INCOME TAXES ■ Paragraph 1. The authority citation

for part 1 is amended by removing the entries for §§ 1.6081–4T, 1.6081–7T, 1.6081–10T, and 1.6081–11T and adding entries in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 * Section 1.6081–1 also issued under 26 U.S.C. 6081. Section 1.6081–3 also issued under 26 U.S.C. 6081. Section 1.6081–4 also issued under 26 U.S.C. 6081. Section 1.6081–5 also issued under 26 U.S.C. 6081. Section 1.6081–7 also issued under 26 U.S.C. 6081. Section 1.6081–10 also issued under 26 U.S.C. 6081.

Section 1.6081–11 also issued under 26 U.S.C. 6081. *

Par. 2. Section 1.911–7 is amended by revising paragraph (c)(2) and adding paragraph (e) to read as follows: § 1.911–7

Procedural rules.

• • • • (c) (2) Extensions. An individual desiring an extension of time (in addition to the automatic extension of time granted by § 1.6081–4) for filing a return until after the completion of the qualifying period described in paragraph (c)(1) of this section for claiming any exclusion or deduction under section 911 may apply for an extension. An individual whose moving expense deduction is attributable to services performed in two years may apply for an extension of time for filing a return until after the end of the second year. The individual may make such application on Form 2350, ‘‘Application for Extension of Time to File U.S. Income Tax Return’’ or in any other manner prescribed by the Commissioner. The application must be filed in accordance with the instructions to the form or as prescribed by the Commissioner. The application must set forth the facts relied on to justify the extension of time requested and must include a statement as to the earliest date the individual expects to become entitled to any exclusion or deduction by reason of completion of the qualifying period. (e) Effective/applicability date. This section applies to applications for extension of time to file returns filed after July 1, 2008. ■ Par. 3. Section 1.6081–1 is amended by revising paragraph (b) and adding paragraph (c) to read as follows: § 1.6081–1 returns.

Extension of time for filing

• • • • (b) Application for extension of time—(1) In general. Under other sections in this chapter, certain taxpayers may request an automatic extension of time to file certain returns. Except in undue hardship cases, no extension of time to file a return will be allowed under this section until an automatic extension of time to file the return has been allowed under the applicable section. No extension of time to file a return will be granted under this section for a period of time greater than that provided for by automatic extension. A taxpayer desiring an extension of the time for filing a return, statement, or other document shall submit an application for extension on or before the due date of such return,

statement, or other document. If a form exists for the application for an extension, the taxpayer should use the form; however, taxpayers may apply for an extension in a letter that includes the information required by this paragraph. Except as provided in § 301.6091–1(b) of this chapter (relating to hand-carried documents), the taxpayer should make the application for extension to the Internal Revenue Service office where such return, statement, or other document is required to be filed. Except for requests for automatic extensions of time to file certain returns provided for elsewhere in this chapter, the application must be in writing, signed by the taxpayer or his duly authorized agent, and must clearly set forth— (i) The particular tax return, information return, statement, or other document, including the taxable year or period thereof, for which the taxpayer requests an extension; and (ii) An explanation of the reasons for requesting the extension to aid the internal revenue officer in determining whether to grant the request. (2) Taxpayer unable to sign. In any case in which a taxpayer is unable, by reason of illness, absence, or other good cause, to sign a request for an extension, any person standing in close personal or business relationship to the taxpayer may sign the request on his behalf, and shall be considered as a duly authorized agent for this purpose, provided the request sets forth the reasons for a signature other than the taxpayer’s and the relationship existing between the taxpayer and the signer. (c) Effective/applicability dates. This section applies to requests for extension of time filed after July 1, 2008. ■ Par. 4. Section 1.6081–2T is revised to read as follows: § 1.6081–2T Automatic extension of time to file certain returns filed by partnerships (temporary).

(a) In general. (1) Except as provided in paragraph (h) of this section, a partnership required to file Form 1065, ‘‘U.S. Partnership Return of Income,’’ or Form 8804, ‘‘Annual Return for Partnership Withholding Tax,’’ for any taxable year will be allowed an automatic 5-month extension of time to file the return after the date prescribed for filing the return if the partnership files an application under this section in accordance with paragraph (b) of this section. No additional extension will be allowed pursuant to § 1.6081–1(b) beyond the automatic 5-month extension provided by this section. In the case of a partnership described in § 1.6081–5(a)(1), the automatic extension of time to file allowed under

this section runs concurrently with an extension of time to file granted pursuant to § 1.6081–5. (2) An electing large partnership (ELP) required to file Form 1065–B, ‘‘U.S. Return of Income for Electing Large Partnerships,’’ for any taxable year will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the partnership files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), the partnership must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the later of— (i) The date prescribed for filing the return of the partnership; or (ii) The expiration of any extension of time to file granted under § 1.6081–5(a); and (3) File the application with the Internal Revenue Service office designated in the application’s instructions. (c) Payment of section 7519 amount. An automatic extension of time for filing a partnership return of income granted under paragraph (a) of this section does not extend the time for payment of any amount due under section 7519, relating to required payments for entities electing not to have a required taxable year. (d) Section 444 election. An automatic extension of time for filing a partnership return of income will run concurrently with any extension of time for filing a return allowed because of section 444, relating to the election of a taxable year other than a required taxable year. (e) Effect of extension on partner. An automatic extension of time for filing a partnership return of income under this section does not extend the time for filing a partner’s income tax return or the time for the payment of any tax due on a partner’s income tax return. (f) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the partnership a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the partnership’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter.

(g) Penalties. See section 6698 for failure to file a partnership return. (h) Special rule for applications for extensions of time to file returns due on or after July 1, 2008 and before January 1, 2009. A partnership required to file Form 1065, ‘‘U.S. Partnership Return of Income,’’ or Form 8804, ‘‘Annual Return for Partnership Withholding Tax,’’ on or after July 1, 2008 and before January 1, 2009, will be allowed an automatic 6month extension of time to file the return after the date prescribed for filing the return if the partnership files an application under this section in accordance with paragraph (b) of this section. (i) Effective/applicability dates. This section applies to applications for an automatic extension of time to file the partnership returns listed in paragraph (a) of this section filed on or after July 1, 2008. (j) Expiration date. The applicability of this section expires on or before June 30, 2011. ■ Par. 5. Section 1.6081–3 is amended by revising paragraphs (a)(1) and (4) and (e) to read as follows: § 1.6081–3 Automatic extension of time for filing corporation income tax returns.

(a) (1) An application must be submitted on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner. (4) The application must include a statement listing the name and address of each member of the affiliated group if the affiliated group will file a consolidated return. Upon the timely filing of Form 7004, the 6-month extension of time to file shall be considered as granted to the affiliated group for the filing of its consolidated return or for the filing of each member’s separate return. * (e) Effective/applicability dates. This section applies to requests for extension of time to file corporation income tax returns filed after July 1, 2008. § 1.6081–3T

[Removed]

■ Par. 6. Section 1.6081–3T is removed.

■ Par. 7. Section 1.6081–4 is added to read as follows:

§ 1.6081–4 Automatic extension of time for filing individual income tax return.

(a) In general. An individual who is required to file an individual income tax return will be allowed an automatic 6-

month extension of time to file the return after the date prescribed for filing the return if the individual files an application under this section in accordance with paragraph (b) of this section. In the case of an individual described in § 1.6081–5(a)(5) or (6), the automatic 6-month extension will run concurrently with the extension of time to file granted pursuant to § 1.6081–5. (b) Requirements. To satisfy this paragraph (b), an individual must— (1) Submit a complete application on Form 4868, ‘‘Application for Automatic Extension of Time To File U.S. Individual Income Tax Return,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the later of— (i) The date prescribed for filing the return; or (ii) The expiration of any extension of time to file granted pursuant to § 1.6081–5; (3) File the application with the Internal Revenue Service office designated in the application’s instructions; and (4) Show the full amount properly estimated as tax for the taxable year. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the individual a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 4868 or to the individual’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file an individual income tax return or failure to pay the amount shown as tax on the return. In particular, see § 301.6651–1(c)(3) of this chapter (relating to a presumption of reasonable cause in certain circumstances involving an automatic extension of time for filing an individual income tax return). (f) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file an individual income tax return filed after July 1, 2008. § 1.6081–4T

[Removed]

■ Par. 8. Section 1.6081–4T is removed.

■ Par. 9. Section 1.6081–5 is amended by revising paragraphs (a), (b), and (f) to read as follows:

§ 1.6081–5 Extensions of time in the case of certain partnerships, corporations, and U.S. citizens and residents.

(a) An extension of time for filing returns of income and for paying any tax shown on the return is hereby granted to and including the fifteenth day of the sixth month following the close of the taxable year in the case of— (1) Partnerships which are required under section 6072(a) to file returns on the fifteenth day of the fourth month following the close of the taxable year of the partnership, and which keep their records and books of account outside the United States and Puerto Rico; (2) Domestic corporations which transact their business and keep their records and books of account outside the United States and Puerto Rico; (3) Foreign corporations which maintain an office or place of business within the United States; (4) Domestic corporations whose principal income is from sources within the possessions of the United States; (5) United States citizens or residents whose tax homes and abodes, in a real and substantial sense, are outside the United States and Puerto Rico; and (6) United States citizens and residents in military or naval service on duty, including non-permanent or short term duty, outside the United States and Puerto Rico. (b) In order to qualify for the extension under this section— (1) A statement must be attached to the return showing that the person for whom the return is made is a person described in paragraph (a) of this section; or (2) If a person described in paragraph (a) of this section requests additional time to file, the person must request the extension on or before the fifteenth day of the sixth month following the close of the taxable year and check the appropriate box on Form 4868, ‘‘Application for Automatic Extension of Time To File a U.S. Individual Income Tax Return,’’ or Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ whichever is applicable, or in any other manner prescribed by the Commissioner. * (f) Effective/applicability date. This section is applicable for returns of income due after July 1, 2008.

§ 1.6081–5T

[Removed]

■ Par. 10. Section 1.6081–5T is

removed. ■ Par. 11. Section 1.6081–6T is revised

to read as follows:

§ 1.6081–6T Automatic extension of time to file estate or trust income tax return (temporary).

(a) In general. (1) Except as provided in paragraph (g) of this section, an estate or trust required to file an income tax return on Form 1041, ‘‘U.S. Income Tax Return for Estates and Trusts,’’ will be allowed an automatic 5-month extension of time to file the return after the date prescribed for filing the return if the estate or trust files an application under this section in accordance with paragraph (b) of this section. No additional extension will be allowed pursuant to § 1.6081–1(b) beyond the automatic 5-month extension provided by this section. (2) An estate or trust required to file an income tax return on Form 1041–N, ‘‘U.S. Income Tax Return for Electing Alaska Native Settlement,’’ or Form 1041–QFT, ‘‘U.S. Income Tax Return for Qualified Funeral Trusts’’ for any taxable year will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the estate or trust files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), an estate or trust must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions; and (3) Show the amount properly estimated as tax for the estate or trust for the taxable year. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Effect of extension on beneficiary. An automatic extension of time to file an estate or trust income tax return under this section will not extend the time for filing the income tax return of a beneficiary of the estate or trust or the time for the payment of any tax due on the beneficiary’s income tax return. (e) Termination of automatic extension. The Commissioner may

terminate an automatic extension at any time by mailing to the estate or trust a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the estate or trust’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (f) Penalties. See section 6651 for failure to file an estate or trust income tax return or failure to pay the amount shown as tax on the return. (g) Special rule for applications for extensions of time to file returns due on or after July 1, 2008 and before January 1, 2009. An estate or trust required to file an income tax return on Form 1041, ‘‘U.S. Income Tax Return for Estates and Trusts,’’ on or after July 1, 2008 and before January 1, 2009, will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the estate or trust files an application under this section in accordance with paragraph (b) of this section. (h) Effective/applicability dates. This section applies to applications for an automatic extension of time to file an estate or trust income tax return filed on or after July 1, 2008. (i) Expiration date. The applicability of this section expires on or before June 30, 2011. ■ Par. 12. Section 1.6081–7 is added to read as follows: § 1.6081–7 Automatic extension of time to file Real Estate Mortgage Investment Conduit (REMIC) income tax return.

(a) In general. A Real Estate Mortgage Investment Conduit (REMIC) required to file an income tax return on Form 1066, ‘‘U.S. Real Estate Mortgage Investment Conduit Income Tax Return,’’ or Form 8831, ‘‘Excise Tax on Excess Inclusions of REMIC Residual Interests,’’ for any taxable year will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the REMIC files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), a REMIC must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office

designated in the application’s instructions; and (3) Show the full amount properly estimated as tax for the REMIC for the taxable year. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Effect of extension on residual or regular interest holders. An automatic extension of time to file a REMIC income tax return under this section will not extend the time for filing the income tax return of a residual or regular interest holder of the REMIC or the time for the payment of any tax due on the residual or regular interest holder’s income tax return. An automatic extension will also not extend the time for payment of any excise tax on excess inclusions of REMIC residual interests. (e) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the REMIC a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the REMIC’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (f) Penalties. See sections 6698 and 6651 for failure to file a REMIC income tax return or failure to pay an amount shown as tax on the return. (g) Effective/applicability dates. This section applies to applications for an automatic extension of time to file REMIC income and excise tax returns listed in paragraph (a) of this section filed after July 1, 2008. § 1.6081–7T

[Removed]

■ Par. 13. Section 1.6081–7T is

removed. ■ Par. 14. Section 1.6081–10 is added to

read as follows: § 1.6081–10 Automatic extension of time to file withholding tax return for U.S. source income of foreign persons.

(a) In general. A withholding agent or intermediary required to file a return on Form 1042, ‘‘Annual Withholding Tax Return for U.S. Source Income of Foreign Persons,’’ for any taxable year will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the withholding agent or intermediary files an application under this section in

accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), a withholding agent or intermediary must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions; and (3) Remit the amount of the properly estimated unpaid tax liability on or before the date prescribed for payment. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the withholding agent or intermediary a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the withholding agent or intermediary’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file a return or failure to pay an amount shown as tax on the return. (f) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file the withholding tax return for U.S. source income of foreign persons return filed after July 1, 2008. § 1.6081–10T

§ 1.6081–11T

[Removed]

■ Par. 17. Section 1.6081–11T is

removed. PART 25—GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954 ■ Par. 18. The authority citation for part

[Removed]

■ Par. 15. Section 1.6081–10T is

removed. ■ Par. 16. Section 1.6081–11 is added to

read as follows:

sponsor files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), an administrator or sponsor must— (1) Submit a complete application on Form 5558, ‘‘Application for Extension of Time To File Certain Employee Plan Returns,’’ or in any other manner as may be prescribed by the Commissioner; and (2) File the application with the Internal Revenue Service office designated in the application’s instructions on or before the date prescribed for filing the information return. (c) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the administrator or sponsor a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 5558 or to the administrator or sponsor’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (d) Penalties. See sections 6652, 6692, and the Employee Retirement Income Security Act of 1974 for penalties for failure to file a timely and complete Form 5500. (e) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file Forms 5500 for plan years ending after July 1, 2008.

25 is amended by removing the entry for § 25.6081–1T and adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 *

§ 1.6081–11 Automatic extension of time for filing certain employee plan returns.

Section 25.6081–1 also issued under the authority of 26 U.S.C. 6081(a).

(a) In general. An administrator or sponsor of an employee benefit plan required to file a return under the provisions of chapter 61 or the regulations under that chapter on Form 5500 (series), ‘‘Annual Return/Report of Employee Benefit Plan,’’ will be allowed an automatic extension of time to file the return until the 15th day of the third month following the date prescribed for filing the return if the administrator or

■ Par. 19. Section 25.6081–1 is added to

read as follows: § 25.6081–1 Automatic extension of time for filing gift tax returns.

(a) In general. Under section 6075(b)(2), an automatic six-month extension of time granted to a donor to file the donor’s return of income under § 1.6081–4 of this chapter shall be deemed also to be a six-month extension

of time granted to file a return on Form 709, ‘‘United States Gift (and Generation-Skipping Transfer) Tax Return.’’ If a donor does not obtain an extension of time to file the donor’s return of income under § 1.6081–4 of this chapter, the donor will be allowed an automatic 6-month extension of time to file Form 709 after the date prescribed for filing if the donor files an application under this section in accordance with paragraph (b) of this section. In the case of an individual described in § 1.6081–5(a)(5) or (6) of this chapter, the automatic 6-month extension of time to file Form 709 will run concurrently with the extension of time to file granted pursuant to § 1.6081–5 of this chapter. (b) Requirements. To satisfy this paragraph (b), a donor must— (1) Submit a complete application on Form 8892, ‘‘Payment of Gift/GST Tax and/or Application for Extension of Time To File Form 709,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the later of— (i) The date prescribed for filing the return; or (ii) The expiration of any extension of time to file granted pursuant to § 1.6081–5 of this chapter; and (3) File the application with the Internal Revenue Service office designated in the application’s instructions. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an extension at any time by mailing to the donor a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 8892, or to the donor’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file a gift tax return or failure to pay the amount shown as tax on the return. (f) Effective/applicability dates. This section is applicable for applications for an extension of time to file Form 709 filed after July 1, 2008. § 25.6081–1T

[Removed]

■ Par. 20. Section 25.6081–1T is

removed.

PART 26—GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1986 ■ Par. 21. The authority citation for part

26 is amended by removing the entry for § 26.6081–1T and adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 and 26 U.S.C. 2663 * Section 26.6081–1 also issued under the authority of 26 U.S.C. 6081(a).

• • • • ■ Par. 22. Section 26.6081–1 is added to read as follows:

§ 26.6081–1T

§ 26.6081–1 Automatic extension of time for filing generation-skipping transfer tax returns.

PART 53—FOUNDATION AND SIMILAR EXCISE TAXES

(a) In general. A skip person distributee required to file a return on Form 706–GS(D), ‘‘Generation-Skipping Transfer Tax Return for Distributions,’’ or a trustee required to file a return on Form 706–GS(T), ‘‘Generation-Skipping Transfer Tax Return for Terminations,’’ will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing if the skip person distributee or trustee files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), a skip person distributee or trustee must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions; and (3) Remit the amount of the properly estimated unpaid tax liability on or before the date prescribed for payment. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the skip person distributee or trustee a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the skip person distributee or trustee’s last

■ Par. 24. The authority citation for part

known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file a generation-skipping transfer tax return or failure to pay the amount shown as tax on the return. (f) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file a generation-skipping transfer tax return filed after July 1, 2008.

[Removed]

■ Par. 23. Section 26.6081–1T is

removed.

53 is amended by removing the entry for § 53.6081–1T and adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 Section 53.6081–1 also issued under 26 U.S.C. 6081(a). ■ Par. 25. Section 53.6081–1 is added to

read as follows: § 53.6081–1 Automatic extension of time for filing the return to report taxes due under section 4951 for self-dealing with a nuclear decommissioning fund.

(a) In general. A ‘‘disqualified person’’ for purposes of section 4951(e)(4) who engaged in self-dealing with a Nuclear Decommissioning Fund, and must report tax due under section 4951 on Form 1120-ND, ‘‘Return for Nuclear Decommissioning Funds and Certain Related Persons,’’ will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the disqualified person files an application under this section in accordance with paragraph (b) of this section. For guidance on requesting an extension of time to file Form 1120-ND for purposes of reporting contributions received, income earned, administrative expenses of operating the fund, and the tax on modified gross income, see § 1.6081–3 of this chapter. (b) Requirements. To satisfy this paragraph (b), a disqualified person must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office

designated in the application’s instructions; and (3) Remit the amount of the properly estimated unpaid tax liability on or before the date prescribed for payment. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the disqualified person a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the disqualified person’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file or failure to pay the amount shown as tax on the return. (f) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file a return to report taxes due under section 4951 for self-dealing with a Nuclear Decommissioning Fund filed after July 1, 2008. § 53.6081–1T

[Removed]

■ Par. 26. Section 53.6081–1T is

removed. PART 55—EXCISE TAX ON REAL ESTATE INVESTMENT TRUSTS AND REGULATED INVESTMENT COMPANIES ■ Par. 27. The authority citation is

amended by removing the entry for § 55.6081–1T and adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 6001, 6011, 6071, 6091, and 7805 Section 55.6081–1 also issued under 26 U.S.C. 6081(a). ■ Par. 28. Section 55.6081–1 is added to

read as follows: § 55.6081–1 Automatic extension of time for filing a return due under Chapter 44.

(a) In general. A Real Estate Investment Trust (REIT) required to file a return on Form 8612, ‘‘Return of Excise Tax on Undistributed Income of Real Estate Investment Trusts,’’ or a Regulated Investment Company (RIC) required to file a return on Form 8613, ‘‘Return of Excise Tax on Undistributed Income of Regulated Investment Companies,’’ will be allowed an

automatic 6-month extension of time to file the return after the date prescribed for filing the return if the REIT or RIC files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), a REIT or RIC must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions; and (3) Remit the amount of the properly estimated unpaid tax liability on or before the date prescribed for payment. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the REIT or RIC a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the REIT or RIC’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file or failure to pay the amount shown as tax on the return. (f) Effective/applicable dates. This section is applicable for applications for an automatic extension of time to file a return due under chapter 44, filed after July 1, 2008. § 55.6081–1T

[Removed]

■ Par. 29. Section 55.6081–1T is

removed.

§ 156.6081–1 Automatic extension of time for filing a return due under chapter 54.

(a) In general. A taxpayer required to file a return on Form 8725, ‘‘Excise Tax on Greenmail,’’ will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the taxpayer files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), a taxpayer must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions; and (3) Remit the amount of the properly estimated unpaid tax liability on or before the date prescribed for payment. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the taxpayer a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the taxpayer’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file or failure to pay the amount shown as tax on the return. (f) Effective/applicable dates. This section is applicable for applications for an automatic extension of time to file a return due under chapter 54, filed after July 1, 2008.

Section 157.6081–1 also issued under 26 U.S.C. 6081(a). * ■ Par. 34. Section 157.6081–1 is added

to read as follows: § 157.6081–1 Automatic extension of time for filing a return due under chapter 55.

(a) In general. A taxpayer required to file a return on Form 8876, ‘‘Excise Tax on Structured Settlement Factoring Transactions’’, will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the taxpayer files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), the taxpayer must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions; and (3) Remit the amount of the properly estimated unpaid tax liability on or before the date prescribed for payment. (c) No extension of time for the payment of tax. An automatic extension of time for filing a return granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return. (d) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the taxpayer a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the taxpayer’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (e) Penalties. See section 6651 for failure to file or failure to pay the amount shown as tax on the return. (f) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file a return due under chapter 55, filed after July 1, 2008.

PART 156—EXCISE TAX ON GREENMAIL

§ 156.6081–1T

■ Par. 30. The authority citation is

removed.

amended by removing the entry for § 156.6081–1T and adding an entry in numerical order to read in part as follows:

PART 157— EXCISE TAX ON STRUCTURED SETTLEMENT FACTORING TRANSACTIONS

§ 157.6081–1T

■ Par. 33. The authority citation is

removed.

■ Par. 32. Section 156.6081–1T is

Authority: 26 U.S.C. 6001, 6011, 6061, 6071, 6091, 6161, and 7805 Section 156.6081–1 also issued under 26 U.S.C. 6081(a). ■ Par. 31. Section 156.6081–1 is added

to read as follows:

[Removed]

amended by removing the entry for § 157.6081–1T and adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 *

[Removed]

■ Par. 35. Section 157.6081–1T is

PART 301—PROCEDURE AND ADMINISTRATION ■ Par. 36. The authority citation is

amended by removing the entry for

§ 301.6081–2T and adding an entry in numerical order to read in part as follows:

§ 301.6081–2T

Authority: 26 U.S.C. 7805 Section 301.6081–2 also issued under 26 U.S.C. 6081(a).

Linda E. Stiff, Deputy Commissioner for Services and Enforcement. Approved: June 24, 2008. Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

removed.

to read as follows: § 301.6081–2 Automatic extension of time for filing an information return with respect to certain foreign trusts.

(a) In general. A trust required to file a return on Form 3520-A, ‘‘Annual Information Return of Foreign Trust with a U.S. Owner,’’ will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the trust files an application under this section in accordance with paragraph (b) of this section. (b) Requirements. To satisfy this paragraph (b), a trust must— (1) Submit a complete application on Form 7004, ‘‘Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns,’’ or in any other manner prescribed by the Commissioner; and (2) File the application on or before the date prescribed for filing the return with the Internal Revenue Service office designated in the application’s instructions. (c) Termination of automatic extension. The Commissioner may terminate an automatic extension at any time by mailing to the trust a notice of termination at least 10 days prior to the termination date designated in such notice. The Commissioner must mail the notice of termination to the address shown on the Form 7004 or to the trust’s last known address. For further guidance regarding the definition of last known address, see § 301.6212–2 of this chapter. (d) Penalties. See section 6677 for failure to file information returns with respect to certain foreign trusts. (e) Effective/applicability dates. This section is applicable for applications for an automatic extension of time to file an information return with respect to certain foreign trusts listed in paragraph (a) of this section filed after July 1, 2008.

Supplementary Information: ■ Par. 38. Section 301.6081–2T is ■ Par. 37. Section 301.6081–2 is added [Removed] DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 31 and 602

Treasury Decision 9420 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS), Treasury.

Action: Final regulations.

Summary: This document contains final regulations that amend the utility allowances regulations concerning the of low-income housing tax credit. The final regulations update the utility allowance regulations to provide new options for estimating tenant utility costs. The final regulations affect owners of low-income housing projects who claim the credit, the tenants in those low-income housing projects, and the State and local housing credit agencies that administer the credit.

Dates: Effective Date: These regulations are effective July 29, 2008. Applicability

Date: For dates of applicability see §1.42–12(a)(4).

For Further Information Contact: David Selig (202) 622–3040 (not a tollfree number).

Background

This document contains amendments to the Income Tax Regulations (26 CFR Part 1) relating to the low-income housing credit under section 42 of the Internal Revenue Code (Code). On June 19, 2007, the IRS and Treasury Department published in the Federal Register proposed regulations under section 42(g)(2)(B)(ii) (72 FR 33703). Written and electronic comments responding to the proposed regulations were received and a public hearing was held on the proposed regulations on October 9, 2007. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision.

General Overview

Section 42(a) provides that, for purposes of section 38, the amount of the low-income housing credit determined under section 42 for any taxable year in the credit period is an amount equal to the applicable percentage of the qualified basis of each qualified low-income building. A qualified low-income building is defined in section 42(c)(2) as any building that is part of a qualified lowincome housing project. A qualified low-income housing project is defined in section 42(g)(1) as any project for residential rental property if the project meets one of the following tests elected by the taxpayer: (1) At least 20 percent of the residential units in the project are rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income; or (2) at least 40 percent of the residential units in the project are rent-restricted and occupied by individuals whose income is 60 percent or less of area median gross income. If a taxpayer does not meet the elected test, the project is not eligible for the section 42 credit. Under section 42(g)(4), section 142(d)(2)(B) applies when determining whether any project is a qualified lowincome housing project under section 42(g)(1). Section 142(d)(2)(B) provides that the income of individuals and area median gross income is determined by the Secretary in a manner consistent with determinations of lower income families and area median gross income under section 8 of the United States Housing Act of 1937. Under Rev. Rul. 94–57 (1994–2 CB 5), taxpayers may rely on a list of income limits released by the Department of Housing and Urban Development (HUD) until 45 days after HUD releases a new list of income limits, or until HUD’s effective date for the new list, whichever is later. In order to qualify as a rent-restricted unit within the meaning of section 42(g)(2), the gross rent for the unit must not exceed 30 percent of the imputed income limitation applicable to the unit. Section 42(g)(2)(B)(ii) requires the inclusion in gross rent of a utility allowance determined by the Secretary after taking into account the determinations under section 8 of the United States Housing Act of 1937. Section 1.42–10(a) provides that if utility costs (other than telephone) for a residential rental unit are paid directly by the tenant, then the gross rent for that unit includes the applicable utility allowance as determined under § 1.42– 10. Section 1.42–10(b) provides rules for calculating the appropriate utility

allowance based upon whether (1) the building receives rental assistance from the Farmers Home Administration (FmHA), now known as the Rural Housing Service; (2) the building has any tenant that receives FmHA rental assistance; (3) the building is not described in (1) or (2) above and the building’s rents and utility allowances are reviewed by HUD on an annual basis; or (4) the building is not described in (1), (2), or (3) above (other buildings). Currently, under § 1.42–10(b)(4), other buildings generally use the applicable Public Housing Authority (PHA) utility allowance established for the Section 8 Existing Housing Program or use a local utility company estimate. The local utility company estimate may be obtained by any interested party (including a low-income tenant, a building owner, or a State or local housing credit agency (Agency)). The proposed regulations proposed two additional options for calculating utility allowances. The first option would permit a building owner to obtain a utility estimate for each unit in a building from the Agency that has jurisdiction over the building (the Agency estimate). The Agency estimate must take into account the local utility rates data, property type, climate variables by region in the State, taxes and fees on utility charges, and property building materials and mechanical systems. An Agency may also use actual utility company usage data and rates for the building. The second option would permit a building owner to calculate utility allowances using the ‘‘HUD Utility Schedule Model’’ found on the Low-Income Housing Tax Credits page at http://www.huduser.org/datasets/ lihtc.html (or successor URL). The HUD Utility Schedule Model is based on data from the Residential Energy Consumption Survey (RECS) conducted by the Department of Energy. RECS data provides energy consumption by structure for heating, air conditioning, cooking, water heating, and other electric (lighting and refrigeration). The HUD Utility Schedule Model incorporates building location and climate.

Summary of Comments and

Explanation of Changes Exclusions From Utility Allowance Prior to these final regulations, § 1.42– 10(a) provided for the exclusion of telephone costs in determining the amount of the utility allowance to be included in gross rent. The proposed regulations excluded cable television costs as well as telephone costs. The

final regulations retain the exclusions for cable television and telephone costs and also exclude Internet costs. The IRS and Treasury Department believe it is appropriate to exclude cable television and Internet costs as comparable to telephone costs. Additional Option for Determining Utility Allowances Commentators stated that the Agency estimate in the proposed regulations may be administratively burdensome for some Agencies. As an alternative, commentators suggested adding an option that would allow utility estimates to be calculated by a statecertified engineer or other qualified professional. The commentators specified that, under this option, computer software could be developed that would estimate the energy or water and sanitary sewer service cost for each type of unit in a building. The estimates would be determined based on the applicable current local utility billing rate schedule and would be applied to all comparable units in the building using specific information about the design, materials, equipment, and location of the building. A computer software model that incorporates specific information about the design and location of the building for which the utility allowances are being developed, and that can be updated with actual consumption data and with consumption estimates as new efficiency measures and improvements are undertaken, would provide more accurate estimates of utility consumption. Therefore, the final regulations also include a new option allowing building owners to retain the services of a qualified professional to calculate utility allowances based on an energy consumption model. The use of this new option is subject to several special rules. First, the energy consumption model must, at a minimum, take into account specific factors including, but not limited to, unit size, building orientation, design and materials, mechanical systems, appliances, and characteristics of the building location. Second, the utility estimates must be calculated by either (1) a properly licensed engineer or (2) a qualified professional approved by the Agency that has jurisdiction over the building (together, qualified professional). The qualified professional and the building owner must not be related within the meaning of section 267(b) or 707(b). Third, the building owner must furnish a copy of the estimates derived from the energy consumption model to the Agency and make copies of the estimates available to

all tenants in the building. Finally, the building owner must pay for all costs incurred in obtaining the utility estimates from the qualified professional and providing the estimates to the Agency and tenants.

Default Option/Option Ordering One commentator suggested that the final regulations should provide a default option because, in the absence of a definitive standard for determining utility allowances, building owners would use the option that yields the lowest utility estimates. Commentators further requested clarification as to which option should be used when multiple options are available, whether building owners may use different options for different utilities, and whether owners may change the options used for calculating utilities from time to time. An energy consumption model developed by a qualified professional that takes into account specific information about the design and location of the building for which the utility allowances are being developed should produce the most accurate utility estimates. It is expected that this more accurate model will be the model most commonly used by most building owners, particularly those with buildings that are not very old. However, if a building owner selects an option that yields higher utility allowances, the building owner should be free to accept a lower amount of rent from tenants. Therefore, there is no need for a stated default option or option ordering rule. Further, the final regulations neither prohibit using different options for different utilities nor prohibit changing the options used for calculating utilities. If an Agency determines that a building owner has understated the utility allowances for the building under the particular option chosen by the owner for calculating the utility allowance, and the building’s units are not rent-restricted units under section 42(g)(2) as a result, the Agency must report the noncompliance on Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition. Application of Newly Calculated Utility Allowances Under current § 1.42–10(c) of the regulations, if the applicable utility allowance for units changes, the new utility allowance must be used to compute gross rent of rent-restricted units due 90 days after the change (the 90-day period). The proposed regulations limited the effective date of any new utility allowances to the earlier

of the date the building has achieved 90 percent occupancy for a period of 90 consecutive days or the end of the first year of the credit period. The proposed regulations also modified § 1.42–10(c) by requiring that a building owner must review at least annually the basis on which utility allowances have been established and must update the applicable utility allowance. The review must take into account any changes to the building such as any energy conservation measures that affect energy consumption and changes in utility rates. Commentators suggested that building owners should be obligated to adjust utility allowances when utility rates increase by a stated percentage, for example, 10 percent, which is the rule for revising utility allowance schedules for PHAs under 24 CFR 982.517(c). This HUD rule provides that a PHA must review its schedule of utility allowances each year and revise its allowance for a utility category if the utility rate has changed by 10 percent or more since the utility allowance schedule was last revised. The commentators did not address decreases in utility rates. A commentator also suggested that the final regulations should require an Agency to review or have owners review local utility rates quarterly to determine if rates have increased sufficiently to require an adjustment. A different commentator suggested limiting reviews to no more than once per year. The IRS and Treasury Department do not believe that fluctuations in utility rates within a given year should trigger recalculations of utility allowances more than once a year. The IRS and Treasury Department do not believe that the additional burden of updating the utility allowances more than once a year is warranted at this time. Utility rates generally do not change more than once a year, and yearly updated utility allowances would reflect average rates applicable to all tenants in a building from year to year. Therefore, the final regulations require building owners to calculate new utility allowances once during the calendar year regardless of any percentage change in utility rates. Building owners may choose, however, to calculate new utility allowances more frequently than once during the calendar year provided the owner complies with the requirements of these regulations, including the notification requirements to the Agency and tenants. Another commentator suggested that new utility allowances should be implemented within 90 days after HUD publishes its annual income limits (which are used in determining section 42 rents), but in no case later than June

30 of any year. Section 42 rents under section 42(g)(2) may or may not increase depending on HUD’s calculation of area median gross income. Therefore, the IRS and Treasury Department do not believe that the rules should require that the effective date of any new utility allowance coincide with the section 42 effective date of HUD’s income lists. Building owners, however, may choose to implement any new utility allowances on the section 42 effective date of HUD’s income lists. To bring financial stability to a project during the beginning of its operations, the final regulations clarify that the building owner is not required to review the utility allowances, or implement new utility allowances, until the earlier of the date the building has achieved 90 percent occupancy for a period of 90 consecutive days or the end of the first year of the credit period. Procedural Safeguards for Tenants One commentator made several recommendations regarding procedural safeguards for tenants including: Owners should be required to give tenants 30 days notice before the effective date of any utility allowance; tenants should be provided with all information used in calculating the utility allowances; tenants should be given the opportunity to comment on the proposed allowances; and owners should be required to review those comments prior to the utility allowances becoming effective. The commentator believed that the new options for determining utility allowances should be available only after one full year of occupancy and one full year after the building is placed in service. A commentator also recommended that a building owner should be allowed to use the new options only if the owner provides all data to the Agency no later than February 15 and the Agency informs the owner whether the proposed utility allowances are approved by March 31. To provide tenants with the opportunity to comment on proposed utility allowances to the Agency and building owner, the final regulations apply the existing disclosure requirement under current § 1.42– 10(b)(4)(ii)(B) (regarding the utility company estimate) to an owner using a utility company estimate, the HUD Utility Schedule Model, or an energy consumption model. Therefore, an owner must submit copies of the proposed utility allowances to the Agency and make the proposed utility allowances available to all tenants in the building at the beginning of the 90-day period before the utility allowances are

used in determining the gross rents of rent-restricted units. Similarly, the final regulations require that any utility estimates obtained under the Agency estimate option must be made available to all tenants in the building at the beginning of the 90-day period. An Agency may continue to require additional information from the owner during the 90-day period. Commentators suggested that the final regulations should limit the use of the HUD Utility Schedule Model to data for a twelve-month period ending in the most recent calendar year and require the owner to certify the accuracy of the data and the calculations of the utility allowances. However, the HUD Utility Schedule Model already incorporates consumption data derived from RECS data. Thus, building owners using this option need not be required to use consumption data for any particular twelve-month period. These final regulations, however, provide that the use of the energy consumption model is limited to consumption data for a twelve-month period ending no earlier than 60 days prior to the beginning of the 90-day period. In the case of newly constructed or renovated buildings with less than twelve months of consumption data, the energy consumption model allows a qualified professional to use consumption data for the twelve-month period of units of similar size and construction in the geographic area in which the building containing the units is located. Further, the final regulations require that utility rates used for the HUD Utility Schedule Model, the Agency estimate option, and the energy consumption model must be no older than the rates in place 60 days prior to the beginning of the 90-day period. In addition to these safeguards, if an Agency determines that a building owner has understated the utility allowances for the owner’s building under the particular option chosen, and, therefore, some or all of the units in the building are not rent-restricted units under section 42(g)(2), then the Agency must report the noncompliance to the Service on Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition. Commentators requested that building owners should be required to certify the estimate and the accuracy of the data used under the new options. Because Agencies may request additional information at any time during their mandatory review of proposed utility allowances, and must report any noncompliance to the Service, the final regulations do not require building owners to provide such certification.

Utility Allowances for Tenants With Special Needs One commentator suggested that the calculation of utility allowances should take into account any special needs tenants such as people with disabilities who require high energy consumption equipment. Section 42 does not require that the owner’s calculation of utility allowances be based on a tenant’s particular use of utility services. If such a requirement were imposed, owners and Agencies would have to determine the utility allowance for the tenants in each unit, as opposed to allowances based on the size of the unit, which would greatly increase burden. Additionally, it is unclear whether it is appropriate to implement rules that might encourage tenants to be indifferent to their energy consumption. Such indifference could lead to cost overruns by owners, and the viability of low-income housing could be jeopardized. Therefore, the final regulations do not require the calculation of utility allowances based on consumption by particular tenants. Calculation of Utility Company Estimate Option for Deregulated Utilities Section 1.42–10(b)(4)(ii)(B) currently provides that any interested party (including an owner, low-income tenant, or Agency) may obtain a local utility company estimate for a unit. The estimate is obtained when the interested party receives, in writing, information from a local utility company providing the estimated cost of that utility for a unit of similar size and construction for the geographic area in which the building containing the units is located. In light of utility services deregulation, the proposed regulations proposed to amend this option by requiring the interested party to obtain cost estimates from the local utility company that include combined rate charges from multiple utility companies. Commentators thought this proposed amendment would require the interested party to obtain utility consumption estimates from every utility company providing the same utility service and stated that this would present an unworkable administrative burden in deregulated jurisdictions with multiple utility providers. In some jurisdictions, many utility providers may be available for a given building. The proposed amendment was not intended to require the interested party to obtain utility consumption estimates from every utility company providing the same utility service. The amendment was proposed to address deregulation by requiring the interested

party to obtain estimates for all the components of the utility service if the service is divided between two or more types of service providers (for example, electric generation and electric transmission). The final regulations clarify that, in the case of deregulated utility services, the interested party is required to obtain an estimate from only one utility company even if multiple companies can provide the same utility service to a unit. However, the utility company furnishing the estimate must offer utility services to the building in order for that utility company’s rates to be used in calculating utility allowances. The estimate should include all component charges for providing the utility service. Agency Costs/Administrative Burden One commentator requested that specific language be added to address when Agencies may charge a reasonable fee for making a determination pursuant to the Agency estimate option, and who bears the fee when a particular option is used. The proposed regulations provided that costs incurred in obtaining an Agency estimate are borne by the building owner. The final regulations adopt this provision, and further require building owners to pay for all costs incurred in obtaining the estimates under the HUD Utility Schedule Model and the energy consumption model and in providing estimates to Agencies and tenants. Effective/Applicability Date The proposed regulations were proposed to be effective for taxable years beginning on or after the date of publication of the final regulations in the Federal Register. A commentator suggested that the final regulations be effective earlier on the basis that if they are published after 2007, they would not be effective until 2009 for calendar year taxpayers. The IRS and Treasury Department believe that the burden associated with an earlier effective date is not warranted. Therefore, the final regulations do not adopt this suggestion. However, in order to allow a building owner to implement the utility allowances as of the first day of the owner’s taxable year beginning on or after July 29, 2008, the final regulations provide that taxpayers may rely on the rules for determining utility allowances before the first day of the owner’s taxable year beginning on or after July 29, 2008 provided that any utility allowances so calculated are effective no earlier than the first day of the owner’s taxable year beginning on or after July 29, 2008.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the information has previously been reviewed and approved under OMB control number 1545–1102, and that the information required by these final regulations adds no new burden to the existing requirements. Accordingly, a Regulatory Flexibility Analysis under the provisions of the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is David Selig, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations ■ Accordingly, 26 CFR part 1 is

amended as follows: PART 1—INCOME TAXES ■ Paragraph 1. The authority citation

for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * ■ Par. 2. Section 1.42–10 is amended by: ■ 1. Revising the first sentence of paragraph (a). ■ 2. Revising paragraphs (b)(1), (b)(2), and (b)(3), and the introductory text of paragraph (b)(4). ■ 3. Adding two sentences at the end of paragraph (b)(4)(ii)(A). ■ 4. Adding three sentences after the second sentence in paragraph (b)(4)(ii)(B). ■ 5. Adding paragraphs (b)(4)(ii)(C), (b)(4)(ii)(D), and (b)(4)(ii)(E).

■ 6. Revising paragraph (c). ■ 7. Adding paragraph (d).

The additions and revisions read as follows: § 1.42–10

Utility allowances.

(a) If the cost of any utility (other than telephone, cable television, or Internet) for a residential rental unit is paid directly by the tenant(s), and not by or through the owner of the building, the gross rent for that unit includes the applicable utility allowance determined under this section. (b) Applicable utility allowances—(1) Buildings assisted by the Rural Housing Service. If a building receives assistance from the Rural Housing Service (RHSassisted building), the applicable utility allowance for all rent-restricted units in the building is the utility allowance determined under the method prescribed by the Rural Housing Service (RHS) for the building (whether or not the building or its tenants also receive other state or federal assistance). (2) Buildings with Rural Housing Service assisted tenants. If any tenant in a building receives RHS rental assistance payments (RHS tenant assistance), the applicable utility allowance for all rent-restricted units in the building (including any units occupied by tenants receiving rental assistance payments from the Department of Housing and Urban Development (HUD)) is the applicable RHS utility allowance. (3) Buildings regulated by the Department of Housing and Urban Development. If neither a building nor any tenant in the building receives RHS housing assistance, and the rents and utility allowances of the building are reviewed by HUD on an annual basis (HUD-regulated building), the applicable utility allowance for all rentrestricted units in the building is the applicable HUD utility allowance. (4) Other buildings. If a building is neither an RHS-assisted nor a HUDregulated building, and no tenant in the building receives RHS tenant assistance, the applicable utility allowance for rentrestricted units in the building is determined under the following methods. (ii) (A) * However, if a local utility company estimate is obtained for any unit in the building under paragraph (b)(4)(ii)(B) of this section, a State or local housing credit agency (Agency) provides a building owner with an estimate for any unit in a building under paragraph (b)(4)(ii)(C) of this section, a cost estimate is calculated using the HUD Utility Schedule Model under paragraph

(b)(4)(ii)(D) of this section, or a cost estimate is calculated by an energy consumption model under paragraph (b)(4)(ii)(E) of this section, then the estimate under paragraph (b)(4)(ii)(B), (C), (D), or (E) becomes the applicable utility allowance for all rent-restricted units of similar size and construction in the building. Paragraphs (b)(4)(ii)(B), (C), (D), and (E) of this section do not apply to units to which the rules of paragraphs (b)(1), (2), (3), or (4)(i) of this section apply. (B) In the case of deregulated utility services, the interested party is required to obtain an estimate only from one utility company even if multiple companies can provide the same utility service to a unit. However, the utility company must offer utility services to the building in order for that utility company’s rates to be used in calculating utility allowances. The estimate should include all component deregulated charges for providing the utility service. (C) Agency estimate. A building owner may obtain a utility estimate for each unit in the building from the Agency that has jurisdiction over the building provided the Agency agrees to provide the estimate. The estimate is obtained when the building owner receives, in writing, information from the Agency providing the estimated perunit cost of the utilities for units of similar size and construction for the geographic area in which the building containing the units is located. The Agency estimate may be obtained by a building owner at any time during the building’s extended use period (see section 42(h)(6)(D)). Costs incurred in obtaining the estimate are borne by the building owner. In establishing an accurate utility allowance estimate for a particular building, an Agency (or an agent or other private contractor of the Agency that is a qualified professional within the meaning of paragraph (b)(4)(ii)(E) of this section) must take into account, among other things, local utility rates, property type, climate and degree-day variables by region in the State, taxes and fees on utility charges, building materials, and mechanical systems. If the Agency uses an agent or other private contractor to calculate the utility estimates, the agent or contractor and the owner must not be related within the meaning of section 267(b) or 707(b). An Agency may also use actual utility company usage data and rates for the building. However, use of the Agency estimate is limited to the building’s consumption data for the twelve-month period ending no earlier than 60 days prior to the beginning of the 90-day period under paragraph (c)(1)

of this section and utility rates used for the Agency estimate must be no older than the rates in place 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section. In the case of newly constructed or renovated buildings with less than 12 months of consumption data, the Agency (or an agent or other private contractor of the Agency that is a qualified professional within the meaning of paragraph (b)(4)(ii)(E) of this section) may use consumption data for the 12-month period of units of similar size and construction in the geographic area in which the building containing the units is located. (D) HUD Utility Schedule Model. A building owner may calculate a utility estimate using the ‘‘HUD Utility Schedule Model’’ that can be found on the Low-Income Housing Tax Credits page at http://www.huduser.org/ datasets/lihtc.html (or successor URL). Utility rates used for the HUD Utility Schedule Model must be no older than the rates in place 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section. (E) Energy consumption model. A building owner may calculate utility estimates using an energy and water and sewage consumption and analysis model (energy consumption model). The energy consumption model must, at a minimum, take into account specific factors including, but not limited to, unit size, building orientation, design and materials, mechanical systems, appliances, and characteristics of the building location. The utility consumption estimates must be calculated by either a properly licensed engineer or a qualified professional approved by the Agency that has jurisdiction over the building (together, qualified professional), and the qualified professional and the building owner must not be related within the meaning of section 267(b) or 707(b). Use of the energy consumption model is limited to the building’s consumption data for the twelve-month period ending no earlier than 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section, and utility rates used for the energy consumption model must be no older than the rates in place 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section. In the case of newly constructed or renovated buildings with less than 12 months of consumption data, the qualified professional may use consumption data for the 12-month period of units of similar size and construction in the geographic area in

which the building containing the units is located. (c) Changes in applicable utility allowance—(1) In general. If, at any time during the building’s extended use period (as defined in section 42(h)(6)(D)), the applicable utility allowance for units changes, the new utility allowance must be used to compute gross rents of the units due 90 days after the change (the 90-day period). For example, if rent must be lowered because a local utility company estimate is obtained that shows a higher utility cost than the otherwise applicable PHA utility allowance, the lower rent must be in effect for rent due at the end of the 90-day period. A building owner using a utility company estimate under paragraph (b)(4)(ii)(B) of this section, the HUD Utility Schedule Model under paragraph (b)(4)(ii)(D) of this section, or an energy consumption model under paragraph (b)(4)(ii)(E) of this section must submit copies of the utility estimates to the Agency that has jurisdiction over the building and make the estimates available to all tenants in the building at the beginning of the 90day period before the utility allowances can be used in determining the gross rent of rent-restricted units. An Agency may require additional information from the owner during the 90-day period. Any utility estimates obtained under the Agency estimate under paragraph (b)(4)(ii)(C) of this section must also be made available to all tenants in the building at the beginning of the 90-day period. The building owner must pay for all costs incurred in obtaining the estimates under paragraphs (b)(4)(ii)(B), (C), (D), and (E) of this section and providing the estimates to the Agency and the tenants. The building owner is not required to review the utility allowances, or implement new utility allowances, until the building has achieved 90 percent occupancy for a period of 90 consecutive days or the end of the first year of the credit period, whichever is earlier. (2) Annual review. A building owner must review at least once during each calendar year the basis on which utility allowances have been established and must update the applicable utility allowance in accordance with paragraph (c)(1) of this section. The review must take into account any changes to the building such as any energy conservation measures that affect energy consumption and changes in utility rates. (d) Record retention. The building owner must retain any utility consumption estimates and supporting data as part of the taxpayer’s records for purposes of § 1.6001–1(a).

■ Par. 3. Section 1.42–12 is amended by adding paragraph (a)(4) to read as follows:

§ 1.42–12 rules.

Effective dates and transitional

(a) * (4) Utility allowances. The first sentence in § 1.42–10(a), § 1.42–10(b)(1), (2), (3), and (4), the last two sentences in § 1.42–10(b)(4)(ii)(A), the third, fourth, and fifth sentences in § 1.42– 10(b)(4)(ii)(B), § 1.42–10(b)(4)(ii)(C), (D), and (E), and § 1.42–10(c) and (d) are applicable to a building owner’s taxable years beginning on or after July 29, 2008. Taxpayers may rely on these provisions before the beginning of the building owner’s taxable year beginning on or after July 29, 2008 provided that any utility allowances calculated under these provisions are effective no earlier than the first day of the building owner’s taxable year beginning on or after July 29, 2008. The utility allowances provisions that apply to taxable years beginning before July 29, 2008 are contained in § 1.42–10 (see 26 CFR part 1 revised as of April 1, 2008). Linda E. Stiff, Deputy Commissioner for Services and Enforcement. Approved: July 20, 2008. Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

DEPARTMENT OF HOMELAND Coast Guard 33 CFR Part 165 [Docket No. USCG–2008–0695] RIN 1625–AA00

Safety Zone; Maine; Sector Northern New England August Swim Events.

Agency: Coast Guard, DHS.

Action: Temporary final rule.

Summary: The Coast Guard is establishing temporary safety zones during the month of August around the ‘‘Sprucewold Cabbage Island Swim,’’ ‘‘Tri for a Cure Triathlon,’’ ‘‘Greater Burlington YMCA Lake Swim,’’ ‘‘Y-Tri Triathlon,’’ and ‘‘Rockland Breakwater Swim’’ marine events while the events are in progress. These safety zones are needed to protect swimmers, event sponsors’ safety vessels, and others in the maritime community from the safety hazards that may arise from events of

Treasury Decision 9587 | Internal Revenue Service (IRS), Treasury

---

Agency: Internal Revenue Service (IRS),

Treasury.

Action: Final Regulations.

Summary: This document contains final

regulations that provide guidance concerning taxpayers’ (that is, owners’) requests to housing credit agencies to obtain a qualified contract (as defined in section 42(h)(6)(F) of the Internal Revenue Code) for the acquisition of a low-income housing credit building. Section 42(h)(6)(F) requires the Secretary to prescribe such regulations as may be necessary or appropriate to carry out the provisions of section 42(h)(6)(F), including regulations to prevent the manipulation of the qualified contract amount. The regulations will affect owners requesting a qualified contract, potential buyers, and low-income housing credit agencies responsible for the administration of the low-income housing credit program.

Dates: Effective Date: These regulations are effective May 3, 2012. Applicability Date: For the applicability date, see § 1.42–18(e).

For Further Information Contact: David Selig at (202) 622–3040 (not a toll-free number).

Paperwork Reduction Act

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545– 2088. The collection of information is required for an owner to provide a written request to a housing credit agency to obtain a qualified contract (as defined in section 42(h)(6)(F) of the Internal Revenue Code) for the acquisition of a low-income housing credit building. The collecting of information is voluntary to obtain a benefit. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents might become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

wreier-aviles on DSK7SPTVN1PROD with RULES

Background

This document contains final regulations that amend the Income Tax Regulations (26 CFR part 1) relating to the low-income housing credit under section 42 of the Internal Revenue Code (Code). On June 19, 2007, a notice of proposed rulemaking (REG–114084–04) and notice of public hearing relating to the qualified contract provisions under section 42(h)(6)(F) was published in the Federal Register (72 FR 33706). Written and electronic comments responding to the proposed regulations were received and a public hearing was held on the proposed regulations on October 15, 2007. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision.

General Overview

Section 42 provides a tax credit for investment in low-income housing buildings placed in service after December 31, 1986. The section 42 credit is a general business credit subject to the provisions of section 38. Section 42(h)(6)(A) provides that no credit will be allowed with respect to any building for the taxable year unless an extended low-income housing commitment (commitment) (as defined in section 42(h)(6)(B)) is in effect as of the end of the taxable year. Section 42(h)(6)(B) provides in part that the term commitment means any agreement between the owner and the housing credit agency (Agency) that requires that the applicable fraction (as defined in section 42(c)(1)(B)) for the building for each taxable year in the extended use period will not be less than the applicable fraction specified in the commitment. Section 42(h)(6)(E)(ii) prohibits the eviction or termination of tenancy (other than for good cause) of an existing tenant of any low-income unit or any increase in the gross rent with respect to such unit not otherwise permitted under section 42 until three years after the termination of such an agreement. Section 42(h)(6)(D) defines the term extended use period as the period beginning on the first day in the compliance period (as defined in section 42(i)(1)) on which the building is part of a qualified low-income housing project and ending on the later

of: (1) The date specified by the Agency in the commitment, or (2) the date which is 15 years after the close of the compliance period. Section 42(h)(6)(E)(i)(II) provides for the termination of the extended use period if the Agency is unable to present within a specified period of time a qualified contract for the acquisition of the low-income portion of the building by any person who will continue to operate such portion as a qualified lowincome building. Section 42(h)(6)(F) defines the term qualified contract as a bona fide contract to acquire (within a reasonable period of time after the contract is entered into) the non low-income portion of the building for fair market value and the low-income portion of the building for an amount not less than the applicable fraction (specified in the commitment) of the sum of: (I) The outstanding indebtedness secured by, or with respect to the building, (II) the adjusted investor equity in the building, plus (III) other capital contributions not reflected in these amounts; reduced by cash distributions from (or available for distribution from) the project. Section 42(h)(6)(F) also provides that the Secretary shall prescribe regulations as may be necessary or appropriate to carry out that paragraph, including regulations to prevent the manipulation of the amount determined under section 42(h)(6)(F). Section 42(h)(6)(I) provides that the Agency must present the qualified contract within the 1-year period beginning on the date (after the 14th year of the compliance period) the owner submits a written request to the Agency to find a person to acquire the owner’s interest in the low-income portion of the building. The proposed regulations addressed the application of the qualified contract provisions of section 42. Section 1.42– 18(c)(1) of the proposed regulations defined the qualified contract formula used to compute the purchase price amount of the low-income housing building generally as: (1) The non lowincome portion of the building for fair market value; plus (2) the low-income portion of the building for the lowincome portion amount. Section 1.42–18(c)(2) of the proposed regulations defined the low-income portion amount as an amount not less than the applicable fraction (as specified in the commitment) of the total of: (a) Outstanding indebtedness secured by, or with respect to the building; plus (b) the adjusted investor equity in the building; plus (c) other capital contributions, not including amounts described in (a) and (b); minus (d) cash

distributions from (or available for distribution from) the building.

Summary of Comments

Fair-Market-Value Cap Prior to the issuance of the proposed regulations, comments were received recommending the inclusion of a fairmarket-value cap for the low-income portion of the qualified contract amount as defined in section 42(h)(6)(F). These comments noted that the qualified contract price may, in some cases, exceed the fair market value of a project. One reason given to explain why the qualified contract price might exceed the fair market value of a project is the formula component for adjusted investor equity, which includes the Consumer-Price-Index-based cost of living adjustments. As explained in the preamble to the proposed regulations, this recommendation was not adopted as a proposed rule because section 42(h)(6)(F) defines a qualified contract, in part, as a contract to acquire the lowincome portion of the building for an amount ‘‘not less than’’ the applicable fraction of the statutorily provided formula. Similar comments were received after publication of the proposed regulations. The IRS and the Treasury Department continue to believe that they do not have the authority under section 42(h)(6)(F) to adopt a fair-market-value cap. Accordingly, the final regulations do not provide a rule providing a fair-marketvalue cap under section 42(h)(6)(F). The IRS and the Treasury Department in the preamble to the proposed regulations requested comments on the extent of Agency and State authority to provide more stringent requirements than those contained in section 42(h)(6)(F). The preamble referenced the flush language of section 42(h)(6)(E)(i), which provides that the qualified contract exception to the termination of an extended use period shall not apply to the extent more stringent requirements are provided in the agreement or in State law. Specifically, the IRS and the Treasury Department requested comments on the authority of Agency or State regulators to require in agreements a fair-market-value cap that would restrict any qualified contract price to fair market value. In response, two comments were received, both opining that an Agency did not possess authority under section 42(h)(6)(E) to set a fair market value limitation. The commentators reasoned that the language ‘‘more stringent requirements’’ relates to the date the extended use period will terminate, rather than to the qualified contract formula. The IRS and

Treasury Department received no comment asserting the view that section 42(h)(6)(E)(i) authorizes an Agency or State regulators to require in agreements a fair-market-value cap that would restrict a qualified contract price to fair market value. The IRS and Treasury Department do not believe that section 42(h)(6)(E)(i) was intended to authorize a fair-market-value cap on the lowincome portion of the building, and, accordingly, the final regulations do not provide for such a cap.

wreier-aviles on DSK7SPTVN1PROD with RULES

Adjustments to Fair Market Value of the Non-Low-Income Portion of the Building Some commentators questioned the provision in the proposed regulations that would allow Agencies to adjust the fair market value of a building, if, after a reasonable period of time within the one-year offer-of-sale period, no buyer has made an offer or market values have adjusted downward. One commentator noted that, as a result of this provision, in order to secure a more favorable price for the building, prospective buyers might wait out the qualified contract process until an Agency reduces the qualified contract price. Another commentator noted the unfairness of granting Agencies the unilateral right to reduce the fair market value of the non low-income portion of the building, particularly when the proposed regulations provide no limitation on how much the Agency may reduce the fair market value. The IRS and the Treasury Department believe these concerns are valid. Accordingly, the final regulations revise this provision to provide that the Agency may adjust the fair market value of the non low-income portion of the building after the Agency’s offer of sale of the building to the general public and before the close of the one-year offer of sale period only with the consent of the owner. If no agreement between the Agency and owner is reached, the fair market value of the non low-income portion of the building determined at the time of the Agency’s offer of sale of the building to the general public remains unchanged. Land The proposed regulations provide that the fair market value of the non lowincome portion of a building is determined at the time of an Agency’s offer of sale of the building to the general public. This valuation must take into account the existing and continuing requirements contained in the commitment for the building. The non low-income portion also includes the fair market value of the land underlying the entire building, including the land

underlying the low-income portion of the building. Commentators questioned the statutory authority of the IRS under section 42(h)(6)(F) to include land value in the qualified contract amount. Specifically, commentators noted that the language under section 42(h)(6)(F) refers to the fair market value of the non low-income portion of the building without addressing the issue of land valuation. Other commentators asserted that adopting a fair market value approach for land underlying the entire building may decrease the likelihood of finding a qualified buyer willing to pay the qualified contract price while continuing to operate the building as a low income building. The IRS and the Treasury Department believe that land is inherently part of the cost underlying the acquisition or construction of a building and should not be ignored in determining the qualified contract amount. Applying fair market value to land is consistent with industry practice regarding land valuation and provides an equitable means for arriving at a contract price between buyers and owners. By valuing land underlying the entire building at fair market value, taking into account the existing and continuing requirements contained in the commitment for the building, the proposed regulations provided an approach that maintains industry practice for valuing land and provided an objective and equitable solution that favors neither the buyer nor the owner. Accordingly, the final regulations provide that the land underlying the entire building (both low-income and non low-income units) is valued at fair market value subject to the existing and continuing restrictions contained in the commitment for the building. Responsibility To Adjust the Qualified Contract Price To Reflect the Changing Amount of Outstanding Indebtedness One commentator expressed concern that the proposed regulations would impose too much burden on Agencies by requiring them to adjust the qualified contract amount between the date on which the sales price under a qualified contract is first determined and the sale’s actual closing date. (For example, an adjustment is needed to reflect mortgage payments that reduce outstanding indebtedness.) The IRS and the Treasury Department concur with this comment, and the final regulations provide that the buyer and owner, and not the Agency, must adjust the amount of the low-income portion of the qualified contract formula to reflect changes in the components of the

qualified contract formula, such as mortgage payments that reduce outstanding indebtedness between the time the Agency first offers the property for sale and the actual sale closing date. Cash Distributions One commentator recommended that the final regulations clarify that the rule in the proposed regulations providing that cash available for distribution includes reserve funds should apply only to the extent that the reserve funds are not legally required to remain with the project after the sale. Other commentators noted the potential for double-counting if cash available for distribution includes the proceeds from refinancing indebtedness or additional mortgages, while simultaneously any refinancing indebtedness or additional mortgages in excess of qualifying building costs are not outstanding indebtedness for purposes of section 42(h)(6)(F). The IRS and the Treasury Department agree with these comments. Accordingly, the final regulations provide that cash available for distribution includes reserve funds that are not legally required by mortgage restrictions, regulatory agreements, or third party contractual agreements to remain with the building following the sale of the building. The final regulations further provide that proceeds from refinancing indebtedness or additional mortgages that are in excess of qualifying building costs are not considered cash available for distribution. The text of the final regulations also adopts the rule discussed in the preamble to the proposed regulations, but not stated in the text of the proposed regulations, that any refinancing indebtedness or additional mortgages in excess of qualifying building costs do not qualify as outstanding indebtedness for purposes of section 42(h)(6)(F). Discounting Indebtedness Removed Some commentators questioned the rationale for the requirement in the proposed regulations that would discount outstanding indebtedness having an interest rate below the applicable Federal rate (AFR) under section 1274 of the Code. In response, the final regulations remove the provision of discounting indebtedness altogether. Instead, the final regulations define outstanding indebtedness to include only those amounts secured by, or with respect to, the building that (1) do not exceed qualifying building costs, (2) are indebtedness under general principles of Federal income tax law, and (3) upon the sale of the building, are

actually paid to the lender or are assumed by the buyer as part of the sale. Appraiser Standards Several commentators noted the absence of any uniform standards for appraisal methodology and qualifications for appraisers. Rather than adopt appraisal standards, the final regulations provide that Agencies shall not utilize any individual or organization as an appraiser if that individual or organization is currently on any list for active suspension or revocation for performing appraisals in any State or is listed on the Excluded Parties Lists System (EPLS) maintained by the General Services Administration for the United States Government. The final regulations also provide the Agencies with the discretion to select the appraisers involved in the qualified contract process and to require all appraisers to be State-certified general appraisers.

wreier-aviles on DSK7SPTVN1PROD with RULES

Actual Offer of Sale The proposed regulations provide that in order to satisfy the qualified contract requirements under section 42(h)(6)(F), the Agency must offer the building for sale to the general public at the determined qualified contract price upon receipt of a written request by the owner to find a buyer to acquire the building. In addressing the issue of how Agencies should advertise the availability of a building to the general public, the final regulations provide a reasonable efforts standard for guiding Agencies in their efforts to find a qualified buyer during the one year offer period. If the determined qualified contract price is not a multiple of $1,000, the final regulations permit the Agency to round up the offering price of the building to the next highest multiple of $1,000. Definition of Bona Fide Contract and Resolution of Disputes Some commentators suggested the inclusion of a specific definition of a bona fide contract under section 42(h)(6)(F), addressing issues such as whether the terms and conditions of any offered contract are unreasonable or impractical. Further, commentators suggested the creation of a mechanism for resolving disputes among the parties concerning the meaning of a bona fide contract. The IRS and the Treasury Department believe that because of variations under State laws concerning the terms of a bona fide contract and methods for resolving disputes, the final regulations should not explicitly address these issues. Instead, the final regulations provide that an Agency has

the administrative discretion to specify other conditions applicable to the qualified contract consistent with section 42 of the Code and the final regulations. Adjusted Investor Equity To avoid ambiguity in the determination of the qualified contract amount, the final regulations require adjusted investor equity to be calculated in a manner that is consistent with inflation adjustments made under section 1(f). Thus, as was required in the proposed regulations, the calculations must use not seasonally adjusted values of the Consumer Price Index for all urban consumers (the data series that the Bureau of Labor Statistics refers to as ‘‘CPI–U’’). The final regulations provide a computational process that is mathematically equivalent to the process described in the proposed regulations but that will be simpler to implement. Because of the uncertainty that can be introduced when one number is divided by another and because different people might choose to retain in the answer different numbers of digits, the regulations require the quotient in this process to be carried out to 10 decimal places. (If standard, off-the-shelf spreadsheet software is used to compute the adjusted investor equity, the computations will generally have at least this degree of accuracy by default.) In addition, the example in the final regulations has been updated to use more recent data. Finally, the final regulations make it possible for the Commissioner to reduce the computational burden by, for example, providing the possible adjustment factors in annual publications or creating a calculator on the IRS Web site.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. The information required to be provided by a taxpayer (that is, by the owner of a low-income building) to a State agency to determine the qualified contract amount is already maintained by the

taxpayer for other purposes of the lowincome tax credit under section 42. Because only a minimal amount of additional time is required for a taxpayer to access and provide the information, this collection of information does not impose a significant burden on the taxpayer. Accordingly, a Regulatory Flexibility Analysis under the provisions of the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, the notice of proposed regulations preceding these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business, and no comments were received.

Drafting Information

The principal author of these regulations is David Selig of the Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 602 Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations Accordingly, 26 CFR Parts 1 and 602 are amended as follows: PART 1—INCOME TAXES ■ Paragraph 1. The authority citation

for part 1 is amended by adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 *

Section 1.42–18 also issued under 26 U.S.C. 42(h)(6)(F) and 42(h)(6)(K); * ■ Par. 2. Section 1.42–18 is added to

read as follows: § 1.42–18

Qualified contracts.

(a) Extended low-income housing commitment—(1) In general. No credit under section 42(a) is allowed by reason of section 42 with respect to any building for the taxable year unless an extended low-income housing commitment (commitment) (as defined in section 42(h)(6)(B)) is in effect as of the end of such taxable year. A commitment must be in effect for the extended use period (as defined in paragraph (a)(1)(i) of this section).

wreier-aviles on DSK7SPTVN1PROD with RULES

(i) Extended use period. The term extended use period means the period beginning on the first day in the compliance period (as defined in section 42(i)(1)) on which the building is part of a qualified low-income housing project (as defined in section 42(g)(1)) and ending on the later of— (A) The date specified by the lowincome housing credit agency (Agency) in the commitment; or (B) The date that is 15 years after the close of the compliance period. (ii) Termination of extended use period. The extended use period for any building will terminate— (A) On the date the building is acquired by foreclosure (or instrument in lieu of foreclosure) unless the Commissioner determines that such acquisition is part of an arrangement with the taxpayer (‘‘the owner’’) a purpose of which is to terminate such period; or (B) On the last day of the one-year period beginning on the date (after the 14th year of the compliance period) on which the owner submits a written request to the Agency to find a person to acquire the owner’s interest in the low-income portion of the building if the Agency is unable to present during such period a qualified contract for the acquisition of the low-income portion of the building by any person who will continue to operate such portion as a qualified low-income building (as defined in section 42(c)(2)). (iii) Owner non-acceptance. If the Agency provides a qualified contract within the one-year period and the owner rejects or fails to act upon the contract, the building remains subject to the existing commitment. (iv) Eviction, gross rent increase concerning existing low-income tenants not permitted. Prior to the close of the three year period following the termination of a commitment, no owner shall be permitted to evict or terminate the tenancy (other than for good cause) of an existing tenant of any low-income unit, or increase the gross rent for such unit in a manner or amount not otherwise permitted by section 42. (2) Exception. Paragraph (a)(1)(ii)(B) of this section shall not apply to the extent more stringent requirements are provided in the commitment or under State law. (b) Definitions. For purposes of this section, the following terms are defined: (1) As provided by section 42(h)(6)(G)(iii), base calendar year means the calendar year with or within which the first taxable year of the credit period ends. (2) The low-income portion of a building is the portion of the building

equal to the applicable fraction (as defined in section 42(c)(1)(B)) specified in the commitment for the building. (3) The fair market value of the nonlow-income portion of the building is determined at the time of the Agency’s offer of sale of the building to the general public. The fair market value of the non-low-income portion also includes the fair market value of the land underlying the entire building (both the non-low-income portion and the low-income portion). This valuation must take into account the existing and continuing requirements contained in the commitment for the building. The fair market value of the non-low-income portion also includes the fair market value of items of personal property not included in eligible basis under section 42(d) that convey under the contract with the building. (4) Qualifying building costs include— (i) Costs that are included in eligible basis of a low-income housing building under section 42(d) and that are included in the adjusted basis of depreciable property that is subject to section 168 and that is residential rental property for purposes of section 142(d) and § 1.103–8(b); (ii) Costs that are included in eligible basis of a low-income housing building under section 42(d) and that are included in the adjusted basis of depreciable property that is subject to section 168 and that is used in a common area or is provided as a comparable amenity to all residential rental units in the building; and (iii) Costs of the type described in paragraph (b)(4)(i) and (ii) of this section incurred after the first year of the lowincome housing building’s credit period under section 42(f). (5) The qualified contract amount is the sum of the fair market value of the non-low-income portion of the building (within the meaning of section 42(h)(6)(F) and paragraph (b)(3) of this section) and the price for the lowincome portion of the building (within the meaning of section 42(h)(6)(F) and paragraph (b)(2) of this section) as calculated in paragraph (c)(2) of this section. If this sum is not a multiple of $1,000, then when the Agency offers the building for sale to the general public, the Agency may round up the offering price to the next highest multiple of $1,000. (c) Qualified contract purchase price formula—(1) In general. For purposes of this section, qualified contract means a bona fide contract to acquire the building (within a reasonable period after the contract is entered into) for the qualified contract amount.

(i) Initial determination. The qualified contract amount is determined at the time of the Agency’s offer of sale of the building to the general public. (ii) Mandatory adjustment by the buyer and owner. The buyer and owner under a qualified contract must adjust the amount of the low-income portion of the qualified contract formula to reflect changes in the components of the qualified contract formula such as mortgage payments that reduce outstanding indebtedness between the time of the Agency’s offer of sale to the general public and the building’s actual sale closing date. (iii) Optional adjustment by the Agency and owner. The Agency and owner may agree to adjust the fair market value of the non low-income portion of the building after the Agency’s offer of sale of the building to the general public and before the close of the one-year period described in paragraph (a)(1)(ii)(B) of this section. If no agreement between the Agency and owner is reached, the fair market value of the non-low-income portion of the building determined at the time of the Agency’s offer of sale of the building to the general public remains unchanged. (2) Low-income portion amount. The low-income portion amount is an amount not less than the applicable fraction specified in the commitment, as defined in section 42(h)(6)(B)(i), multiplied by the total of— (i) The outstanding indebtedness for the building (as defined in paragraph (c)(3) of this section); plus (ii) The adjusted investor equity in the building for the calendar year (as defined in paragraph (c)(4) of this section); plus (iii) Other capital contributions (as defined in paragraph (c)(5) of this section), not including any amounts described in paragraphs (c)(2)(i) and (ii) of this section; minus (iv) Cash distributions from (or available for distribution from) the building (as defined in paragraph (c)(6) of this section). (3) Outstanding indebtedness. For purposes of paragraph (c)(2)(i) of this section, outstanding indebtedness means the remaining stated principal balance (which is initially determined at the time of the Agency’s offer of sale of the building to the general public) of any indebtedness secured by, or with respect to, the building that does not exceed the amount of qualifying building costs described in paragraph (b)(4) of this section. Thus, any refinancing indebtedness or additional mortgages in excess of such qualifying building costs are not outstanding indebtedness for purposes of section

wreier-aviles on DSK7SPTVN1PROD with RULES

42(h)(6)(F) and this section. Examples of outstanding indebtedness include certain mortgages and developer fee notes (excluding developer service costs not included in eligible basis). Outstanding indebtedness does not include debt used to finance nondepreciable land costs, syndication costs, legal and accounting costs, and operating deficit payments. Outstanding indebtedness includes only obligations that are indebtedness under general principles of Federal income tax law and that are actually paid to the lender upon the sale of the building or are assumed by the buyer as part of the sale of the building. (4) Adjusted investor equity—(i) Application of cost-of-living factor. For purposes of paragraph (c)(2)(ii) of this section, the adjusted investor equity for any calendar year equals the unadjusted investor equity, as described in paragraph (c)(4)(ii) of this section, multiplied by the qualified-contract cost-of-living adjustment for that year, as defined in paragraph (c)(4)(iii) of this section. (ii) Unadjusted investor equity. For purposes of this paragraph (c)(4), unadjusted investor equity means the aggregate amount of cash invested by owners for qualifying building costs described in paragraph (b)(4)(i) and (ii) of this section. Thus, equity paid for land, credit adjuster payments, Agency low-income housing credit application and allocation fees, operating deficit contributions, and legal, syndication, and accounting costs all are examples of cost payments that do not qualify as unadjusted investor equity. Unadjusted investor equity takes an amount into account only to the extent that, as of the beginning of the low-income building’s credit period (as defined in section 42(f)(1)), there existed an obligation to invest the amount. Unadjusted investor equity does not include amounts included in the calculation of outstanding indebtedness as defined in paragraph (c)(3) of this section. (iii) Qualified-contract cost-of-living adjustment. For purposes of this paragraph (c)(4), the qualified-contract cost-of-living adjustment for a calendar year is the number that is computed under the general rule in paragraph (c)(4)(iv) of this section or a number that may be provided by the Commissioner as described in paragraph (c)(4)(v) of this section. (iv) General rule. Except as provided in paragraph (c)(4)(v) of this section, the qualified-contract cost-of-living adjustment is the quotient of— (A) The sum of the 12 monthly Consumer Price Index (CPI) values whose average is the CPI for the

calendar year that precedes the calendar year in which the Agency offers the building for sale to the general public (The term ‘‘CPI for a calendar year’’ has the meaning given to it by section 1(f)(4) for purposes of computing annual inflation adjustments to the rate brackets.); divided by (B) The sum of the 12 monthly CPI values whose average is the CPI for the base calendar year (within the meaning of section 1(f)(4)), unless that sum has been increased under paragraph (c)(4)(iii)(D) of this section. (v) Provision by the Commissioner of the qualified-contract cost-of-living adjustment. The Commissioner may publish in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) a process pursuant to which the Internal Revenue Service will compute the qualified-contract cost-of-living adjustment for a calendar year and make available the results of that computation. (vi) Methodology. The calculations in paragraph (c)(4)(iv) of this section are to be made in the following manner: (A) The CPI data to be used for purposes of this paragraph (c)(4) are the not seasonally adjusted values of the CPI for all urban consumers. (The U.S. Department of Labor’s Bureau of Labor Statistics (BLS) sometimes refers to these values as ‘‘CPI–U.’’) The BLS publishes the CPI data on-line (including a History Table that contains monthly CPI–U values for all years back to 1913). See www.BLS.gov/data. (B) The quotient is to be carried out to 10 decimal places. (C) The Agency may round adjusted investor equity to the nearest dollar. (D) If the CPI for any calendar year (within the meaning of section 1(f)(4)) during the extended use period after the base calendar year exceeds by more than 5 percent the CPI for the preceding calendar year (within the meaning of section 1(f)(4)), then the sum described in paragraph (c)(4)(i)(B) is to be increased so that the excess is never taken into account under this paragraph (c)(4). (vii) Example. The following example illustrates the calculations described in this paragraph (c)(4): Example. (i) Facts. Owner contributed $20,000,000 in equity to a building in 1997, which was the first year of the credit period for the building. In 2011, Owner requested Agency to find a buyer to purchase the building, and Agency offered the building for sale to the general public during 2011. The CPI for 1997 (within the meaning of section 1(f)(4)) is the average of the Consumer Price Index as of the close of the 12-month period ending on August 31, 1997. The sum of the CPI values for the twelve months from

September 1996 through August 1997 is 1913.9. The CPI for 2010 (within the meaning of section 1(f)(4)) is the average of the Consumer Price Index as of the close of the 12-month period ending August 31, 2010. The sum of the CPI values for the twelve months from September 2009 through August 2010 is 2605.959. At no time during this period (after the base calendar year) did the CPI for any calendar year exceed the CPI for the preceding calendar year by more than 5 percent. (ii) Determination of adjusted investor equity. The qualified-contract cost-of-living adjustment is 1.3615962171 (the quotient of 2605.959, divided by 1913.9). Owner’s adjusted investor equity, therefore, is $27,231,924, which is $20,000,000, multiplied by 1.3615962171, rounded to the nearest dollar.

(5) Other capital contributions. For purposes of paragraph (c)(2)(iii) of this section, other capital contributions to a low-income building are qualifying building costs described in paragraph (b)(4)(ii) of this section paid or incurred by the owner of the low-income building other than amounts included in the calculation of outstanding indebtedness or adjusted investor equity as defined in this section. For example, other capital contributions may include amounts incurred to replace a furnace after the first year of a low-income housing credit building’s credit period under section 42(f), provided any loan used to finance the replacement of the furnace is not secured by the furnace or the building. Other capital contributions do not include expenditures for land costs, operating deficit payments, credit adjuster payments, and payments for legal, syndication, and accounting costs. (6) Cash distributions—(i) In general. For purposes of paragraph (c)(2)(iv) of this section, the term cash distributions from (or available for distribution from) the building include— (A) All distributions from the building to the owners or to persons whose relationship to the owner is described in section 267(b) or section 707(b)(1)), including distributions under section 301 (relating to distributions by a corporation), section 731 (relating to distributions by a partnership), or section 1368 (relating to distributions by an S corporation); and (B) All cash and cash equivalents available for distribution at, or before, the time of sale, including, for example, reserve funds whether operating or replacement reserves, unless the reserve funds are legally required by mortgage restrictions, regulatory agreements, or third party contractual agreements to remain with the building following the sale. (ii) Excess proceeds. For purposes of paragraph (c)(6)(i) of this section,

wreier-aviles on DSK7SPTVN1PROD with RULES

proceeds from the refinancing of indebtedness or additional mortgages that are in excess of qualifying building costs are not considered cash available for distribution. (iii) Anti-abuse rule. The Commissioner will interpret and apply the rules in this paragraph (c)(6) as necessary and appropriate to prevent manipulation of the qualified contract amount. For example, cash distributions include payments to owners or persons whose relation to owners is described in section 267(b) or section 707(b) for any operating expenses in excess of amounts reasonable under the circumstances. (d) Administrative discretion and responsibilities of the Agency—(1) In general. An Agency may exercise administrative discretion in evaluating and acting upon an owner’s request to find a buyer to acquire the building. An Agency may establish reasonable requirements for written requests and may determine whether failure to follow one or more applicable requirements automatically prevents a purported written request from beginning the oneyear period described in section 42(h)(6)(I). If the one-year-period has already begun, the Agency may determine whether failure to follow one or more requirements suspends the running of that period. Examples of Agency administrative discretion include, but are not limited to, the following: (i) Concluding that the owner’s request lacks essential information and denying the request until such information is provided. (ii) Refusing to consider an owner’s representations without substantiating documentation verified with the Agency’s records. (iii) Determining how many, if any, subsequent requests to find a buyer may be submitted if the owner has previously submitted a request for a qualified contract and then rejected or failed to act upon a qualified contract presented by the Agency. (iv) Assessing and charging the owner certain administrative fees for the performance of services in obtaining a qualified contract (for example, real estate appraiser costs). (v) Requiring all appraisers involved in the qualified contract process to be State certified general appraisers that are acceptable to the Agency. (vi) Specifying other conditions applicable to the qualified contract consistent with section 42 and this section. (2) Actual offer. Upon receipt of a written request from the owner to find a person to acquire the building, the Agency must offer the building for sale

to the general public, based on reasonable efforts, at the determined qualified contract amount in order for the qualified contract to satisfy the requirements of this section unless the Agency has already identified a willing buyer who submitted a qualified contract to purchase the project. (3) Debarment of certain appraisers. Agencies shall not utilize any individual or organization as an appraiser if that individual or organization is currently on any list for active suspension or revocation for performing appraisals in any State or is listed on the Excluded Parties Lists System (EPLS) maintained by the General Services Administration for the United States Government found at www.epls.gov. (e) Effective date/applicability date. These regulations are applicable to owner requests to housing credit agencies on or after May 3, 2012 to obtain a qualified contract for the acquisition of a low-income housing credit building. PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT ■ Par. 3. The authority citation for part

602 continues to read as follows:

■ Par. 4. In § 602.101, paragraph (b) is

amended by adding an entry to the table in numerical order to read, in part, as follows: *

OMB Control numbers.

• • (b) *

CFR part or section where identified and described

Current OMB control No.

• • • 1.42–18 .................................

• 1545–2088

Steven T. Miller, Deputy Commissioner for Services and Enforcement. Approved: April 24, 2012. Emily S. McMahon, Acting Assistant Secretary of the Treasury (Tax Policy).

DEPARTMENT OF JUSTICE 28 CFR Part 0 [CIV Docket No. 152; AG Order No. 3330– 2012]

Authorization To Redelegate Settlement Authority for Claims Submitted Under the Federal Tort Claims Act

Agency: Department of Justice.

Action: Final rule.

Summary: The Department of Justice is

amending its internal organizational regulations to clarify the authority of the respective agency heads of the Bureau of Prisons, the Federal Prison Industries, the United States Marshals Service, the Drug Enforcement Administration, the Federal Bureau of Investigation, and the Bureau of Alcohol, Tobacco, Firearms, and Explosives to settle claims under the Federal Tort Claims Act.

Dates: This rule is effective June 4, 2012.

For Further Information Contact: Phyllis J. Pyles, Director, Torts Branch, Civil Division, Department of Justice, 1331 Pennsylvania Avenue NW., Washington, DC 20004; telephone: 202– 616–4400.

Background

Authority: 26 U.S.C. 7805.

§ 602.101

The Federal Tort Claims Act (FTCA), 28 U.S.C. 1346(b), 2671–2680, provides a remedy for injury or loss of property, or personal injury or death caused by the negligent or wrongful act or omission of any employee of the Government while acting within the scope of his office or employment, under circumstances where the United States, if a private person, would be liable to the claimant in accordance with the law of the place where the act or omission occurred. Prior to filing suit, a claimant must file an administrative tort claim with the appropriate agency. 28 U.S.C. 2675. Pursuant to 28 U.S.C. 2672, the head of each Federal agency or his designee, in accordance with regulations prescribed by the Attorney General, may consider, ascertain, adjust, determine, compromise, and settle FTCA claims. In the present organizational regulations of the Department of Justice, the Attorney General delegated his authority to settle FTCA claims for amounts of $50,000 or less to the Director of the Bureau of Prisons, the Commissioner of Federal Prison Industries, the Commissioner of the Immigration and Naturalization Service (INS), the Director of the United States